You Have This Steel Thing Backward

The shape of futures curves supports the idea that real demand is driving prices.

Here's one piece of evidence that the surge in Chinese building materials prices is driven by fundamental demand: People are paying a premium to get hold of commodities now rather than waiting.

That would be an anomaly if the recent run-up was purely a speculative bubble. Traders may be crazy but they're not stupid. Buying steel now in the hope of selling it at a profit later is an extremely risky strategy when futures are priced at a discount.

Buy Later, Pay Now

Prices for spot rebar consistently track above those for futures contracts in China

Source: Bloomberg data

Backwardation -- when near-dated futures contracts cost more than longer-term ones -- is generally seen as a sign of genuine demand: Consumers are paying a premium for prompt delivery because their needs are real and immediate.

That would be consistent with evidence that China's sharp expansion of credit in the first quarter has sparked a rebound in materials consumption.

In the case of rebar, used in construction concrete, the backwardated futures curve has steepened sharply in recent months as prices have risen. At the start of February, rebar for delivery that month cost about 3.5 percent less than for April. Now, there's a 9 percent premium to take delivery in May rather than July:

Contango and Cash

Higher near-term prices for Shanghai rebar futures are an indicator of real demand pressures

Source: Bloomberg data

That reversal is in marked contrast to other commodities that have seen a strong rise in speculative interest but lack the obvious demand drivers behind steel's gains.

Take a look at eggs, for instance. Contracts representing almost 1.2 million metric tons of eggs changed hands on the Dalian commodities exchange on April 20. However, the surge in trading wasn't matched by a rise in near-term contract prices: Egg prices are still in contango, meaning you pay more to take delivery later than sooner:

An Egg in the Hand

Contract prices for Dalian egg futures are in contango

Source: Bloomberg data

China's materials demand is probably still being inflated by a credit bubble as the economy slows. It would be brave to call a bottom in the commodities rout right now, Sam Walsh, chief executive officer of Rio Tinto, the world's second-biggest iron ore miner, told reporters this week. While China boosted steel production to a record in April, according to Sanford C. Bernstein, the country is still consuming far more metal than comparable economies.

In addition, speculators don't completely clear out of a market when it dips into backwardation. Indeed, the signal of real demand often encourages net-long speculators to open positions, in the expectation that longer-dated contracts will eventually rise to match short-term prices.

Still, with China's imported iron-ore price up 38 percent already this year, even Goldman Sachs has reversed its bearish stance. The investment bank has lifted its full-year forecast for iron-ore prices by 19 percent and boosted its estimate for the current quarter by 47 percent.

China doesn't need as much metal as it uses, but when Beijing decides to stimulate the economy by juicing the construction sector, it unleashes a juggernaut. With that sort of demand bearing down on them, shorts would do well to get out of the way.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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    David Fickling in Sydney at

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