Why Does A Penny Cost Nearly 2 Cents?

pennies penny

The U.S. mint reported last year that it cost $0.0179 to put a single copper-plated penny in circulation. Soon pennies, wires and everything else containing the red metal will likely cost even more, and market forces are not the only explanation.

Despite sky-high prices, vast quantities of copper and other materials are going into storage in warehouses around the world. Much smaller quantities dribble out of those warehouses.

The resulting supply squeeze pushes prices even higher, which leads to more production, much of which then gets stuck in the warehouses too.

The cash price of a ton of copper on the London Metals Exchange, which hovered near or below $2,000 from 2000 through 2003, is now around $9,000. The climb hasn’t been a completely smooth one. The increase in prices began around 2003, with copper jumping as high as $8,000 between 2006 and 2008. Then the financial crash sent the price back down to around $3,000 at the start of 2009. Early this year, prices rallied higher than ever, reaching around $10,000. But as the year has progressed, prices have been knocked back down by growing worries about the global financial situation.

Despite the dips, however, the overall trend is toward ever-higher prices. Other metals are travelling on similar trajectories. aluminium prices have risen 13 per cent since the start of 2010, and tin prices have quintupled since 2005. Most analysts expect the rise to continue. Goldman Sachs has forecast that the price of a ton of copper will soon rise to $11,000.

When asked to explain their forecasts, analysts almost uniformly give the standard, catchall answer: supply and demand.

There certainly is a lot of demand. One recent and important source of that demand has been investors who are increasingly concerned about inflation. They see commodities as a key inflation hedge. New financial vehicles, such as exchange-traded funds, are also opening up the commodities market to a wider range of investors. Hedge funds and other short-term traders, meanwhile, are drawn to the commodities market because of its volatility, which creates opportunities for short-term gains.

Then there are the people who actually want to use commodities to make and build things. A lot of those people are in China. Rapid economic growth in China, and in other developing nations, is another major force behind rising commodity prices. China’s copper-products output last month was 20 per cent greater than during the same period just one year earlier, according to data from the country’s statistics bureau as cited by Bloomberg. China’s seemingly insatiable appetite places constant pressure on the world’s resources. Largely because of the increasing demand from China and other fast-growing countries, the International Copper Study Group has forecast a 377,000-ton global shortage this year.

By the logic of the market, the high demand for metals and other commodities should spur more production. The resulting increase in supply would satisfy the demand, and prices would fall to a natural, sustainable level.

But according to some industry-watchers, increased production won’t solve the supply problem, because in reality there is no supply problem. There is plenty of metal, but large quantities of it are withheld from the market.

In a June BBC radio documentary called “Bubble Trouble,” Steven Spencer, a principal at the commodities trading firm Traderight, suggested that around 2 million tons of copper may have ended up in stockpiles in China in the past year. Chinese industry may be booming, he said, but it is not consuming all of the materials that the country is importing.

If these stockpiles do exist, they are distorting the market by making large amounts of production effectively disappear without being used. Chinese warehouses do not share information about their holdings, making it impossible for traders elsewhere to know how much metal is out there. A recent report from Bloomberg said copper inventories in Chinese warehouses may have dropped 50 per cent, but no one really knows.

The lack of information from the Chinese, while unfortunate, is about what we would expect. But conditions in non-Chinese warehouses, including those under the oversight of the market-dominating London Metals Exchange, are almost equally opaque. In the same BBC documentary, reporter Michael Robinson visited a commodities warehouse owned by the Steinweg Group, which is authorised to hold LME-registered metal. There, he was reduced to guessing how long certain pieces of copper had been in storage by the amount of dust they had accumulated. Despite the supposed shortage, there was a lot of copper and a lot of dust. John Van der Lek, head of metals for the Steinweg Group, explained to Robinson that only a small portion of the metal held in the warehouse was included in the LME’s supply calculations.

The reason for the discrepancy is that, in addition to holding metal owned by producers and available for sale, warehouses also hold metal that has already been purchased until it can be delivered to buyers. In today’s world of overnight deliveries and just-in-time supply chains, it is hard to imagine why warehouses would hold more than a few days’ worth of metal that buyers are ready and eager to receive. It gets easier to imagine, however, when you learn that warehouses have a great deal of discretion over how quickly they deliver metal, and that they can charge rent in the meantime. It’s the Hotel California principle: metal can be checked in any time producers like, but it can almost never leave.

The LME sets quotas for how much warehouses must send out each day, but in the case of big warehouses, the quotas are far lower than real outbound capacity and also far lower than the amount the warehouses take in. The result is a funnel, with metal getting stuck in warehouses. This creates an artificial supply shortage while warehouse operators keep metal off the market and gouge metal-buyers for months’ worth of rent.

Recently, this system of warehousing has provoked complaints in the aluminium industry. The problem is particularly pronounced in Detroit, where 24 of the LME’s 600 approved warehouses are situated. Waits for aluminium from these warehouses can stretch as long as seven months. When aluminium buyers do finally get their orders, they pass the high price of the metal, along with the costs of the mandatory “rent,” on to customers, including aircraft manufacturers and beverage packagers. Eventually these costs make their way to consumers.

The bottleneck isn’t the only problem with the warehouse system. Most commodities warehouses are owned by big banks and commodities firms, including Goldman Sachs, J.P. Morgan, and Glencore International. Other branches of these entities make money by trading in the products that the warehouses store. While regulations supposedly prevent firms from sharing information between the trading and warehouse divisions, the potential for abuse is clear. Warehouse operators are privy to detailed information about how much metal goes in and out. Other traders must rely on what they are told.

The LME is making some modest improvements. The exchange recently voted to double the amount the largest aluminium warehouses must ship out each day. However, the LME still insists that the problem is limited to aluminium storage and to the Detroit area. “The LME does not have a systemic issue with its warehouse network,” the LME’s CEO, Martin Abbott, said in a May 27 notice to members. The LME, we should note, collects 1.1 per cent of the daily rental fees for metal stored in its approved warehouses and, over the past few years, has made a healthy profit. The exchange also has yet to take any real action to crack down on the conflict of interest surrounding the big banks that are its most important traders.

Given the exchange’s reluctance to fully acknowledge the problem, governments ought to take a look at the situation. While we can’t do much about Chinese secrecy, it would be appropriate for regulators to consider whether the LSE’s standards for warehouse commodity movements and information disclosure are reasonable and in the public interest.

We neither can nor should do much about commodity prices that rise due to higher demand, whether that demand is from users or speculators. Either way, ordinary market forces can be trusted to bring things into balance in the long term. But when supply is manipulated and information is withheld or distorted, market forces do not work. That is when governments can, and should, step in.

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