Is copper the key to the gold price?

2007 started off badly for base metals: copper fell 10% in the first week of the New Year before recovering slightly, lead declined by 7%, nickel by 9% (but has since recovered) and zinc dropped a whopping 15%.

For me, this rapid decline in metal prices during the first two weeks of 2007 supports the hypothesis that Chinese, Indian and other emerging markets demand was not the cause of rising metal prices in 2006, but that investment funds speculating in metals as a hedge against the US dollar were driving up metal prices. Partners of limited investment partnerships that sold positions in January will not have to pay income tax on the gains they made in metals until the beginning of the next quarter (if they file quarterly) or 2008 if they file their taxes annually. So by waiting until the first trading days of 2007 to sell they were able to lock in profits and defer taxes for as long as possible. If metal prices were being driven by demand from economic development we would not have seen this phenomenon.

The market blamed copper, the bellwether of base metals, for the rapid decline in base metals prices and its price drop was pinned on an increase in copper inventories.

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Copper inventories increase to blame

Copper stocks at the London Metals Exchange (LME) rose 12,000 tonnes in the first week of January and this, apparently, spooked the market. 12,000 tonnes represent a 6% increase in copper inventory, which is a rather large increase to see in one week, especially if the world is supposed to be short of copper and emerging market demand for raw materials is going to push prices higher. But if you consider that copper inventories have more than doubled since January last year then you realize that the jump we saw in the first week of January might have been expected. LME copper stocks were volatile last year and have risen by more than 70% since October. A quick look at a copper price chart will show that the market has consistently been selling copper as inventories have risen. Copper fell from over $3.40 a pound in the beginning of October to under $2.60 a pound. That is a 24% decline in four months.

Why gold is at risk from a copper sell-off

During December the gold price increased by more than $20 an ounce (3%) and I was just starting to think that gold might break away from base metals when, in January, the gold price fell from a high of $640 to as low as $605. As I mentioned several times last year, the biggest risk to the gold price is a sell-off in base metals; particularly copper.

I don't believe the worst is over for base metals and consequently I would not bet that the worst is over for gold. But someday the gold price will disconnect from base metals prices and when that happens I expect gold to outperform its cousins. Until then I will remain somewhat cautious with enough exposure to gold so as not to be left out in the cold if the price unexpectedly rises, and enough cash in the bank to comfortably watch the price decline in the hope of getting better deals at lower prices.

First published on Kitco.com (www.kitco.com)

By Paul van Eeden

Paul van Eeden works primarily to find investments for his own portfolio and shares his investment ideas with subscribers to his weekly investment publication. For more information please visit his website (www.paulvaneeden.com). If you would like to read more from Paul, you can sign up to get his weekly commentary at https://www.paulvaneeden.com/commentary.php.