What LME bazooka means for aluminium trade

November 8, 2013 8:54 am

What LME bazooka means for aluminium trade

By Jack Farchy in Abu Dhabi

Some traders believe the premiums may even rise

Boom! Charles Li just fired his bazooka. After a two-week dramatic pause that kept the market on tenterhooks, the London Metal Exchange on Thursday announced its solution to the thorny issue of warehousing: the LME will cap queues at 50 days and to arm itself with a range of punishments for badly-behaving warehouses. One question hangs over the market. What does Mr Li’s bazooka (which the chief executive of LME’s owners,Hong Kong Exchanges & Clearing, has recently rebranded “Chinese medicine”) mean for aluminium premiums?Long queues have helped warehouses bid for metal in the physical market and so driven premiums – the difference between the price of physical metal and LME futures – to record highs.

Whether or not premiums fall from their elevated levels is no mere academic discussion. It could decide whether some aluminium smelters stay in business; it may also determine whether the LME can maintain its relevance to the market.

The LME has explicitly targeted high premiums – in July, Mr Li called persistently called elevated premiums “highly irritating”. The LME also believes premiums will fall. In the lengthy consultation document it published on Thursday it said that its analysis “would tend to imply that – ceteris paribus – the “all-in” metals price should remain constant, with the premium falling as a proportion, and the LME price rising as a proportion”.

But what if, after all that fuss, premiums stay high? Or even – whisper it quietly – rise? That is becoming an increasingly widely-held view among some metal traders.

Indeed, despite the looming LME rule change, premiums have in fact risen in recent weeks.

That is counterintuitive. The rise of queues to take delivery of metal since 2010 has allowed warehouses to pay more to attract metal, knowing that any tonne of metal they bring in will stay in the shed for a certain length of time.

With its new rule, the LME has effectively put a cap on the warehouse bid in the market. With a queue of 50 days at current rents and delivery charges a warehouse would earn a guaranteed $60-65 for each additional tonne of metal delivered in, compared to current spot premiums of $190-$220.

But warehouses are just one source of demand for physical metal. And there are good reasons to think the others may keep premiums supported.

First, consumers – the rolling mills, extruders, and other aluminium fabricators who are the traditional source of aluminium demand. While they generally satisfy the majority of their needs using long-term contracts, many consumers have been wary about booking large volumes on annual contracts this year given the uncertainty over rules. Moreover, the scrap market is tight and the global economy is in recovery mode. Consumers may soon find themselves in the unfamiliar position of bidding up aluminium premiums.

Second, there are financiers. Financiers will buy physical aluminium if by doing so they can lock in a profitable financing deal. This depends on a number of variables: the cost of rent, the cost of capital, and the shape of the futures curve – since they make money by buying spot metal and selling futures. The outlook for premiums will also affect the attractiveness of the trade, since financiers must sell their metal at the end of the trade – if they have to do so for a lower premium than they paid for it, they could lose a large chunk of their profits.

Despite expectations of rising US rates and falling premiums, the financing trade is alive and well. The recent rise in premiums, traders say, has been driven by renewed financing demand.

If, then, premiums do not fall, will the LME have failed?

Not necessarily. Long queues have become self-reinforcing, with the largest warehouses able to offer higher incentives as queues build up, which leads to an increase in their stocks and therefore an increase in the length of the queue. This in turn allows them to offer yet higher incentives to attract more metal, and so forth, in perpetuity.

It is this circular effect that has most vexed the LME’s new owners, HKEx: after all, there is no logical cap on how high premiums can be driven by warehouses acting in this way.

Already, premiums have risen to as much as 15 per cent of LME prices; what is to say that they couldn’t reach 50 per cent, or 99 per cent? It is easy to see that in such a scenario the LME price would become entirely irrelevant as a benchmark for the aluminium industry.

“It’s not for the LME to say where premiums as a whole should go because there is a whole range of reasonable economic reasons for premiums,” Matthew Chamberlain, the LME’s queues tsar, said on Thursday. “Actually what matters here is . . . not all of premiums but the queue-based element of premiums.”

The Commodities Note is a regular online commentary on the industry from the Financial Times