* Copper market backwardation could spike
* Large copper stocks position returns to LME
* Available LME copper stocks down 75 pct since March
By Eric Onstad
LONDON, Feb 13 (Reuters) - A short, sharp squeeze could be on the cards for physical copper markets as inventories fall and healthy demand outpaces expected new material from smelters.
Analysts expect the market to be weighed down by a surplus later this year due to rising mine output, but for now availability of refined copper is tight.
"There is clearly a substantial risk that the copper market could invert more aggressively during the early part of the year before higher refined output finally pushes the market into surplus," said Nic Brown, head of commodities research at Natixis.
"If anything were to occur which might impact supply unexpectedly ... then the market might find itself staring at the prospect of a brief but very painful shortage of metal."
The shortages are showing up in copper on the London Metal Exchange (LME), which has been in backwardation for over a month - a situation in which the nearby price is higher than the forward price due to strong immediate demand.
The premium of cash LME copper over three-month copper spiked to a peak of $64.50 per tonne on Jan. 21, the highest since May 2012, and was last quoted at $43. The premium could spike to $300 if the market is squeezed, Brown said.
The market is vulnerable because LME on-warrant inventories - those available for withdrawal - have tumbled by 75 percent since last March to 125,675 tonnes.
Consumers who need copper and speculators betting on lower prices could find themselves squeezed if shortages emerge and a big player builds back a position in LME inventories.
In December, one party gathered 50-80 percent of available LME copper stocks and over 90 percent of combined stocks and short-term trading instruments, a position worth nearly a billion dollars on paper.
That huge position was liquidated a few weeks ago as prices declined and after short holders rolled positions into future months, lessening the chances of making money from a squeeze.
But a battle between longs and shorts may only have been postponed as a sizeable position in copper reappeared this week.
LME data showed one investor holding 30-40 percent of available stocks while two other parties had big short positions in March futures, one with 10-19 percent and the other with 20-29 percent of the market.
"It kind of looks like the focus of the squeeze is shifting. I think the dominant position will come back towards the end of February as the March date (futures expiry) approaches," said Wiktor Bielski, head of commodities research at VTB Capital.
Investors betting on lower prices and consumers who need supplies are counting on smelters to step up the pace of processing after stronger mine production last year resulted in stockpiles of concentrates.
Refined copper output in top consumer China in December fell 5.9 percent from the previous month to a three-month low.
Higher processing fees were expected to give incentives to Chinese smelters, but this may not provide as much of a boost as expected, especially due to shortages of scrap metal needed to blend with concentrates, an industry source said.
"I really don't think there's a huge amount of scrap in the system so I think in the next four to six weeks we'll see the scrap market get very tight, which will put constraints on refined production," said the source.
"I think it (physical shortages) will last three months at least. It's no science that Chilean refined output is having chronic issues."
In Chile, the world's biggest copper-producing country, overall smelter output dropped by a quarter in December after a strike at Codelco's Chuquicamata smelter while port strikes also put a lid on copper exports. [ID:nL2N0K50BQ}
Those who caution about refined shortages also point to Indonesia, which banned unprocessed ore exports in January but later loosened restrictions on copper.
"I think many people are underestimating demand and overestimating supply, particularly when you look at what's happening in Indonesia. It's not at all clear what's going to happen to concentrate exports," Bielski said.
Freeport-McMoRan Copper & Gold and Newmont Mining Corp are in talks with the government about a new tax and have yet to resume exports, while a trade group has filed a legal challenge.