LME Reform Unlikely To Significantly Alter Market Pricing

BMI View: We believe LME reforms are unlikely to have any significant and immediate impact on aluminium future contract prices or premiums. After end users of aluminium launched public complaints over queues at LME-controlled warehouses, the LME released a plan in early-November 2013, to be implemented in April 2014, which would mandate warehouses with queues longer than 50 days deliver more metal than they bring in. While load-out queues also affect other LME-traded metals, reforms are likely to be most felt in the aluminium market given its size and the metal's role in the cash and carry trade. Here we discuss potential outcomes that such reform may bring and our view towards the likely impact of rule changes.

In the years since the 2008-9 financial crisis, market participants have taken advantage of low interest rates and aluminium's steep contango curve through the cash and carry trade, whereby investors borrow money, purchase metal, and sell it forward at a profit. This has been cited as a major factor driving rising premiums, since more metal steadily locked away in such financing deals has limited immediate supply to traditional commercial and industrial end users, raising the premium charged for immediate delivery from LME warehouses. Historically low interest rates have driven this market dynamic, with warehousing firms keen to store metal locked in such deals by traders given the rent they can charge to metal sitting as inventory. Indeed, current market estimates indicate around 80% of aluminium in LME-licensed warehouses remains locked up in financing deals.

This market structure has left buyers and suppliers at fundamental odds with one another. Elevated premiums incentivize production and support margins and profits at firms such as Rusal and Alcoa at a time when LME futures contract prices remain at multi-year lows. Yet downstream producers such as Novelis argue higher premiums inflate prices and encourage warehouse operators, several of whom are owned by banks and other firms engaging in the aluminium cash and carry trade, including Goldman Sachs, JP Morgan, and Glencore Xstrata, to increase load-out times. While warehouses make money on rent charged to hold metal inventories, the parent company engaged in aluminium trading makes money off of elevated premiums received at contract expiry. Though the latter two firms are seeking to sell their stakes in warehouse units following regulatory scrutiny, we expect cash and carry trading to continue given sustained financial incentive.

Warehousing Scheme Set To Continue
LME Aluminium Warehousing - Market Actors

LME Reform Unlikely To Significantly Alter Market Pricing

BMI View: We believe LME reforms are unlikely to have any significant and immediate impact on aluminium future contract prices or premiums. After end users of aluminium launched public complaints over queues at LME-controlled warehouses, the LME released a plan in early-November 2013, to be implemented in April 2014, which would mandate warehouses with queues longer than 50 days deliver more metal than they bring in. While load-out queues also affect other LME-traded metals, reforms are likely to be most felt in the aluminium market given its size and the metal's role in the cash and carry trade. Here we discuss potential outcomes that such reform may bring and our view towards the likely impact of rule changes.

In the years since the 2008-9 financial crisis, market participants have taken advantage of low interest rates and aluminium's steep contango curve through the cash and carry trade, whereby investors borrow money, purchase metal, and sell it forward at a profit. This has been cited as a major factor driving rising premiums, since more metal steadily locked away in such financing deals has limited immediate supply to traditional commercial and industrial end users, raising the premium charged for immediate delivery from LME warehouses. Historically low interest rates have driven this market dynamic, with warehousing firms keen to store metal locked in such deals by traders given the rent they can charge to metal sitting as inventory. Indeed, current market estimates indicate around 80% of aluminium in LME-licensed warehouses remains locked up in financing deals.

Warehousing Scheme Set To Continue
LME Aluminium Warehousing - Market Actors

This market structure has left buyers and suppliers at fundamental odds with one another. Elevated premiums incentivize production and support margins and profits at firms such as Rusal and Alcoa at a time when LME futures contract prices remain at multi-year lows. Yet downstream producers such as Novelis argue higher premiums inflate prices and encourage warehouse operators, several of whom are owned by banks and other firms engaging in the aluminium cash and carry trade, including Goldman Sachs, JP Morgan, and Glencore Xstrata, to increase load-out times. While warehouses make money on rent charged to hold metal inventories, the parent company engaged in aluminium trading makes money off of elevated premiums received at contract expiry. Though the latter two firms are seeking to sell their stakes in warehouse units following regulatory scrutiny, we expect cash and carry trading to continue given sustained financial incentive.

Reforms Unlikely To Alter Market - In Short Term

Though significant market uncertainty remains, we believe that reforms aimed at reducing queues for metal delivery and increasing the load-out rates at LME-licensed warehouses are unlikely to immediately increase the supply of available aluminium to end users and lower premiums. While we acknowledge that the composition of all-in prices, made up of underlying LME futures contracts and the premium paid for physical delivery, may eventually shift back towards the former in line with historical pricing, we do not see such a reversion as being imminent. Rather, as long as the aluminium cash and carry trade remains profitable, supplies will get locked away and premiums should remain elevated relative to LME futures contracts. More metal is likely to be moved to non-LME warehouses, distorting supply and leading buyers within the LME system to bid up premiums.

Available Supply Dwindling
Global: LME Aluminium Inventories Less LME Cancelled Warrants (tonnes)

We expect ongoing financier interest in aluminium cash and carry trades to support elevated premiums at least into mid-2014, primarily due to the effect of shifting inventories. Despite the announcement of LME reforms in Q313, various regional premiums have either held steady or even increased. LME reforms are likely to hasten the movement of aluminium to non-LME warehouses, particularly as traders are likely to be attracted by discounted rents offered outside of the LME system. A recent Reuters reports claims that Pacorini Metals, a subsidiary of Glencore Xstrata, has already delisted 14 of its 52 warehouses in the Netherlands from the LME network, where it has upwards of 2mnt of aluminium stored. This will give Pacorini greater autonomy to reduce rent rates and encourage traders to store metal at its delisted warehouses as it will not be constrained by LME rules. Less metal will be available for physical settlement of LME trades, though Pacorini and other warehousing firms stand to benefit from rent on stored metal.

Market To Remain Supportive
Global - Aluminium Premiums, Monthly (US$/tonne)

With more metal moved to non-LME registered warehouses, aluminium markets are likely to become less transparent. This will put further constraints on traditional commercial and industrial end-users seeking to secure metal on the spot market outside of multiyear supply contracts, and lead to premiums being bid upward. Ultimately, we believe that once the cash and carry trade becomes less profitable, premiums are likely to fall and more metal will be released to end users. This will happen over a multi-year period, as we expect continued monetary policy normalisation in developed markets, particularly in the US, leading to increasing interest rates. However, aluminium financing will remain alive for the foreseeable future, exacerbating current market trends.

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