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5. Base Metals

Teaching rewrite of base metals: production, copper, aluminium, steel, the London Metal Exchange, price drivers, and hedging for consumers. Original wording; worked numbers recomputed. Prices (aluminium ~USD 2,500, copper ~USD 7,000) are teaching values. Not investment advice.

Introduction​

Base metals — copper, aluminium, zinc, nickel, lead, tin — wire our homes, build our cars, and carry our electricity. Unlike gold (lesson 4), most base metal supply sits below ground, inventories are thin, and prices respond quickly to economic cycles. Their price benchmark is set mostly on one unusual exchange: the London Metal Exchange (LME).

This lesson covers:

  • How metals are produced: ore → concentrate → smelting → refining
  • Copper reserves, uses, supply chain, scrap, trade flows; aluminium; steel
  • The LME: futures, TAPOs, prompt dates, ring trading, clearing, margining, warehouses and warrants
  • Price drivers, the business cycle, electric vehicles
  • Long-term prices, forward-curve moves, marginal cost curves, regional premiums
  • Hedging for an automaker: forwards, carry (“lend/borrow”), options, min-max, three-way, knock-out forwards, forward plus, basket options, FX and compo swaps

5.1 How metals are produced​

  1. Exploration — geological surveys and test drilling; a mine goes ahead only if expected value exceeds development and operating costs (including roads, buildings, environment). Discovery to production can take ~10 years; lenders often require hedging of future revenues.
  2. Separation — about 80% of elements are metals, but most occur as compounds (ores). Rock and ore are ground and separated mechanically.
  3. Extraction — breaking the compound: carbon/oxygen processes, or for very reactive metals, smelting and electrolysis. The more reactive the metal, the costlier.
  4. Refining — removing impurities so the metal can be fabricated.

Gold and silver are unreactive and occur pure; francium reacts instantly with air or water.

5.2 Copper​

Reserves vs resources​

TermMeaning≈ 2016 estimate
Resources (total)Everything known or predicted5,600 Mt
Undiscovered resourcesPostulated only3,500 Mt
Identified resourcesLocation and grade known/estimated2,100 Mt
ReservesEconomic to extract now~720 Mt

Mine output was about 20 Mt a year (2016). Reserves have stayed at roughly 40 years of demand for decades because higher prices turn resources into reserves, technology improves, copper is fully recyclable, and innovation economises on use.

Uses​

Electrical (cables, appliances), electronics and communications, construction (plumbing, frames), transport (motors, wiring, EVs), industrial machinery, coins and cookware.

Supply chain​

flowchart LR
  M[Mine<br/>ore] --> C[Concentrate<br/>20–40% Cu]
  C --> S[Smelter<br/>matte 50–70%] --> B[Blister / anode<br/>98.5–99.5%]
  B --> R[Refinery<br/>cathode ≥99.99%] --> F[Semi-fabricator<br/>rod, tube, strip, brass]
  F --> P[Manufacturer] --> E[End of life → old scrap]
  F -. new scrap .-> R
  E -. old scrap .-> S
StageTop countries (source era)
MiningChile, Peru, China, US, Australia
SmeltingChina, Japan, Chile, Russia, India
RefiningChina, Chile, Japan, US, Russia
Semi-fabricationChina, US, Germany, Japan, Korea

Scrap: new scrap = offcuts from manufacturing; old scrap = recovered from end-of-life products. Refined copper from scrap = secondary production.

Trade flows: concentrates (Chile, Peru, Indonesia → China, Japan, Spain); blister/anode (Chile, Bulgaria, Namibia → China, Belgium, India); refined copper (Chile, Japan, Russia → China, Germany, US); semis (Germany, Taiwan, China → China, US, Italy).

5.3 Aluminium​

  • Largest non-ferrous metal by output (60 Mt+ a year).
  • Bauxite → dissolved in caustic soda → alumina (Al₂O₃, white powder) → electrolysis → aluminium.
  • 4 t bauxite → 2 t alumina → 1 t aluminium.
  • Very energy-intensive — electricity can be ~40% (up to ~50%) of costs, so smelters cluster near cheap power (e.g. Iceland). Recycling uses only ~5% of the energy.
  • Alumina traditionally sold on long-term contracts at 12–14% of the aluminium price.
  • Producers: China, then the Gulf, North America, Western Europe. Demand: transport ~⅓ (engine blocks, body panels), construction ~25%, packaging ~16%.

5.4 Steel​

Steel is an alloy (iron + carbon, plus elements such as manganese and silicon) — it doesn’t occur naturally.

RouteShareMain inputs per tonne of crude steel
Basic oxygen furnace (BOF)~72%1,370 kg iron ore, 780 kg coal, 270 kg limestone, 125 kg scrap
Electric arc furnace (EAF)~28%710 kg scrap, 586 kg iron ore, 88 kg limestone, 2.3 GJ electricity
  • 3,500+ grades; alloying adds properties (manganese → harder; nickel/molybdenum → resistant; zinc coating → rust-proof).
  • Long products (billet/bloom → wire rod, rebar, sections, rails) and flat products (slab → plate, hot/cold-rolled coil).
  • Uses: buildings and infrastructure ~51%, mechanical equipment 15%, automotive 12%, metal products 11%.
  • Price drivers: met coke, iron ore, scrap, energy, freight; China is both the largest producer and consumer.
  • Hedging is relatively new: the LME lists cash-settled steel scrap (10 t lots, settled on the monthly average of a Platts Turkey scrap assessment — Turkey is the key scrap importer) and rebar futures.

Checkpoint 1: production and metals​

Quiz

Checkpoint — sections 5.1 to 5.4

1 / 5

Why have copper reserves stayed near 40 years of demand for decades?

Pick an answer to see if you are right.

5.5 The London Metal Exchange​

The LME provides transparent benchmark prices that much of the physical metals trade references. Physical participants (producers, processors, consumers) are roughly a third of volume; the rest is financial. Much trade is OTC, but OTC risk is often hedged on the LME.

Products​

  • Futures (physically settled; only ~1% delivered — positions are closed by opposite trades for the same prompt date)
    • Non-ferrous: copper, primary aluminium, aluminium alloy, NASAAC, lead, nickel, tin, zinc
    • Ferrous: steel scrap, rebar · Minor: cobalt, molybdenum · Precious: gold, silver
  • Options on futures (American style for copper)
  • TAPOs — traded average price options, settled on the monthly average settlement price (MASP)
  • Premium futures (e.g. US Midwest aluminium premium)

What the contract delivers​

The LME prices metal at the refined stage (e.g. Grade A copper cathode). Other stages trade at adjustments: concentrates at a discount; semis and products at a premium.

TC/RCs: pricing concentrate​

Smelters charge miners treatment charges (per dry metric tonne of concentrate) and refining charges (per pound of contained copper).

Worked example: concentrate 30% Cu, payable at 96.65% of LME USD 7,000:

  • Payable value = 30% × 96.65% × 7,000 = USD 2,029.65 / DMT
  • Refining charge at USD 0.045/lb: 30% × 0.045 × 2,204.6 lb/t = USD 29.76 / DMT
  • Plus a treatment charge (USD/DMT), both deducted from the payable value
Correction

The source uses 22,046 lb per tonne. One metric tonne is 2,204.6 lb, giving USD 29.76/DMT for the refining charge.

Contract specs​

MetalLot size
Aluminium, copper, lead, zinc25 t
Aluminium alloy, NASAAC20 t
Nickel6 t
Tin5 t

Prompt dates: daily out to 3 months; weekly (Wednesdays) 3–6 months; monthly (third Wednesday) out to 123 months (metal-dependent). The 3-month date is most liquid — historically the time to ship metal to London.

Trading: the ring​

Open-outcry ring sessions plus 24-hour electronic trading. Copper: ring 1 12:00–12:05, ring 2 (official prices) 12:30–12:35, kerb 13:25–13:35; afternoon rings and kerb follow. Official prices (cash, 3-month, three December prompts) are benchmarks for settlement.

Clearing and margining​

LME Clear becomes buyer to every seller and seller to every buyer (novation). Brokers’ clients still face their broker’s credit.

Unusual margin rule: losses are paid immediately (like other exchanges) but profits are not paid until the position closes or matures (like OTC).

Example: buy 1 lot aluminium at 1,900, initial margin 100. Next day the prompt trades 1,950:

  • Close out → receive margin back + 50 profit
  • Keep the position → no cash for the 50 gain
  • If it had fallen to 1,850 → pay 50 variation margin now

OTC trades are often collateralised under an ISDA Credit Support Annex: frequency, threshold, minimum transfer amount, eligible collateral.

Delivery: warehouses and warrants​

  • 600+ LME-approved warehouses in ~35 countries, mainly near consumers. The LME owns neither warehouses nor metal; stocks are watched as an inventory gauge.
  • Metal meeting specs is “put on warrant” (warrant = title); cancelling it takes metal “off warrant”.
  • LMEsword transfers warrants electronically; warrants are allocated randomly to longs.
  • The seller chooses location and brand → a “cheapest-to-deliver” element; off-exchange warrant swaps and premiums for popular locations/brands result.
  • Delivered weight may vary ±2%; the invoice adjusts.
Since the source was written

In March 2022 the LME suspended nickel trading and cancelled trades after prices more than doubled in hours — a reminder that exchange rules and liquidity can change abruptly. Sanctions have also restricted delivery of newly produced Russian metal on the LME since 2024.

Checkpoint 2: the LME​

Quiz

Checkpoint — section 5.5

1 / 5

Lot size of LME copper?

Pick an answer to see if you are right.

5.6 Price drivers​

DriverEffect
Raw material qualityRich, cheap, long-life ore bodies are depleting
InventoriesThin above-ground stocks → copper prone to backwardation (vs gold’s contango)
Fiscal/monetary policyStimulus → more cars, chips, housing → more metal
US dollarWeaker USD → cheaper for others → more demand → higher USD price
China and IndiaChina ≈ 50% of world copper use (≈ 11.4 Mt of 23.3 Mt in 2016) despite producing ≈ 8.4 Mt refined
Finance availabilityTight credit after 2008 → less capex → eventually less supply
Capex and explorationCut in busts, so supply lags booms (up to ~10 years discovery-to-output)
Environmental approvalsLong lead times
SubstitutionFeasible over 2–3 years when prices stay high
DisruptionsStrikes (labour ≈ 26% of copper cost), accidents
InfrastructurePower and transport in producing countries
Resource nationalismPressure to take resources into local ownership
Production costsHigher steel and energy prices feed back
Investment flowsWatched via the CFTC Commitments of Traders (commercial vs non-commercial)

The business cycle​

flowchart LR
  I[I. Prosperity<br/>prices rise, stocks full] --> II[II. Transition<br/>prices overshoot, stocks drawn, scrap rises, investors exit]
  II --> III[III. Recession<br/>low demand, little production]
  III --> IV[IV. Recovery<br/>restocking, capacity tight, prices rise]
  IV --> I

Electric vehicles​

  • Types: hybrid, plug-in hybrid, battery EV. Emissions shift toward power generation.
  • More copper, nickel, cobalt, lithium; less palladium/rhodium (catalytic converters).
  • Lithium (“the new gasoline”, 40–80 kg per pack — falling with technology); cobalt largely a by-product of copper, concentrated in the DR Congo and processed mainly in China.
  • The LME lists cobalt, nickel, copper, aluminium (and has added battery-metal contracts such as lithium hydroxide).

5.7 Market price structure​

Long-term prices​

Five ways to pick a “long-term price” (e.g. for a mine loan): mean reversion to a historic average · future average of forecasts · equilibrium price (judgement or inventory link) · back end of the forward curve · incentive price (high enough to justify new investment).

How forward curves move​

  • Level (parallel shift), slope (two-point steepen/flatten), shape (curvature: middle vs ends).
  • The short end reacts to physical events and is most volatile; the long end to financial factors (rates, inflation).

Forwards are breakevens, not forecasts​

Cash copper 6,700, 3-month 6,800. A seller who expects cash in 3 months above 6,800 stays unhedged; below 6,800 sells forward; at 6,800 is indifferent. In high-price, steeply backwardated markets producers often don’t hedge (shareholders want upside) while consumers and investors buy forward — damping the backwardation.

Marginal cost curves​

Plot cumulative production (x) against cost (y). Producers above roughly the 90th percentile are marginal: if prices stay below their cash cost, they should cut output — a soft floor in gluts. It works poorly in demand booms, and the curve itself shifts with the cycle.

Regional premiums​

“All-in” price = LME price (date or average) + regional premium (local availability and delivery) + shape/quality/alloy premium ± FX ± supply-chain stage adjustment.

  • 2018 US tariffs on aluminium pushed up the US Midwest premium.
  • A 2014 US Senate review found warehouse queues lengthened load-out times, raising rents and premiums.
  • The LME aluminium premium futures (25 t, monthly to 15 months, physically delivered) let users hedge the premium; residual basis risk remains.

Worked example: all-in price​

LME 3-month aluminium 2,500 + US Midwest premium 400 + billet (shape) premium 150 = USD 3,050/t delivered.

Checkpoint 3: drivers and structure​

Quiz

Checkpoint — sections 5.6 and 5.7

1 / 5

Why is copper more prone to backwardation than gold?

Pick an answer to see if you are right.

5.8 Hedging for an aluminium consumer (automaker)​

Automakers hedge aluminium, copper, zinc, lead, platinum/palladium, plastics, and steel — aluminium is the biggest by volume. The LME NASAAC contract (engine-block alloy, US delivery) was designed for them but has poor liquidity (natural sellers are mostly lower-credit scrap merchants).

Market: cash 2,400, 3-month 2,500 (contango); options European, cash-settled, 20% vol, 3 months. The consumer buys physical metal on a floating price (average of the month before delivery) — it is short forward: hurt by rising prices.

Forward purchase (cash-settled “swap”)​

Buy a 3-month floating-price forward at 2,500, settled against the same monthly average:

Average at settlementPhysical costHedgeNet
2,4002,400Pays 1002,500
2,6002,600Receives 1002,500

Carry trades: lend and borrow​

Supplier delays delivery a month. After one month: 2-month 2,600, 3-month 2,650.

  • Sell the 2-month (closing the original 2,500 long) → +100
  • Buy the new 3-month at 2,650
  • Effective new cost ≈ 2,650 − 100 = 2,550 (less with interest on the 100)

Selling near / buying far = a lend; buying near / selling far = a borrow (the economics of a gold or FX swap).

Option strategies​

StrategyConstructionResult for the consumer
Buy OTM call (strike 2,600, premium 60)Short forward + long call = synthetic long putMax cost 2,660; full benefit if prices fall (minus premium). Suits a consumer who expects a fall but can’t afford to be wrong — if it expected a rise, a forward (no premium) is better
Sell OTM put (strike 2,450, premium 76)Short forward + short put = synthetic short callPrice 2,300 → cost 2,300 + 150 − 76 = 2,374; price 2,700 → 2,700 − 76 = 2,624. Subsidy only; no cap
Sell OTM callPremium receivedRisky: if prices spike, pays more for both metal and option
Producer sells calls (“swaptions”)Miner with idle capacity sells calls ~15% above spotIf exercised, restart production — which is now profitable

Zero-premium combinations​

StructureLegsOutcome
Min-max (collar)Buy call 2,600, sell put 2,410Cost bounded 2,410 – 2,600
Ratio min-maxBuy call 2,600, sell put on 75% at 2,458Cap 2,600; below 2,458 benefits from only 25% of further falls — but no hard floor
Three-waySell put 2,376; buy call 2,450; sell call 2,550Below 2,376 → 2,376; 2,376–2,450 → market; 2,450–2,550 → 2,450; above 2,550 → market − 100

Structured (barrier) solutions​

StructureTermsCatch
Knock-out forwardBuy at 2,450 (vs 2,500 market) — built from a knock-out call and short knock-out put; terminates if cash hits 2,932Unhedged exactly when prices are very high
Forward plusLong call 2,600 (60) financed by a short knock-in put 2,600 with trigger 2,139Never pays more than 2,600; benefits from falls only down to 2,139 — then locked at 2,600

Basket options​

An option on a weighted basket of metals is cheaper than separate options because prices don’t always move together.

Basket call payoff = max(0, w₁S₁ + w₂S₂ − X)

Example: 50/50 aluminium (3-month 2,500) and copper (7,000) → strike 4,750. At expiry 2,600 and 7,100 → basket 4,850 → payoff 100 (vs 200 from two separate calls).

Basket vol = √(w₁²σ₁² + w₂²σ₂² + 2w₁w₂ρσ₁σ₂)

With σ_Al = 20%, σ_Cu = 25%:

Correlation ρ−1.0−0.50+0.5+1.0
Basket vol2.50%11.46%16.01%19.53%22.50%
Premium (USD)125155181204224

Separate ATM calls cost 99 (Al) + 348 (Cu) = 447 — even at ρ = +1 the basket (224) is about half, since it is weighted 50/50.

FX exposures​

Vanilla: a bank sells copper to a EUR client at a fixed EUR price. 3-month copper USD 7,000, 3-month forward €1 = USD 1.20 → EUR 5,833. If unhedged and EUR/USD ends at 1.15, the EUR received buys only USD 6,708 — short of 7,000. The bank sells EUR forward (executed as an FX swap: spot + forward), funding USD and lending EUR in the money market.

Compo (FX-linked commodity) swap: a EUR consumer fixes EUR/USD at 1.20. Copper settles USD 6,500, spot FX 1.15:

  • Bank pays: 6,500 / 1.15 = EUR 5,652 (what the client needs to buy USD 6,500)
  • Client pays: 6,500 / 1.20 = EUR 5,417
  • Net EUR cost of the copper fixed at the 1.20 rate. Variants fix the commodity, the FX, or both.

Checkpoint 4: hedging​

Quiz

Checkpoint — section 5.8

1 / 6

Consumer hedged at 2,500; monthly average settles 2,450. Hedge cash flow per tonne?

Pick an answer to see if you are right.

Rank: base metals practice​

Quiz

Base metals practice

1 / 2

Rank the basket premiums by correlation (CHEAPEST first).

OrderDrag the handle to rearrange — top should be first.

  1. 1ρ = 0 (181)
  2. 2ρ = +0.5 (204)
  3. 3ρ = +1.0 (224)
  4. 4ρ = −1.0 (125)

Drag items into the correct order (or use ↑↓), then check.

Check: base metals​

Quiz

Base metals

1 / 6

At which stage of the supply chain is the LME contract priced?

Pick an answer to see if you are right.

Calculate: numeric practice​

Type the number (no units; minus sign for payments). 1 metric tonne = 2,204.6 lb.

Formula sheet​

ItemFormula
Concentrate payableCu % × payable % × LME
Refining charge (USD/DMT)Cu % × RC (USD/lb) × 2,204.6
Bauxite needed4 × aluminium
LME lotstonnes / lot size
Floating forward settlement (consumer)(average − fixed) × tonnes
Lend roll effective pricenew far price − profit on closing near
Collar costmin(max(price, put strike), call strike)
Basket payoffmax(0, Σwᵢ Sᵢ − X)
Basket vol√(w₁²σ₁² + w₂²σ₂² + 2w₁w₂ρσ₁σ₂)
EUR priceUSD price / EUR-USD forward
Compute

Calculate: base metals

1 / 12

Story problem — figure out which numbers are the formula inputs, then compute.

Concentrate: 25% Cu, payable 96.5% of LME USD 9,000. Payable value per DMT?

Enter a number (at most 2 decimal places).

Randomized practice​

Compute

Practice: base metals drills

1 / 6

Story problem — figure out which numbers are the formula inputs, then compute.

How many tonnes of bauxite are needed for 23,000 t of aluminium (4:2:1 rule)?

Enter a number (at most 0 decimal places).

Takeaways​

Remember
  • Production: ore → concentrate → smelt → refine; copper reserves stay ~40 years because economics redefine them
  • Aluminium: 4:2:1 bauxite→alumina→metal, power-hungry; steel via BOF (ore + coal) or EAF (scrap)
  • LME: refined-metal benchmark; 25 t lots for major metals; daily/weekly/monthly prompts; ring official prices; losses paid now, profits at close; warrants and seller’s delivery choice
  • Drivers: thin inventories, China, USD, capex lag, disruptions, policy, investment, EVs
  • Forwards are breakevens; marginal cost is a soft floor; premiums turn the global LME price into a local all-in price
  • Consumer hedges: forwards, lend/borrow carry, calls, collars, three-ways, knock-out forwards, forward plus, baskets (cheaper via correlation), compo swaps for FX

Further Reading​

  • 4. Gold
  • 3. Risk management principles
  • Next: 6. Crude oil
  • LME (lme.com) — contract specifications; International Copper Study Group, World Copper Factbook; World Steel Association statistics
  • Background: N. Schofield, Commodity Derivatives: Markets and Applications (Wiley) — used as a study outline