Metals pricing under threat from warehousing rule change; reduced dominance of warehousing companies in physical metals markets could lead to significant price drops for some metals

July 4, 2013 5:47 pm

Metals pricing under threat from warehousing rule change

By Jack Farchy

Warehousing sounds dull. But investors should pay attention: it may be about to reshape the global metals markets. The buzz among metals traders this week was not about Chinese growth or US monetary policy, but a proposed change in warehousing rules by the London Metal Exchange. The move, coming just six months after the LME was acquired by Hong Kong Exchanges & Clearing for £1.4bn, aims to reduce long queues to remove metal from some warehouses in the LME’s global network. Should the LME push ahead with its proposal, traders and analysts say, the impact on the global metals markets could be dramatic, reducing the dominance of warehousing companies in physical metals markets and possibly leading to significant price drops for some metals.“We are in no doubt this is one of the most significant developments in LME-traded metals markets in a long time,” says Duncan Hobbs, metals analyst at Macquarie’s closely followed commodities team.

To understand why, it is necessary to dive into the arcane world of metal warehousing.

In 2008, when the global economy went into a tailspin, demand for industrial metals from global manufacturers dried up, leading to a large pile-up of inventories. Stocks at LME warehouses rose from just 1.5m tonnes at the start of 2008 to 6.2m tonnes by the end of 2009. Currently they stand at a record 7.7m tonnes.

That made warehousing an attractive and lucrative business. Banks and traders including Goldman Sachs,JPMorgan, Glencore and Trafigura all piled in, buying warehousing companies to profit from storing LME metals.

But though the metal flooded in, the quantity of metal that warehouses must deliver out each day is limited by LME rules. That created enormous bottlenecks at some warehouses, where queues have stretched up to well over a year.

Since owners of the metal must continue to pay rent on it, even while it is in a queue to be delivered out, the limit on the loading out rate gives warehouses a guaranteed income. As a result, it has become economical for warehouse companies to buy metal in and then sell that metal on the exchange, in the knowledge that whoever buys it will be forced to pay rent while they wait for physical delivery out of the warehouse.

In the past two years, warehouses have sucked up stocks of aluminium, copper and zinc. These so-called “warehouse wars” have helped to drive up physical premiums – the cost of metal over and above the LME benchmark – to record levels, creating a disconnect between the LME price and the physical market and leading metal users from Coca-Cola to General Motors to voice their dissatisfaction.

On Monday, Charles Li, chief executive of HKEx, made clear that he wished to put an end to the issue, describing it as “highly irritating” and with “the potential to cause long term harm”. He proposed a new rule, open to consultation, that would force long queues to be reduced from April next year.

The impact on the behaviour of warehouse companies has been immediate, traders say, with the two most active buyers of metal – Glencore’s Pacorini unit and Goldman’s Metro unit – both suspending the incentive payments they make to attract metal to their warehouses.

The forced reduction of queues should reduce premiums, particularly in the aluminium market, where the “warehouse wars” have caused premiums to more than double since 2010. “Premiums have to come down,” says one senior trader. “We’ve essentially taken out a bid from the market.”

The immediate effect would be to put pressure on aluminium producers such asRusal, Chalco, Rio Tinto and Alcoa, already struggling with low aluminium prices, which last week hit a fresh four-year low of $1,758 a tonne.

“Mainly it’s terrible for the producers in the short term,” said one trading house executive. “At these levels the reason why many of these guys don’t shut down is because they have a high premium. If that disappears, you have smelters going out of business.”

The second order effects of the change in rules are less easy to predict. The prospect of falling premiums may make banks and traders less willing to buy aluminium for so-called “financing deals” – potentially putting additional downward pressure on prices.

Indeed, Mr Hobbs of Macquarie notes that as large queues for aluminium are reduced in Detroit and the Netherlands, “the changes to load-out rates as proposed would have the effect of opening two medium-size aluminium smelters”.

Nonetheless, the market is unlikely to move in a straight line. In particular, traders say, the nature of the proposed rule change means it will not always be economical for warehouses to take delivery of metal.

That could make the market more vulnerable to squeezes, since traders who have sold LME futures may find themselves in some cases unable to deliver metal to the exchange to settle their contract. “The warehouse will definitely have no interest to take on big tonnages if they already have an existing queue,” says one senior trader. “I think it’s a serious problem.”

What is clear, though, is that if the rule – which Mr Li once jokingly referred to as his “bazooka” – is implemented, it will cause a fundamental shift in the trade of aluminium and to a lesser extent other metals. As one aluminium trader puts it: “It completely changes the landscape.”