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Eurodollar Futures Pricing And The Forward Rate Market

Forward Rate Agreements (FRA)

A Forward Rate Agreement (FRA) is a forward contract on interest rates. While FRAs exist in most major currencies, the market is dominated by U.S. dollar contracts and is used mostly by money center banks.

An FRA is a cash-settled contract between two parties where the payout is linked to the future level of a designated interest rate, such as three-month LIBOR. The two parties agree on an interest rate to be paid on a hypothetical deposit that is to be initiated at a specific future date. The buyer of an FRA commits to pay interest on this hypothetical loan at a predetermined fixed rate and in return receive interest at the actual rate prevailing at the settlement date.

Example Trade

Assume that in December 2017, a June 2017 Eurodollar futures is priced at 99.10. This price reflects the market’s perception that by the June 2017 expiration, three-month LIBOR rates will be .90% (IMM Price convention= 100 – 99.10 = .90%). Eurodollars are really a forward-forward market and their prices are closely linked to the implied forward rates in the OTC market.

Eurodollars and FRAs

Just as stock index futures reflect the cash S&P 500 market and soybean futures reflect the spot soybean market, Eurodollar futures should price at levels that reflect rates or implied rates in the FRA market. In addition, Eurodollar futures prices directly reflect, and are a mirror of, the yield curve. This is intuitive if one considers that a Eurodollar futures contract represents a three-month investment entered into N days in the future. Certainly, if Eurodollar futures did not reflect IFRs, an arbitrage opportunity would present itself.

Example

Consider the following interest rate structure in the Eurodollar (Euro) futures and cash markets. Assume that it is now December. Which is the better investment for the next six months:

Invest for six months at 0.80%;
Invest for three months at 0.70% and buy March Euro futures at 99.10 (0.90%); or
Invest for nine months at 0.90% and sell June Euro futures at 98.96 (1.04%)?

Assume that these investments have terms of 90- days (0.25 years), 180-days (0.50 years) or 270- days (0.75 years).

March Euro Futures 98.10 (0.90%)

June Euro Futures 98.96 (1.04%)

Three-month Investment 0.70%

Six-month Investment 0.80%

Nine-month Investment 0.90%

The return on the first investment option is simply the spot six-month rate of 0.800%. The second investment option implies that you invest at 0.700% for the first three months and lock in a rate of 0.900% by buying March Eurodollar futures covering the subsequent three-month period. This implies a return of 0.800% over the entire six-month period.

The third alternative means that you invest for the next 270 days at 0.90% and sell June Eurodollar futures at 1.04%, effectively committing to sell the spot investment 180 days hence when it has 90 days until maturity. This implies a return of 0.83% over the next six-months.

The third alternative provides a slightly greater return of 0.83% than does the first or second investment options with returns at 0.80%.

Eurodollar futures prices reflect IFRs in the FRA market because of the possibility that market participants may pursue arbitrage opportunities when prices become misaligned. Thus, one might consider an arbitrage transaction by investing in the third option at 0.83% and funding that investment by borrowing outright at the term six-month rate of 0.80%. This implies a three basis point arbitrage profit.

Conclusions

This module demonstrates the close linkage of the FRA and Eurodollar futures market. These contracts allow a firm to replace floating interest rates with fixed interest rates or vice-versa. FRAs are customized contracts that can be obtained through investment banks. These banks hedge the risk of these products by using Eurodollar futures. In hedging the sale of a forward contract with futures, the marking to market feature of futures must be considered. As a result, the pricing of FRAs is very competitive and bid-ask spreads are very narrow as arbitrage opportunities keep prices in the two markets very closely aligned.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Understanding Eurodollar Strips

One of the key reasons the Eurodollar contract has become so liquid and successful is because of hedgers using the market to hedge against adverse interest rate fluctuations.

Because Eurodollar futures move inversely with interest rates, if you are concerned about rising rates, you can sell Eurodollar futures and if you are concerned about declining rates, you might buy Eurodollar futures.

Many loans are structured such that the rate floats periodically (i.e. the interest rate is reset quarterly) as a function of LIBOR plus a fixed premium. This introduces a periodic risk that rates may fluctuate before the time of each periodic loan reset date. Eurodollar futures may be used to address this possibility to the extent that they are listed on a quarterly basis extending 10 years out into the future.

Eurodollar Strip Example

There exist various strategies for hedging with Eurodollars involve stacking and stripping futures contracts as well as products called packs and bundles, which are packaged strips.

Assume that it is March 2017 and a corporation assumes a two-year bank loan repayable in March 2019 for $100 million. The loan rate is reset every three months at LIBOR plus a fixed premium. As such, the loan may be deconstructed into a series, or strip, of eight successively deferred three-month periods. Note: If the loan is secured currently, the effective rate may be fixed at the current rate for the first three months. Thus, there is no risk over the first three-month period between March and June 2017. However, the corporation remains exposed to the risk that rates advance by each of the seven subsequent loan rate reset dates.

Considering that the floating rate loan may be decomposed into seven successively deferred 90-day loans. The BPV associated with each of those seven loans equals $2,500.

BPV = $100,000,000 x (90÷360) x 0.01% = $2,500

The corporation might sell 100 Eurodollar futures in successive quarterly contract months to match the seven successive quarterly loan reset dates. Therefore, one might effectively hedge each of the seven loan periods independently. This transaction is often referred to as a strip hedge, or a series of short (or long) Eurodollar futures in successively deferred contract months to hedge the risk of rising (or declining) rates, respectively.

Reset Date	Action to Hedge Rate Reset
June 2017	Sell 100 Jun-17 futures
September 2017	Sell 100 Sep-17 futures
December 2017	Sell 100 Dec-17 futures
March 2018	Sell 100 Mar-18 futures
June 2018	Sell 100 Jun-18 futures
September 2018	Sell 100 Sep-18 futures
December 2018	Sell 100 Dec-18 futures

Conclusion

If rates climb higher over the term of the loan, the short Eurodollar futures contracts would be profitable as the futures decline as rates rise. The profit on the strip of Eurodollar futures would offset the increase borrowing costs effectively locking in a lower rate.

Corporate treasurers and bank asset liability mangers are particularly aware of fluctuations in interest rates as borrowing and lending rates directly influence profitability. They have many tools available to hedge their interest rate exposure and on the Eurodollar or LIBOR side of the business, there is no better instrument.

Indeed, the hedging community has embraced strip hedging so enthusiastically that CME Group has launched a variety of pre-packaged strips that are called packs and bundles.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Understanding Convexity Bias

To understand the convexity bias, you must understand the parallels between the Eurodollar futures market and the forward rate agreement (FRA) market. Both of these markets are large, liquid and have a vast influence on short-term interest rate pricing.

FRAs are an over the counter (OTC) bilateral agreement that allows the buyer/seller to notionally borrow/lend a specified amount at a LIBOR-based linked rate over a forward period.

What is Convexity Bias?

Convexity bias appears in short-term interest rate instruments because of the payoff differences in the futures market versus the OTC FRA market (aka forward market).

For example, as Eurodollar futures (the underlying interest rate for Eurodollar futures) moves up and down, the payoff for the Eurodollar futures contract remains the same. If rates move up one basis point, the futures will change by $25.00 per contract. If rates move down one basis point, futures will also change by $25.00 per contract. Whether you profit or book a loss depends on if you are long or short on the futures.

With FRA agreements there is a convex payoff. Increases and decreases in rates produce differing payoffs. Its market value rises more for a given decline in rates than it would for a decline for the same size in the forward rate.

As rates decrease 10 basis points from 2.00 to 1.90, notice the Eurodollar (ED) futures lose $250,000, but the FRA payoff is 250,062. The same thing happens for an increase in rates. ED futures gain $250,000 but the FRA loses $62.00 less.

Remember ED futures move inversely with interest rates.

The table shows the convexity bias between a position of short 1000 Eurodollar (ED) futures and an offsetting short $1005m 3-month FRA (slightly more than $1000m to compensate for discounting methodology), both instigated at a rate of 2%.

An increase in underlying rates from 2% to 2.10% would result in a credit to the variation margin account of short 1000 ED STIR position of $250,000 and a debit of slightly less than that in the discounted equivalent of $1005m-3M FRA collateral account (assuming zero threshold – zero threshold means every dollar of value change has to be made good.).
A decrease in underlying rates of 10 basis points to 1.9% would result in a debit to the variation margin account of a short 1000 ED STIR position of $250,000 and a credit of slightly more than in the $1005m 3-month FRA collateral account (assuming zero threshold).

Source: STIR Futures—Trading Euribor and Eurodollar futures, by Stephen Aikin

The amount of the convexity is small at the short end of the curve. The example is using a three-month FRA and Eurodollar futures. Further out on the curve the convexity increases and sometimes dramatically.

Why is Convexity Important?

Although changes in the market have diminished the convexity phenomenon, fixed income traders have to be aware of the bias because of the effects on larger OTC transactions, like FRAs, that are further out on the yield curve. While the change might only be a few hundred dollars on a short term FRA, the changes in a 5-year FRA could be orders of magnitude higher, costing portfolio managers valuable capital.

Still the Eurodollar futures markets and the underlying FRA market closely track each other as spreading and arbitrage opportunities keep them from getting too far out of line.

What Contributes to Convexity Bias?

It is thought that the Convexity bias is due to the following:

The way Eurodollar futures are margined versus an FRA instrument
The cash flows paid out over the life of a futures contract versus an FRA. Futures are marked-to-market each day by the clearinghouse, while cash flows in an FRA are paid off differently.
Volatility in the interest rate markets, generally increasing volatility could cause margin changes.

Final Considerations

Over the years since the financial crisis, the convexity bias has significantly declined. Since many OTC swaps/FRAs etc. have migrated to central counterparty clearing models such as the exchanges, the margining similarities have contributed to a decline in the convexity bias.

Uncleared margin rules also have impacted funding on OTC trading such as swaps and forward rate agreements. Higher funding rates should, in theory, drive such transactions to the exchanges, such as CME Group, where margin benefits and margin offsets can be realized.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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The Importance of Basis Point Value (BPV)

A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument.

One basis point is equivalent to 0.01% (1/100 of a percent) or 0.0001 in decimal form. If interest rates rose from 2.00% to 2.50%, it would be said that rates rose 50 basis points. In many cases, basis point refers to changes in short-term interest rates, such as Eurodollars, but it is also important with longer-term bond yields.

Basis Point Value, also known as DV01 (the dollar value of a one basis point move) represents the change in the value of an asset due to a 0.01% change in the yield.

BPV or DV01 calculations are used in many ways, but primarily to show the dollar amount of change for each increase or decrease in interest rates. If the value of the Eurodollar futures contract moves by one basis point (.01%), it would equate into a $25.00 move in the contract value. If Eurodollar futures moved four basis points or .04%, it would equate to a $100 move in the value of the contract.

Show graphic calculating this BPV or DV01 for Eurodollars:

Basis Point Value Calculation

The face value of the Eurodollar futures contract is $ 1,000,000. The futures track three-month Eurodollar rates (three-month LIBOR) hence we use 90 days in the equation, and .01% in decimal form is .0001.

Basis Point Value (BPV) = Face Value x (#days ÷ 360) x .01%

BPV = 1,000,000 x (90 ÷ 360) x .0001

BPV = $25.00

Example

This example shows Eurodollars in terms of the IMM Price index. Assume Eurodollar interest rates rose from 1.00% to 1.05%, this would represent a .05% or five basis point rise in Eurodollar interest rates. But remember from the prior modules that Eurodollar futures are priced off the IMM price index.

IMM price index = 100 – Eurodollar rate (or three month LIBOR)

In the example above, Eurodollars were at 1.00%. The IMM price index, therefore, would be 100 – 1.00 = 99.00. Subsequently, interest rates rose to 1.05%. The IMM price index at that point would be 100 – 1.05 = 98.95.

As you can see, interest rate prices move inversely with interest rate yields. As rates rose five basis points, the Eurodollar IMM price index declined from 99.00 to 98.95.

To find out how much that means in terms of dollar value, we have to convert basis point movement into dollar movement. This requires knowing the DV01 (dollar Value of a .01 move)

The basis point value in Eurodollar futures from our calculation above is $25.00. Therefore, a five basis point move equates to $125.00

5 basis points x $25.00/basis point = $125.00.

Basis Points and Tick Size in Eurodollar Futures

The minimum allowable price fluctuation, or tick size, is generally established at ½ basis point., or .005%. Based on a million-dollar face value 90-day instrument, this equates to $12.50. However, in the nearby expiring contract month, the minimum price fluctuation is set at 1/4 basis point, or .0025%, equating to $6.25 per contract.

Nearby Expiring Contract:

One Tick (.0025 basis pts) = $6.25

Tick Movement	Quote
Starting price	99.0000
Increased one tick (.0025 basis points)	99.0025
Increased two ticks (.0050 basis points)	99.0050
Increased three ticks (.0075 basis points)	99.0075

All Other Expiring Contracts:

One Tick (.005 basis pts) = $12.50

Tick Movement	Quote
Starting price	99.000
Increased one tick (.005 basis points)	99.005
Increased two ticks (.010 basis points)	99.010
Increased three ticks (.015 basis points)	99.015

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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What is the Eurodollar Settlement Process (cash settled)

What is the Eurodollar Settlement Process?

Some futures contracts are cash-settled, others are settled via physical delivery.

Soybeans, for example, are physically-delivered as part of the contract terms. They settle with the exchange of actual physical soybeans or cash soybeans between buyer and seller.

Eurodollar futures however, are cash-settled. Buyers and sellers of Eurodollar futures contracts that hold their contracts through final settlement will be credited the difference, in cash, between what they paid for the contract and what they sold the contract at, if there is a profit. If there is a loss, their account will be debited cash.

It is CME Clearing, in conjunction with the FCMs (Futures commission merchant or broker), that makes sure trader accounts are debited and credited accordingly and that cash settlements are made in a timely and accurate fashion.

Eurodollar Settlement Process

Assume that in March, a trader bought March Eurodollar futures at a price of 98.75 when three-month LIBOR was trading at about 1.25 (using the IMM price quotation convention the Eurodollar futures price would be 98.75 (100.00 – 1.25 = 98.75).

The trader decides to hold onto the futures contract until the final settlement day (usually the third Monday of the expiration month). The final settlement is determined using the IMM price quote convention.

Final Settlement of an expiring contract shall be 100 minus the three-month Eurodollar interbank time deposit rate, determined by the ICE LIBOR setting administered by ICE Benchmark Administration Ltd, as first released on the second London bank business day immediately preceding the third Wednesday of the contract delivery month.

3 month LIBOR rate	Eurodollar IMM price quote
1.00	99.00
1.25	98.75
2.50	97.50
3.15	96.85

Returning to our example, the three-month Eurodollar interbank time deposit rate according to the ICE LIBOR setting is 1.19. The final settlement is arrived at by subtracting the ICE LIBOR setting from 100.00.

100.00 – 1.19 = 98.81 = the final settlement price of the March Eurodollar settlement.

If the trader originally bought the futures at 98.750, and they settled at 98.810, the trader would make 12 ticks profit (a tick = .005 price points). Each tick is worth $12.50. So, the trader profits by $150.00 per contract.

The clearinghouse, working through the trader’s broker, will credit his account with $150.00 cash. And the losing side of the trade will have $150 cash debited from his account to finalize the cash settlement process.

Regards,
Peter Knight Advisor

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Understanding Intermarket Spreads: Platinum and Gold

Spread trading is a widely-used trading strategy in futures markets and offers some key advantages over outright futures trading (i.e., going long or short a single futures contract), including capital efficiencies with lower margin outlay and potentially superior risk-adjusted returns. This is particularly true for precious metals markets, where the underlying commodities demonstrate strong correlations with each other due to close economic links, but also distinct fundamental drivers that can create profitable spreading opportunities using the associated futures contracts.

Creating a Futures Spread

A spread trade using futures is created by buying a futures contract and simultaneously selling another futures contract against it. The spread acts as a hedging transaction, altering your exposure from an outright price fluctuation to the price differential between the individual legs of the spread trade. The profitability of a futures spread trade depends on the price direction, or differences in price movement, for the legs of the strategy.

Spread trades may be executed across many markets, but traders often look at similar contracts, or related markets, for spread trading opportunities. A closer relationship between the spread markets means the individual legs are more likely to move in tandem, enabling relatively stable price changes governed primarily by the pace of price moves between the legs (i.e., the relative performance of the legs), thereby reducing the level of risk for the trader. These strategies are referred to as relative value strategies.

Types of Spreads

Spreads may be broadly classified as intra-market spreads and inter-market spreads.

Intra-market spreads, also known as calendar spreads, are where a trader opens a long or short position in one contract month and then opens an opposite position in another contract month for the same futures market. Given the popularity of these spread trades, as well as their contribution to futures rollover activity, dedicated calendar spread markets are available on the CME Direct platform, which allows spread execution with no legging risk.

Inter-market spreads involve two separate, but related, futures markets with legs of the same maturity time frames. Inter-market spread strategies may have legging risk, but can be mitigated by using dedicated inter-market spread contracts or by selecting liquid underlying contracts for each leg in conjunction with using the auto-spreading functionality offered by some software vendor trading screens.

Benefits of Spread Trading

The main advantages of spread trading are reduced volatility and lower margin requirements, as the legs are generally in related markets at the same exchange.

Compared to outright futures, which can exhibit significant price swings, spreads can demonstrate extended trending price moves, making it easier for you to visualize patterns and take a directional view or implement a technical trading strategy.

Spread Trading with Precious Metals

The precious metals complex includes gold, silver, platinum and palladium contracts and offers trading opportunities to a global market through a wide variety of instruments. These markets not only provide highly correlated commodities, but also with unique price drivers that can create many attractive spread trading opportunities.

While you can choose from the range of instruments available for trade execution once you have identified your preferred strategies, the Precious Metals futures markets at CME Group offers highly liquid and deep markets that enable the fast, efficient execution of spread strategies, with the additional benefits of considerable margin savings (as all trades are centrally cleared through CME Clearing) and much alleviated legging risk.

More importantly, these futures contracts are predominantly electronically traded (over 90%) on CME Globex, which allows easy access for participants across the world and high-quality trade executions virtually 24 hours a day.

Gold-Platinum Spread Trade

Platinum is both a precious and industrial metal, widely used in catalytic converters in the automotive industry but also in jewelry and as an investment asset.

The price relationship and the price spread between gold and platinum may be useful as an indicator of shifts in the macro environment. Historically, platinum has been more expensive than gold since the white metal is about 15 times rarer than gold and has many industrial uses compared to the yellow metal. However, gold can become pricier during times of economic distress and political uncertainty when the yellow metal sees increased demand as a safe-haven asset. Conversely, during a positive economic cycle with increasing automobile sales, platinum’s premium over gold prices can rise even further as the metal will see increased industrial use. Since 2015 Gold has been trading at a premium to Platinum and the spread has been widening.

Platinum-Gold Price Spread (in U.S. dollars per troy ounce) Chart based on NYMEX Platinum and COMEX Gold Futures Prices

CME Group offers one of the most liquid Platinum futures, making it a convenient instrument to manage risk and instantly capture trading opportunities, such as the platinum-gold price spread strategy.

Platinum-Gold Spread Profit and Loss Example

On March 2, a trader expects platinum demand to increase in the short term due to higher car sales and the platinum-gold spread to narrow. The trader buys two April Platinum futures contracts at $988.40/oz and simultaneously sells one April Gold futures contract at $1,231.90/oz (the Platinum contract is half the size, 50 oz, of the 100-oz Gold contract).

The resulting notional amounts for the legs are $98,840 and $123,190, respectively. The trader has thus entered the spread trade at -$243.50 and is long the spread.

The tables below show the trader’s realized profit and loss (P&L) as negative spread, narrowed as both Gold and Platinum increased, but at different rates.

Platinum-Gold (negative) spread narrows when position is closed by selling two Platinum April contracts and buying one Gold April contract simultaneously on March 30.

	Platinum April	Notional Amt	Gold April	Notional Amt	Spread
Trade Enter Prices	Buy $988.40	$98,840	Sell $1,231.90	$123,190	($243.50)
Trade Exit Prices	Sell $1,056.40	$105,640	Buy $1244.20	$124,420	($187.80)

Strategy Leg P&L		$6,800		-$1,230

Total P&L			$5,570

Margin Offsets

One of the benefits of spread trading with futures is the reduced cost of margin, otherwise known as margin offset. Margin discounts can occur when CME Clearing scans the trader’s portfolio of futures positions looking for offsets.

In our example, we had a long Platinum position and a short Gold position. This spread position would have been identified as an offset and therefore would require less margin than the two outright positions.

Platinum-Palladium Spread Trade

Palladium, like platinum, is also a precious metal widely used in the automobile industry as an auto catalyst. The difference being palladium is predominantly used in petrol-engine vehicles, whilst platinum is used in diesel-engine vehicles. In the recent past, platinum has traded at a premium to palladium, but as the chart below illustrates, the premium has narrowed. The spread may cross, but the last time this happened was approximately 20 years ago. Traders can express a view on the platinum-palladium spread through trading individual outright futures contracts in a spread strategy like the ones demonstrated above.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Supply and Demand: Ferrous Metals

Ferrous metals, metals that contain iron, are distinct from both precious and base metals. They include raw materials like iron ore and steel scrap as well as semi-finished products such as hot rolled coil.

Iron Ore

Iron Ore is found in the earth’s crust and mined from open pits. China is the world’s largest producer, consumer and importer of iron ore, producing 1.3 billion metric tonnes, equivalent to 44% of the world’s output. Australia is the second-largest producer of iron ore and has the world’s largest deposits. Chinese iron ore deposits are of lower iron content than those typically found in Australia and Brazil.

Iron ore is the key ingredient in the steel making process using the blast furnace. The earliest blast furnaces date back to first century in China. In a blast furnace, which is lined with refractory brick, iron ore, coke and limestone are heated to produce liquid iron. Once a blast furnace is started, it will continuously run for years, with only short stops for planned maintenance. The temperature in a blast furnace can reach up to 4200 °F (2300 °C).

Steel is also produced via an Electric Arc Furnace (EAF) using steel scrap. About one-third of the world’s crude steel is made in an EAF. In an EAF, the scrap metal is charged using graphite electrodes to heat the metal. The temperature reaches 6300ºF (3500ºC). In the U.S., steel is typically produced using EAFs rather than blast furnaces.

Steel production using EAFs compared with primary steel production using a blast furnace has some benefits including the ability to use 100% recycled scrap feedstock, thereby being less energy-intensive and the flexibility to start and stop production being more responsive to changes in demand.

Iron Ore Market Fundamentals

Iron ore supply has been increasing over the last 10 years in response to China’s industrialization during the commodity super cycle. To meet China’s demand for iron ore, which is the key ingredient in steel making which is required for construction and white goods, world supply from iron ore mines increased.

This had an impact on the way iron ore was priced. In the decades between the 1960s and the millennium, iron ore prices were stable with plentiful supply. But China’s demand for iron ore caused prices to rise, and miners and steel makers who had traditionally agreed on annual prices following long negotiations, moved to quarterly prices in 2010 and then eventually spot pricing.

Iron ore is transported via ocean freight on capsize vessels. Some of these very large ore carriers have a deadweight capacity of 400,000 metric tonnes.

Steel

Steel scrap is collected from recyclable materials left over from product manufacturing and consumption. Scrap collection and supply is responsive to changes in price.

Steel Production

China is the world’s largest steel-producing country representing over half of all crude steel. In 2015 it produced 50.3% of the world’s 1,599.5 million metric tonnes. Japan (105.15 million metric tonnes), India (89.58 million metric tonnes), the United States (78.92 million metric tonnes) and Russia (71.11 million metric tonnes) make up the top five steel producing countries.

Steel Demand

Different types of steel are produced according to the properties required for their application, such as density, strength, thermal conductivity and elasticity. They are broadly categorized into carbon steels, alloy steels, stainless steels and tool steels. Steel is used in construction of bridges, roads, railways and buildings. It is also used in the white goods sector, which includes large electrical goods such as refrigerators and washing machines, named such because they are typically white in color.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Base Metals Supply and Demand

Copper Production

Copper ore is found in the earth’s crust and is either mined from open pits or underground. Most of the world’s copper ore originates from Chile (approximately 30%). The Escondida copper mine in northern Chile is the world’s largest copper mine by reserve. In 2012, it had 32 million metric tons in copper reserves.

Copper ore is processed by breaking the rocks into smaller pieces and is turned into copper concentrates through the process of beneficiation. Then, through the smelting process, copper is extracted from the ore. Once copper is extracted from the smelter, it is melted and cast as anodes. High-purity copper cathodes are created from anodes in the final step of the process.

Copper is a commodity and, if meeting all specifications, can be delivered into exchange-approved warehouses.

Copper Market Fundamentals

Copper supply has increased over the last 10 years in response to China’s industrialization during the commodity “super cycle.” To meet China’s demand, world supply from copper mines doubled over the period 1994-2014. Copper’s price performance is well-linked to the performance of the Chinese economy.

Mining companies have been cutting costs since 2003, and with any fall in demand, cutting the cost of production has been a way to maintain profitability. The collapse of oil prices from $115 per barrel in June 2014 to under $35 in February 2016 also reduced the price of copper because mining and refining are energy-intensive. The currencies of copper-producing countries have fallen, down 10.4% in 2014 from 2013, and down by 13.4% in 2015 from 2014 (USGS, Bloomberg, CME Group). This would have reduced labor costs.

Copper is widely used in both industrial and commercial markets, from electronics and plumbing to power generation, and is viewed as a reliable indicator of economic health. Copper is often referred to as Dr. Copper because of its ability to predict turning points in the global economy.

Other factors that positively impact copper demand are government-backed copper, intensive power infrastructure, home appliance subsidy schemes, and promotion of electric vehicles. The growth in urban population with higher disposable incomes increases demand for buildings, home appliances and consumer electronics.

Aluminum Production

China is the world’s largest aluminum producer, representing 54% of the world’s 58 million metric ton production in 2016, based on International Aluminium Institute data.

Aluminum is produced through the electrolysis of bauxite (aluminum ore). Australia is the number one bauxite producer, followed by China and Brazil. Bauxite is mined, crushed and processed to remove silicon impurities.

Alumina, the common name for aluminum oxide, is extracted from bauxite. Alumina is extracted through aluminum smelting by the Hall-Héroult electrolysis process. This requires a great deal of energy and smelters are often located near hydro-electric power plants. Primary aluminum is then cast into ingots or used in alloys.

Aluminum is a commodity and, if meeting all specifications, can be delivered into exchange-approved warehouses.

Aluminum Market Fundamentals

The production of aluminum has shifted to China over the last 15 years. During this period, demand increased ninefold.

China is therefore both a producer and consumer of aluminum. Currently, there is an over-supply of global aluminum, which has put global prices under pressure.

The production of aluminum requires tremendous amounts of electricity. Many smelters in China connect directly to the electrical grid and provide a baseline power demand for underserviced regions in the country. In China, aluminum production serves more than one purpose; it provides the metal for the domestic market, powers communities and provides jobs and economic growth for many municipalities.

The cost of production in China was around $1550/mt and at the start of 2016 and 35% of producers operated at a loss.

Regional differences in aluminum markets are clear when you compare China to the U.S., which is currently in a structural deficit. Aluminum producers have fared better than copper producers because they have cut production and reduced inefficiencies in response to the lower prices and high stockpiles. Demand for automotive vehicles, which are increasingly aluminum intensive, power transmission investment, housing development and electrical appliances create aluminum demand.

In the U.S., the substitution of aluminum for steel in car manufacturing, such as Ford’s F-150 model, will be positive for demand. Whereas the fall in consumption of carbonated soda drinks, the largest share of demand for can sheet in North America, will weigh on the aluminum demand.

If you have questions send us a message or schedule an online review .

Regards,
Peter Knight Advisor

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Introduction to Base Metals