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Copper loses its luster - where next?

Prices of copper – the industrial metal used in everything from cars to houses – have declined this week, heading towards a one-month low, with analysts concerned the sell-off could continue and become worse than the recent March fall.

The drop in price has centered on reports of an investigation at China's northeastern port of Qingdao, which has raised fears that large quantities of the metal could flood the market. Three-month copper on the London Metal Exchange edged lower by 0.35 percent on Thursday morning to $6,666 per tonne, close to levels not seen since early May. Prices on Asian benchmarks also fell lower during the overnight session.

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ChinaFotoPress | ChinaFotoPress | Getty Images

In China, the world's biggest consumer of the metal, cooper is used as collateral in financial deals as well as for manufacturing purposes. China's copper inventories have increased to around 800 kilotonnes in 2014 of which around 300-400 kilotonnes is held in financing deals, according to figures from Bank of America Merrill Lynch. Officials in Qingdao are investigating whether some financing deals have been made using copper that didn't actually not exist.

This has spooked the market despite the port holding an extremely small portion of global inventories. It has also led some to shift their stocks to supposedly more reputable warehouses and has led others to speculate that investors could walk away from these deals, thus liquidating the market. Analysts at Citi predicted a continued pullback in net long positions of copper this month after it witnessed a 24 percent reduction in net long positions on the U.S. COMEX exchange at the beginning of the month.

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"Many of these extreme scenarios are not our base case, although we acknowledge that the issues in Qingdao could continue to cause short-term distortions and may ultimately limit liquidity available for financing deals," commodity analysts at Bank of America Merrill Lynch, led by Michael Widmer, said in a note on Thursday.

The investment bank has been forecasting a continued slide in copper for the whole of this week, and maintained that outlook on Thursday. BofA Merrill Lynch's average second-quarter forecast remains at $6,500 per tonne, but it does not anticipate a collapse. Prices had slipped to these levels in March when a sudden drop coincided with fears of regulatory tightening in China for these copper-backed deals.

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The metal is often seen as a gauge for the health of the global economy – hence its nickname "Dr Copper". For investors it has become increasingly difficult to separate how much copper imports are due to "real" industrial demand or how much is due to financing activities. More and more of these copper-backed loans originate from Singapore, according to a report on Thursday in the Financial Times. This is due to international banks moving their China business out of Hong Kong, it said, and it has cast a shadow on the sovereign city-state.

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Over the long term, Deutsche Bank believes that the tighter control on the use of copper would add a degree of confidence to the market. In a report last week, the bank said it could limit the divergence between real and apparent demand. Meanwhile, Societe Generale analysts have shrugged off the concerns from China and have instead released a report this week detailing how Indian consumption could surge in the wake elections in the country. Its forecasts are for copper to average $6,750 in 2014 and up to $7,500 in 2019.