Financial and Monetary Systems

Revitalizing the future economy: Critical mineral derivatives could bring stability

Cobalt, copper and nickel in tis natural and raw form: Slow electric-vehicle growth has caused a volatile market but critical mineral derivatives could be the answer.

Slow electric-vehicle growth has caused a volatile market but critical mineral derivatives could be the answer. Image: Unsplash/Paul-Alain Hunt

Reese Epper
Master's student | Mineral and Energy Economics program, Colorado School of Mines
Brad Handler
Researcher and Program Lead, Sustainable Finance Lab, Payne Institute for Public Policy, Colorado School of Mines
Morgan Bazilian
Director, Professor of Public Policy, Payne Institute for Public Policy
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  • Despite very likely high demand growth for some minerals, recent price drops give poor signals to investors.
  • Futures and options markets – derivatives – for critical minerals could enhance pricing transparency and stability.
  • Limited market pricing information and the unique characteristics of these minerals present challenges for critical mineral derivatives.

Slower-than-expected growth in the electric vehicle sector, especially in China, combined with supply increases, has weighed heavily on the prices of several critical minerals.

For example, the price of lithium fell 75% in 2023 after spiking over 400% in 2022, and cobalt has lost two-thirds of its value from its peak in 2022, albeit with less volatility.

These price decreases come at a bad time. As key inputs to energy transitions, military technologies and consumer electronics, demand for various critical minerals is expected to range from doubling to quadruple by 2040, and forecasts indicate a potential supply deficit as soon as 2028.

Given the long lead times to develop new supply sources, investments in mining these minerals must begin now. Yet, in the face of low prices, the mining industry is delaying projects, scaling back work and suspending operations.

Cobalt and lithium hydroxide prices.
Cobalt and lithium hydroxide prices. Image: CME Group

For these minerals, emerging futures and options markets – collectively known as derivatives – present a promising avenue to increase pricing transparency and stability by increasing liquidity. Contracts in metals markets traditionally can go three to five years forward. These contracts, therefore, provide visibility on sellers’ profits and buyers’ costs, enabling them to plan for the future.

Derivative markets could offer stability

Although not without some detractors, research has suggested that deep derivatives markets, i.e. those with many active participants and significant trading volume, can reduce pricing volatility due to increased liquidity, enhanced risk management capabilities and improved mechanisms for price discovery.

Futures markets exist for the most widely used critical minerals and have grown consistently since their inception in 2021. However, they remain tiny relative to their role in “traditional” metals markets. Currently, daily traded volumes of lithium and cobalt account for less than 1% of their respective annual production; in contrast, nickel, zinc and copper have trade volumes ranging from 10-30%.

The volume-to-open-interest ratios, which measure liquidity, of lithium and cobalt on the CME Group represent only a small fraction of more established metals such as gold and copper.

Cobalt and lithium hydroxide aggregate OI.
Cobalt and lithium hydroxide aggregate OI. Image: CME Group

Critical minerals derivatives market challenges

Two major challenges must be addressed for critical minerals derivatives markets to grow large enough to play a price-stabilizing role.

The first is limited market pricing information that results from the high market concentration among lithium and cobalt producers. These companies primarily sell their products through private, long-term offtake agreements.

As such, the firms preserve their bargaining power and ability to set prices on a case-by-case basis, as well as conceal cost curves. Moreover, control over prices can be exerted to marginalize new entrants and smaller producers.

The second challenge is product complexity. Lithium and cobalt, due to their unique characteristics, are not entirely fungible, unlike most traditional metals, albeit in different ways.

Lithium is often considered more of an industrial chemical than a metal commodity. It varies in purity, has a limited shelf life and comes in different final forms. Cobalt, on the other hand, is more consistent in its physical characteristics but faces ethical concerns based on its sourcing, particularly in the Democratic Republic of the Congo, where most of the metal originates.

Strategies for market growth and stability

Fortunately, market forces are helping to overcome these challenges and more can be done to help critical minerals derivatives markets realize their potential.

Addressing the first challenge, large firms are beginning to use derivatives markets more as they respond to investors’ and lenders’ concerns regarding the impact of pricing volatility on financial performance. This increased participation should improve price signals in derivatives markets.

However, more can be done to increase price transparency. For example, reporting requirements for public companies could include pricing to be realized in forward contracts. Such disclosures could help price reporting agencies set more accurate benchmarks.

Changes at the exchanges are also required. In response to the product handling and provenance “complexity,” major derivatives markets, including the London, Chicago and Singapore exchanges, have opted to launch cash-settled contracts versus physically-settled ones. This means that the contracts only handle lithium and cobalt “financially” while buyers and sellers continue to contract separately for actual product delivery, limiting the utility for market participants.

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The future of critical minerals trading

In contrast, lithium carbonate derivatives in the Chinese market, GFEX, which offers physically settled contracts, are seeing more significant volumes, liquidity and pricing index contributions than in markets with only cash-settled contracts.

Addressing the physical challenges of trading these minerals may be worthwhile for markets in the United States and Europe. Physical trading capacity should align with battery manufacturing growth in these regions. Implementing regulations and logistics to support physically settled exchanges outside China would further enhance market depth and liquidity.

As exchanges add physical settlement to their offerings, it is also possible to “tag” specific products with attributes, such as where and under what conditions the product has been mined. Such tagging of derivatives contracts can further broaden market participation by tapping into the growing demand for sustainable investment and sourcing options.

A combination of more price reporting along with the exchanges adapting to investor and buyer demand can help derivatives markets realize their potential. In turn, needed investment in mining and processing for the economy – especially in the case of ex-China – will be supported.

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Related topics:
Financial and Monetary SystemsEnergy Transition
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