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|