What the Zinc Contango Tells Us About Forward Price Curves

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Continued from Part One. 

If a metal is in short supply, there could be issues around delivery or access to metal, in which case owning the metal now has benefits. Indeed, if supply becomes even slightly more constrained, being in physical possession of the asset could be advantageous. This is sometimes called the convenience yield.

Take zinc, which was the subject of stock financing a year or so back, but fell out of favor when the difference between spot and 12- or 18-month pricing fell.

As Home’s article explains, the zinc forward curve has risen sharply over the last month. Right now the zinc contango would generate a gross return of almost 4 percent for holding metal for a 12-month period, still not quite as good as aluminum at 5 percent over 12 months, but sharply up from the end of June when the gross return would have been under 2 percent.

There has been a sudden surge in cancellations of LME zinc stocks. This week’s warehouse report shows another 26,850 tons moving into position for exiting the LME warehouse at Johor in Malaysia. That brings total cancelled tonnage across the LME system to 147,375 tons, equivalent to 15.5 percent of registered tonnage.

As with aluminum, Andy Home observes these sorts of tonnages imply investment rather than manufacturing demand and, as with aluminum, the driver is almost certainly warehouse rent differentials – off-market is cheaper than on-market.

So rather than the layman’s intuitive reading that a rising forward price means the market is expecting prices to rise in the future, in reality a rising forward price tells us the market is in over or at least adequate supply, and as such has little obvious reason to rise.

On the other hand, a flat or, better still, inverted curve, said to be in backwardation, shows a market in short supply – and if for that and no other reason has a better chance of a price rise in the future.

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