Upheaval In Metal Markets; Prices At Risk

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– LME moves to unblock warehouse bottlenecks
– Storage premiums at risk
– Fed to reconsider bank commodity trading
– Downside risk to metal prices

By Greg Peel

About six months ago, Hong Kong Exchanges & Clearing acquired the London Metals Exchange. Earlier this month the LME proposed rule changes for the warehousing of metals in order to reduce long queues that build up in the attempt to remove metal from the exchange’s network of warehouses across the globe.

While warehousing may seem like a trivial element of metals trading, traders and analysts have suggested the proposed changes could dramatically impact on global metals markets and potentially lead to significant price falls.

In a pre-GFC world, it made sense for the LME to limit the amount of metal which could leave an exchange-approved warehouse each day in order to maintain minimum inventory levels to prevent price squeezes. But when the GFC killed off demand for metals, inventories began to pile up. At the beginning of 2008, LME inventories totalled 1.5m tonnes but by 2009 had hit 6.2m tonnes and currently sit at around a record 7.7m tonnes. Under LME rules restricting daily deliveries, buyers can wait up to a year to take delivery out of a warehouse.

So what’s the problem? Lift the delivery limit, as the LME is now proposing, and unblock the bottleneck.

The problem is that a rather lucrative little side industry has built up around LME warehousing as a result of the delivery restrictions. Why else would major US banks such as Goldman Sachs, Morgan Stanley and JP Morgan decide to buy into the warehousing game? A seller must deliver metal to an LME warehouse, at a choice of locations across the globe, and a buyer must take delivery from an LME warehouse. As the metal sits in the warehouse, it attracts a storage cost. That storage cost must be paid even if the metal is in the queue to leave the warehouse but hasn’t yet been able to do so.

The result is the creation of a price differential between LME-published metal prices and actual traded metal prices, representing a premium for storage costs that have blown out due to said bottlenecking. One can understand why big buyers of aluminium for example, like Coca-Cola and General Motors, have made complaints to the exchange. The premium goes to the warehouse owner.

If that little game is not sly enough, it gets worse. So lucrative are the premiums on offer that warehouse owners have taken to buying in metal to their warehouses and then selling it on the LME, knowing full well the buyer will be stuck paying the storage cost for as long as it takes to take delivery.

And it gets worse still. Detroit represents one of the LME’s approved warehousing locations, and Goldman Sachs owns 27 different actual warehouses in the city. While the current LME rules restrict the level of metal which can be delivered in a day they also set a minimum level which must leave a warehouse each day, being 3000 tonnes. Goldman Sachs is not actually obliged to deliver the metal to a buyer, just to shift 3000t out of a warehouse. That 3000t can simply be taken to another Goldman warehouse, ensuring storage premiums are maintained.

Goldman Sachs and the other US banks do not just own warehouses, but oil refineries, tankers and power plants as well. Those banks are now under attack on two fronts. On one side is the LME, which is trying to alleviate delivery bottlenecks and reduce costs to buyers, and on the other the US Federal Reserve has now stepped into the ring, proposing to review a 2003 approval to allow banks to engage in physical commodity activities complementary to financial activities.

While the 2003 Fed approval allowed banks to trade in physical commodities, it stopped short of approving deposit-taking banks’ involvement in the storage of those commodities. There would otherwise be an implicit risk to depositor funds if those funds were used to finance commodity holdings, and commodity prices collapsed. Yet for reasons unknown, the Fed did not step in when in 2008 JP Morgan acquired one of the world’s biggest metal warehousing companies. Up until 2008, non-commercial banks such as Goldman Sachs and Morgan Stanley were not prevented from operating warehousing businesses as they did not take deposits. But under the TARP bail-out of that year, all US investment banks were forced to become commercial banks by default.

Were the Fed to reconsider its approval for banks to be involved in physical commodity trading and storage, it would affect all of JP Morgan, Goldman Sachs and Morgan Stanley – the biggest players in the global warehousing game. Goldman Sachs’ March quarterly financial report listed US$7.7bn of commodities on the books, and Morgan Stanley’s US$6.7bn. JP Morgan has already been asked to face allegations of energy price manipulation.

Notwithstanding any significant change in policy from the Fed, the fact remains the unblocking of LME warehouse bottlenecks would dramatically reduce the premiums metal owners are being forced to pay. The London Financial Times reports that over the past two years, warehouses have sucked up stocks of aluminium, copper and zinc, doubling the storage premium over that period as the banks engage in “warehouse wars”. These premiums are being passed onto to real end-users such as Coca-Cola, a significant producer of aluminium cans.

Coca-Cola would clearly then pass that additional cost on to consumers of Coca-Cola, of which there are quite a few across the globe. The bottom line is that bank warehouse wars are forcing global consumer price inflation (not just in Coke, but across all metal products or products sold in metal) at a time the global economy is struggling. Meanwhile, all the major US banks have now reported their June quarter earnings, and all have posted significant profit increases year on year.

Rah rah for the LME then, I hear you think. The problem is, US banks may simply lose a lucrative little sly earner if the LME rules are changed and/or if the Fed steps in, but the greatest negative impact would be felt by metal producers.

The lure of high storage premium generation is attracting warehouse companies into buying metal even at a time official LME metal prices are weak due to weak global demand. Warehouse wars are thus holding up prices. Analysts agree the metal under most risk of price falls from LME rule changes is aluminium, with a Macquarie analyst suggesting that if long queues for the metal are reduced in Detroit and the Netherlands, the price impact would be equivalent to two new medium-sized aluminium smelters opening for business. LME aluminium prices are likely to fall, and this would impact on global producers such as Alcoa and Rio Tinto ((RIO)).

A sharp drop in prices can not necessarily be assumed, nevertheless, given there is a flipside to the potential impact of new warehouse rules. Right now it is in the interests of warehouse owners to take as much metal as they can store, so to exacerbate delivery queue problems and collect greater premiums. But under new rules if a queue forms simply on natural demand, warehouses may be unwilling to take on new deliveries until the backlog is shifted. A seller of metal may thus not be able to deliver to said warehouse, and a price squeeze could ensue. Thus all-up the risk in implementing new changes is one of unwittingly fuelling price volatility.

The impact of even proposing such rule changes has already been immediate. Goldman Sachs has ceased offering price incentives to attract metal into their warehouses, the FT reports. Yet strangely enough, we are yet to see any negative impact on the spot price of aluminium, or any other LME metal.

The lack of response in the aluminium price is rather perplexing to Macquarie, who suggests the LME rule change “is one of the most significant changes on the exchange in recent history”. The views on the impact on the LME price are divided, Macquarie concedes, but there has been little change in total aluminium net positions (long or short) on the exchange, which remain well below record highs.

Macquarie suggests that a recent modest bounce in all metal prices is not about a turnaround in demand or demand expectations but more the impact of short-covering. The past couple of weeks have seen a sharp fall in open positions in LME metals, in some cases as much as 10%, which suggests the closing of short positions (covering) has been most dominant. The bears, suggests Macquarie, appear to have “thrown in the towel” for now. This is particularly apparent in nickel.

The opposite is true for copper, which is also traded on Comex in the US. There short positions held by speculators and funds are at all-time highs. Of all base metals, Macquarie is most bearish on copper over the next twelve months, but such an extent of short positions will likely dampen any near-term price falls. As for aluminium, a lack of movement in positions remains a mystery.

Perhaps with LME rule changes afoot and the Fed now rethinking bank commodity trading, the speculators have decided to remain safely on the sidelines to see what transpires.

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