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Plunging prices have brought this once mighty market to its knees. But a few OTC dealers have managed to prosper despite the carnage.

The late 1990s may be the go-go years of the U.S. and European equity markets, but they are lean times indeed for the metals business. While the Dow Jones Industrial Average returned to record territory by late 1998, metals prices skulked about at multiyear lows. Gold prices have fallen 36 percent since a 1996 peak, while, according to a base metals index compiled by Flemings Global Mining Group, base metals prices have fallen a staggering 43 percent since mid-1996.

Any first-year economics student knows that the price of a commodity is a function of supply and demand. It has become painfully clear to metals mavens that demand—by traders, investors and, in certain cases, metal consumers—is flat-lining.

At the New York Mercantile Exchange, January–October 1998 gold volume totaled 7.7 million contracts, compared with 8.1 million contracts in the same period in 1997. For silver, the news was even worse—3.5 million contracts were traded in the first 10 months of 1998, compared with 4 million in 1997. The London Metals Exchange has been mired in a similar malaise—volume on its base metals contracts through November 1998 was off nearly 8 percent from the same period in 1997.

The result? A mad scramble for traders, brokers and dealers to stay afloat. A spate of mergers and acquisitions last year signaled that retrenchment is now the name of the game in the metals business. Last April, London-based ED&F Man acquired Gerald Metals; in November 1998 Billiton Metals announced it was being acquired by German metals monolith Metallgesellschaft, while the South Korean firm LG Metals invited a handful of Asian and European metals and trading companies to invest in it—in effect begging to be taken over. The LME’s Category I trading members—the biggest market-making players at the exchange—will shrink to 14 firms once the Billiton acquisition is finalized, down from 16 in 1996. And dealers are feeling the pinch as well: last November, Merrill Lynch, a long-time over-the-counter metals player, announced it was closing its OTC base and precious metals operations.

“Exchange and brokerage revenues are off significantly, particularly in precious metals,” says Bill Byers, senior managing director in Bear Stearns’ futures department. “People who counted on that as a business, if they’re still around, are probably making a lot less money than they used to.” Others are equally somber. “These are tough times,” says a New York dealer. “For most, it’s a matter of survival.”

George Gero, senior vice president of investments at Prudential Securities and chairman of the New York Commodity Floor Brokers and Traders Association, agrees. “Everything is pretty much sick,” he says. “I’d love to be wildly bullish and say, for instance, that precious metals are a screaming buy. Unfortunately, conditions have changed—the culture of the business has changed.”

One result of flagging investment demand and industry retrenchment is a smaller universe of active metals traders. Hedge funds have become driving forces in certain metals markets. “A few well-known hedge funds have been extremely active, especially at the short end,” says John Tyree, an account executive at Fimat in New York. “The funds that have taken short positions have done well.” Another trader agrees: “The smaller investor audience has left the metals market in large institutional hands. John Henry, Tudor Investment, George Soros—the usual suspects. If they’re not there today, they’re there tomorrow or the day after. All they need is an event. Metals have now become almost totally event-driven, so when you have an event, investment demand flows into or out of the market.”

The U.S. metals market in particular is suffering from this increasingly oligarchic structure. Smaller investors who were active in the markets in the robust 1970s and 1980s have steered clear of metals in recent years, because of bearish market conditions and a growing variety of other, more attractive derivative and cash investment vehicles. In an increasingly technological and sophisticated financial world, investing in metals is viewed by some as anachronistic—and even archaic.

But while the U.S. metals audience dwindles, pockets of demand still exist. “In India or Pakistan, when there is an economic problem, they turn to silver—they’re basically silver hoarders,” says a Nymex trader. “The gold hoarders are in the Middle East, and they always have some sort of barrels-per-ounce-of-gold mentality. But in the United States, which hasn’t had a history like the Swiss of forever being involved in gold, investors view precious metals as just another trading situation.”

“I’d love to be wildly bullish and say that precious metals are a screaming buy. Unfortunately, conditions have changed.”
George Gero
Prudential Securities

Another problem affecting the U.S. metals business is the currency market. Many foreign traders are unwilling to buy and sell dollars in order to trade metals in the United States, because the dollar has fluctuated greatly against the yen and other currencies. While foreign traders may be right in their market hunches, they could lose all their gains in the dollar fluctuation. “In the last two years,” says Gero, “the Tokyo Commodity Exchange has had something on the order of 10-fold volume in open interest over that of Nymex. For example, you often see a 300,000 open interest between platinum and palladium in Tokyo, and a 15,000 open interest in New York, even though it’s one-third the contract size. Tokyo trades 10,000 or 20,000 contracts a day. We barely trade a couple thousand. Some of that is a result of the U.S. dollar margin risk for Tokyo.”

The metals trading business as a whole is likely to continue its sinking trajectory throughout the rest of the year. Rudolf Wolff, the commodity trading subsidiary of Canada-based Northern, a natural resources group, predicts that the year 2000 problem will increase metals volatility later this year, and will likely cause a global recession next year, dragging metals markets even further down. Many traders agree that the outlook is bleak. “I don’t see any reason for any speculative interest in precious metals,” says Bear Stearns’ Byers. “The only thing that would change that would be some type of global inflationary pressure, and, looking at commodity prices, I don’t see any building pressure. It’s unfortunate, because we already have oil at a 25-year low. You never want to be bearish at the bottom, but I don’t see anything on the horizon to make it any better.”

Opportunity knocks

The outlook may be dismal to traders, dealers and brokers alike, but that doesn’t mean there are not opportunities out there for savvy players. “The markets are certainly sufficiently liquid for speculative purposes,” says Philip Gotthelf, publisher of the Commodex system, a daily futures trading model, and author of The New Precious Metals Market: How the Changes in Fundamentals Are Creating Extraordinary Profit Opportunities, “and they’re certainly liquid enough for industrial hedge programs.”

Gotthelf believes that even the darkest metals clouds have silver linings. “There have been huge opportunities missed over the last several years,” he says. “When Warren Buffett took a brief cornering of the silver market early last year, for example, anyone with half a brain who has been involved in futures could see that he was squeezing the March 1998 contract but selling his silver into the July 1998 contract, which is a standard manipulative play. This pushed the price up above $7 as March was approaching, and then Buffett allowed the delivery of the March contract, which capped at just under $7.50. He made huge profits on the backs of unwitting traders who didn’t understand how to play the game.”

Another Nymex gold and silver trader agrees. “If you had rolled down the silver calls from $7.50 all the way to $5 from the time that Buffett was playing his game to the present, you would probably have made more than 150 percent on your money. Why isn’t that talked about? Because people like Buffett and Soros don’t want you to know. They’re having a great time in the metals market, and they’re keeping their mouths shut.”

Gotthelf notes that there were other metals opportunities last year as well. “There was a massive opportunity in the long palladium/short platinum spread for anybody who was following the markets, as well as straight long palladium. There continues to be profit opportunity in palladium, and potentially an opportunity in platinum. And there was a great opportunity in the platinum-gold spread. These are all high-potential, reasonable-exposure speculations in futures and options.”

He also sees opportunities for corporates and some hedge fund managers who hold massive amounts of bullion. “If you’re holding, say, a million ounces of silver, I would recommend selling call options against your inventory—covered calls—which will yield reasonable returns in the form of premium on a per-ounce basis. If you look at these covered calls historically, they’ve yielded anywhere from 0.75 percent to 1.5 percent per quarter. So you’re getting a yield better than that of Treasury bills, and you’re still holding the metal.”

The metals malaise is far-reaching, encompassing not only metals producers, brokers and traders but OTC dealers and project financiers as well. “Debt lenders are pointing to deteriorating debt-carrying capacity and correspondingly higher debt/equity ratios,” says Alexander Mintcheff, managing director of global commodities at Chase Manhattan. “As a result, conventional bullion bank financing terms are now much more restrictive to borrowers—and with fewer financing opportunities, some lenders have exited the business or scaled back operations.” Merrill’s decision to scale back OTC metals operations is but one example of this trend, and many lenders are now insisting that borrowers include hedging structures into their financing deals to protect against further price erosions.

With lending and production levels scaled back, many metals consumers believe prices will rise at some point in the future. Historically, consumers have been reluctant to hedge their production costs beyond a year or two because of the vicissitudes of the metals business. But with prices at multiyear lows, some consumers have begun locking in their production costs in the longer term via hedging. General Motors is reportedly negotiating a 10-year aluminum contract with one or more producers—a deal unthinkable a few years ago.

As a result of both these developments, OTC business has picked up for some dealers. “The trend over the last two or three years has been that the OTC market has developed quite rapidly,” says a New York dealer. “We’ve seen a lot more sizable deals being done, and longer-tenored deals as well.”

“There have been huge opportunities missed. [Warren Buffett] made huge profits on the backs of unwitting traders who didn’t understand how to play the game.”
Philip Gotthelf

The task of pitching to producers the benefits of hedging, of course, has always been difficult, and the current depressed environment hasn’t made things easier. Producers are generally wary of giving up even a modicum of upside participation for downside protection. Moreover, equity investors in mining firms often rail against hedging, because their stock investments are de facto metals market plays. But as the 1996 Sumitomo episode proved, metals hedging can be quite profitable. Copper producers who locked in hedges at 1996 prices—which, even though in backwardation, were within shouting distance of the $1.40 a pound spot price—have made out like proverbial bandits. Many quickly made dividend payments to happy shareholders.

The LME Digs In
Everyone knows the base metals market is in the tank. But while brokers and dealers soldier on, hoping to hang on long enough to ride out the tough times, the London Metals Exchange is beefing up staff and developing new products with an astonishing degree of aggressiveness.

It’s important to remember that, while 1998 was by all accounts a terrible year for metals, with LME volumes declining by about 8 percent from October 1997 to October 1998, 1997 was a record year for the exchange. “In 1997 there was a 21 percent increase in trading volume from 1996,” says Michael Gardner, head of marketing in the LME division of GNI. “So although we’ve had a bit of pullback in activity recently, volume-wise it’s not that bad.”

While 1998 may have been a bit bumpy, the LME is bullish about the future. So much so, in fact, that in the past 18 months it increased its staff from 45 to 70. More important to traders, it has improved its regulatory regime, rearranged its management structure and beefed up its market transparency.

Now, it’s busy developing a new index product that will cover all of its base metals. “The benefit for us would be that brokers wanting to sell would be in a position of wanting to hedge their risk in the underlying market, and would therefore improve liquidity throughout the whole of our contracts,” says Jonathan Haslam, director of corporate affairs at the exchange. The exchange is also developing along with the London Clearing House an electronic warrant transfer system called Sword, which it hopes will improve efficiency and security.

Haslam is absolutely delighted with the LME’s market position. “We’re still an enormously liquid market,” he says. “We’ve got probably 90 percent to 95 percent of the world’s nonferrous base metals business. We’ve got only some competition in copper from Nymex and a tiny bit in aluminum from Tokyo. We’re acknowledged as the leader in setting the world reference price for our metals. While we’re in an extremely strong position, we’re not complacent about that position. Hence our desire to look into new products.”


“Hedging is a prudent risk management tool,” says Ian McDonald of MKS Finance, a Geneva-based OTC metals boutique. “We’ve been in a bear market in precious metals since 1980. The opportunity costs are enormous if you don’t hedge. The argument for hedging is almost overwhelming at this point.”

In fact, according to a 1997 study published by Chase, gold miners who had hedged their exposures in the previous five years would have been in the money 96 percent of the time. Gold is a particularly attractive hedging candidate, since its forward pricing curve is extremely contango. Selling puts to monetize the contango curve, says a New York dealer, can be quite profitable.

Citibank, for one, has been active on the metals hedging front. “The business has had excellent growth for the last three or four years,” says Chris Fehon, global head of commodities at Citibank. “Certainly from our point of view, it’s a business our global client base values, and we’ve put more and more emphasis on it as a result. That has proved quite beneficial. Our customers are happy with the results we’ve achieved with the resources we’ve put against it, and we’re continuing to grow the business.”

The key to success in the OTC metals business is size. As metals market dealers consolidate, four firms are poised to dominate for the foreseeable future: Morgan Stanley, Goldman Sachs, Citibank and Chase. All are active in the area that many believe represents the next phase in the development of the OTC metals market: lending institutions becoming intermediaries between metals producers and investors via securitization. “As investors meet borrowers,” says Alexander Mintcheff, “a new generation of derivatives is being created to protect cash flows and to match future production and the specific risk profile of the client. But retrofitting these cash flows to meet investor requirements is now a growing part of the equation. For example, debt investors in gold companies are attracted to cash flows and will, therefore, require more hedging from producers in the form of swaps and forwards. Equity investors, on the other hand, will require a larger proportion of puts or convertible puts. Regardless, the trick is to link more closely debt payment costs with revenue generation while establishing for investors cash-flow certainty and cash-flow generation on day one.”

Mintcheff predicts four major developments in the OTC metals market: more emphasis on risk-reducing derivatives that protect declining producer margins; a greater focus on integrated hedges, including local currencies, revenues generated from other metals, currency, interest rates and energy costs; more derivative mechanisms to monetize unrealized contract gains in hedging as long as metals prices remain low; and dealers writing longer-tenored swaps, caps and floors. While these may succeed in strengthening the foundations of the OTC business, pickings will likely remain slim until metals prices rise. Most dealers aren’t holding their breaths waiting for that to occur.

Surveying the Metals Market
Metals markets, of course, do not march in lockstep. Although a few metals have fared reasonably well of late, gold cannot be counted among the success stories. In fact, its recent history has taken it from the sublime to the ridiculous to the pathetic. Gold prices fell to an 18-year low last year—and have been sinking like a gold brick since 1996. Moreover, last December open interest in Nymex gold contracts sank to 1995 levels, worrying traders that decreasing liquidity made the market more susceptible to manipulation.

Much of the recent troubles can be traced to weak demand in Asia—particularly in Japan, where gold demand decreased by 40 percent in the first quarter of 1998 as the country slipped into recession. As a result, according to the World Gold Council, production will increase by a paltry 1 percent per year for the next four years, down from a 5 percent annual growth rate in the 1980s. As recently as late 1997, miners predicted that gold production would rise by 3.6 percent through 2001.

But the gold market has structural problems that extend far deeper than cyclical fluctuations in consumer demand. Improvements in production techniques, such as heat bleaching, have made gold extraction cheaper and more efficient. Moreover, gold has lost most of its status as a universal store of value. Free-flowing international capital markets and the advent of financial derivatives have drastically reduced the need to hedge against inflation—or protect against political instability—with gold. And since central banks from the United States to Western Europe have become unprecedentedly adept at controlling inflation in the last two decades, gold hedging has virtually dried up.

The Maastricht Treaty, which serves as the basis for European economic and monetary union, specifically omitted gold as a reserve asset, and EMU countries are expected to hold only 10 percent to 20 percent of their assets in gold. The rest, of course, will be sold. Moreover, central banks in non-EMU countries such as Switzerland, Argentina and the Czech Republic began dumping gold in 1997. The demonetization of gold is in full swing.

There are generational forces at work as well. “Generation X has had a major impact on gold, because they are not familiar with its historical significance,” says Philip Gotthelf of Commodex. “They are out of touch with it from a personal perspective and don’t understand its values. They aren’t cognizant of Nixon’s closing of the gold window, and don’t know that it was made legal for investors to hold only in 1975. They are completely ignorant, and thus are unlikely to rush to gold in a crisis situation.” And the generational break cuts across geographical boundaries. “It was believed that when China industrialized, it would buy every ounce of gold available, because of the Chinese tradition that every human being needs to have at least one gold trinket. But the youth in China are breaking with those traditions and are not accumulating gold.”

As a result of all these developments, gold forecasts for 1999 are generally bearish. Anderson Cheung, head of precious metals trading for Asia at Warburg Dillon Read, is the most upbeat, forecasting that gold will hit $325 an ounce this year. Bear Stearns is less optimistic, predicting a 1999 peak of $315—better than 1998, but still far less than the $400-plus levels of mid-1996.

Silver is a classic example of a news-driven market dominated by big players. Early last year, Warren Buffett announced that he had bought a quarter of the world’s silver supply, mostly over the counter. Prices rose more than 80 percent over six months to more than $7 an ounce, before falling to $4.69 by December 3, 1998, as Buffett gradually unwound the position. In an Internet statement to investors last November, Buffett made no mention of silver, indicating that he had no immediate plans to go long in the foreseeable future. The result: what George Gero of Prudential Securities calls “dismal” rollover in the December 1998 contracts, since investors saw little reason to push silver positions into this year.

Despite fleeting bursts of activity, silver, like gold, is beset by deep problems that threaten future price levels and liquidity. The biggest: silver is a byproduct metal, meaning its production is based on the mining of other metals. Its supply, in other words, increases even when demand decreases. Moreover, silver’s industrial demand—primarily in the photography industry, which accounted for 27 percent of worldwide silver fabrication demand in 1997—is poised for massive decline when digital imaging comes to dominate the photography business. Although the Washington, D.C.-based Silver Institute projected that the use of silver in the industry will increase by 10 percent in the next five years—and there is talk of possible applications of silver in thermodynamic superconducting wire and antibacterial water purification systems—the possible gains aren’t likely to be significant enough to prevent the slide of silver prices for the foreseeable future.

“Any rallies in silver prices are likely to be followed by dumping from producers,” says Gotthelf. And if silver dips below $2, there is a good chance that silver will once again become a monetary metal—as coinage.

Platinum has had a rocky road of late as well, although lower industrial demand isn’t the sole culprit. In summer 1997, delivery problems by Russian producers led to a severely backwardated pricing curve, imposing a premium of almost $60 for spot delivery. The backwardation has now disappeared, but the curve still is not contango, since spot and one-month platinum trade at similar levels. Prices are consistently dropping since platinum is increasingly being supplanted by palladium as a result of new automobile emissions standards. But platinum may become resurgent if new fuel-cell vehicles, which each use about half an ounce of platinum, take off. Such vehicles will likely hit the market in California and New York, among other places, in the next three to five years, and rosy predictions could boost platinum prices.

Palladium has been the shining star of the metals business. Industrial demand is the main engine driving palladium prices up, as a result of year 2000 automobile emissions standards in the United States, Europe and Japan. Uncertainty in Russian delivery—particularly after the country’s announcement that it plans to use palladium as collateral for credit in coming years—is jacking forward prices even higher. “We are looking at growth rates of between 8 percent and 22 percent through 2002,” says Gotthelf. “That’s why the Stillwater, Mont., palladium facility is being beefed up considerably, and is viewed as a major investment possibility both as a stock play and as a commodity play.”

Base metals

The base metals market has its own share of problems. Ever-more-efficient extraction methods have swelled supplies of most base metals in recent years, while industrial demand has dropped off precipitously as a result of the Asian meltdown. The result: massive gluts in metals such as copper, whose surplus swelled to 204,000 tons in August 1998 as consumption took a nosedive. Copper prices late last year reached 11-year lows.

“Improvements in base metals production and extraction and the opening of new mines and facilities, prompted by the high price levels of the mid-1990s, have combined with the slowdown in the Far East to tip the supply-demand balance, and the perception of it, on its head,” says John Tyree of Fimat. As a result, many copper producers have scaled back production. Phelps Dodge, one of the world’s biggest producers, announced last October that it was closing its mines and cutting jobs. Vice president and treasurer Thomas Foster later told the Wall Street Journal that “We were not making very much money on a valuable resource and...were better off leaving it in the ground. We understood the world [didn’t] need the copper.”

Nick Moore, an analyst with Flemings Global Mining Group, predicts that “2000 will be the start of the recovery [in copper], when a smaller supply surplus will allow prices to revive a shade with a more worthwhile recovery in 2001 and a strong revival the following year.” But Richard de J. Osborne, chairman of Asarco, a major copper producer, is much more bullish. He predicts that copper prices have already reached bottom, and could shoot up 35 percent to more than $1 a pound this year. Copper bears, he maintains, have overestimated supply and underestimated demand. He lays much of the blame for copper’s woes on speculators. “The market is not responding to producers and consumers,” he says. “The market is responding to hedge funds.”

But the Sumitomo copper debacle of 1996 is still fresh in people’s minds, and prices aren’t likely to move higher anytime soon, says Gero. “People who say that copper can’t go lower are full of nonsense. They just don’t know the market. Copper can go lower, and it can remain profitable for producers.” Another trader agrees. “Base production is now as low as 27 cents a pound. So even at 75 cents, producers are doing okay. Anybody who can’t produce at that level should be cutting back a great deal.”

Meanwhile, says a London copper trader, “copper’s influence spreads across all base metals. It brought them up during the Sumitomo affair, and it’s bringing them down now.” He may be right: According to a Flemings report last November, Western zinc consumption was poised to register its first yearly contraction since 1989, since it was expected to fall by 1.2 percent for the year. And nickel, mired in an all-time low price slump in real terms, saw consumption decline by 1 percent last year.


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