Commodities | Nov 19 2013
– LME implements strict changes to warehouse rules
– Producers the victim
– Exchange may also suffer
– Aluminium under particular stress
By Greg Peel
In recent times the London Metals Exchange – the world’s leading centre of base metal trade and price discovery – has wrestled with warehousing rules and their impact on global metals trade. The bottom line is that long established rules intended to avoid price volatility have inadvertently led to exploitation by US investment banks, with the end result being lengthy delays between metal purchase and delivery for wholesale consumers.
Large consumers of aluminium, for example, such as Coca-Cola and car manufacturers, have been vocal in their protests to London. In response, the LME decided to review its warehouse rules and opened up a consultation period with industry participants over the September quarter.
Previously the LME rules ensured a minimum level of inventory would be maintained in exchange-approved warehouses to ensure a permanent supply balance and avoid sudden spikes of price volatility. This was achieved by limiting the amount of metal that can be moved from a warehouse each day. But to avoid stockpiling, there is also a minimum level which must be moved from a warehouse each day. Long story short, exploitation of these rules by warehouse owners has meant purchasers of LME metal can wait up to a year before actual delivery while being forced to pay a storage premium in the meantime.
For an explanation as to how US investment banks have been exploiting LME rules to their own advantage and the disadvantage of consumers, see Upheaval In Metal Markets; Prices At Risk.
When metal demand was skyrocketing in the noughties, led by China, and metal prices were following accordingly, warehouse rules acted to everyone’s advantage. But in a post-GFC world of lower metal demand, and a lower pace of Chinese growth, metal inventories have been piling up and US investment banks have been reaping in illicit profits from storage charges while manipulating inventory management.
On the other side of the equation however, such illicit activity has supported base metal prices in a time of production surpluses, thus keeping many a marginal miner afloat.
The LME has now delivered its verdict following the consultation period. The initial proposal from the exchange suggested a maximum permissible queue for delivery of 100 days (bearing in mind consumers could be stuck in an expensive queue for up to a year previously). The industry began to prepare itself. But the exchange has dropped a bombshell, lowering the maximum permissible queue to 50 calendar days.
The exchange has really flexed its muscles, Macquarie suggests. Aside from this limit, the LME rule change release included thinly veiled threats of increased transparency, future reviews, promises to target queue incentivisation and disciplinary action for anything deemed potential manipulation. It is an attempt by the exchange to regain credibility, Macquarie suggests.
But at what cost?
Producers were always going to be losers, hence their appeals to the LME to maintain the status quo. Aluminium and zinc storage premiums will almost certainly now fall, Macquarie contends, as will the “all-in” price as markets rebalance. Outside of China, supply of these metals will need to be cut further to return to balance.
But the LME itself could also be a loser. These tough new rules should see a redistribution of stock out of LME warehouses and in to others in the system, or stock may simply disappear under the radar, perhaps, over time, into a new exchange.
The other issue is that of metal financing. Despite the new rules implying metal will now shift quickly out of warehouses and stockpiles will be reduced, a large proportion of inventories cannot be sold as they are under financing arrangements. Holders of metal will often borrow funds using the metal itself as collateral – a popular trick in China, where metal stockpiling is common, to overcome tighter bank lending restrictions out of Beijing.
Falling premiums may encourage new financing deals to be put in place, Macquarie suggests, thus undermining the new rule changes and leading LME credibility to be questioned. Citi suggests reducing maximum permissible queues will not actually release significant tonnages of metal onto the open market simply because most of the said metal is being financed and thus not available anyway.
The financing offset goes some way to explaining why metal prices in general, and the price of aluminium in particular, did not start dropping the moment the LME proposed a warehouse rule review, much to the confusion of metal analysts at the time. Indeed, the FNArena article referenced above was written in July, at the beginning of a consultation process which lasted through to the end of September. Yet global aluminium production rebounded in the month of September, Citi reports, to the third highest monthly level on record (50.1mt). The two stronger months were also this year, in February and June. LME rules aside, additional production has come despite industry-wide calls for producer discipline and the need for production cuts to bring markets back into some semblance of balance.
The main offender is China, despite ongoing threats from Beijing to restrict smelter capacity growth. Not only did Chinese production reach 17.9mt in the month of September, an increase of 1.5mt year to date, around another 10mt of new capacity is under construction and around 1.3mt of this is due to start up before year-end, Citi notes.
Citi suggests statistics from China do not tell the true picture, which may be why the government has not put its foot down. Simple aluminium trade data imply China is currently a net importer of primary aluminium, but Citi believes these data ignore significant Chinese export of aluminium “semis”. Taking semis into account, Citi believes China’s aluminium market is in significant surplus.
Morgan Stanley has looked at the wider picture, and suggests the LME rule changes should ultimately be supportive to the aluminium industry. But not before a period of pain.
As more metal becomes available from LME warehouses and more evenly distributed, location premiums will shrink, MS suggests, and underlying prices will decline. Marginal producers will then come under significant pressure and some may be forced to trim production. This will then flow onto feedstocks, with the alumina market also facing pressure if demand from smelters recedes.
But reduced production will restore global balance, MS notes. The analysts believe aluminium will remain oversupplied in 2013-14 and a lower price is required to shift the market toward demand-supply equilibrium. It is difficult to predict how long rebalancing might take – at this stage Morgan Stanley is assuming 1-2 years – but “we expect the end-result will reinvigorate investment interest in this beleaguered market by the second half of 2014,” the analysts declare.
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