(The opinions expressed here are those of the author, a columnist for Reuters.)
By Andy Home
LONDON, (Reuters) – The splintering of the global aluminium price is becoming ever more acute.
Physical premiums on both sides of the Atlantic have just sailed through the $500 per tonne level, widening the disconnect between the global reference price set on the London Metal Exchange (LME) and the “all-in” price paid by manufacturers.
There is accumulating evidence that first-stage aluminium users, who have up to now taken the unhedgeable premium pain, are looking to pass it down the supply chain to their own customers.
If they do, what was once considered a temporary aberration risks becoming embedded throughout the aluminium industry.
The LME is racing to catch up with its U.S. competitor CME Group in offering premium contracts, a potentially valuable hedging tool but one that may act to cement the fracturing of the previous pricing model.
And all the time the premiums keep rising. Why? And what will halt this seemingly unstoppable premium machine?
IN THE BEGINNING THERE WAS DETROIT
Aluminium manufacturers have blamed the LME’s warehousing network for causing premiums to rise. The exchange has in turn pointed to the extraordinary combination of financial crash in 2008-2009 and the subsequent period of negative real interest rates.
What’s not in doubt is that huge amounts of unwanted metal flowed into LME warehouses, particularly in Detroit, at the end of the last decade as financial crisis became manufacturing crisis.
That transformed the LME forward aluminium curve into “super contango”, attracting the attention of stocks financiers, who realised they could earn a return by buying spot and selling forward. “Free” QE money both facilitated the trade and, by obliterating any positive return in fixed-income markets, incentivised it.
The main cost of what LME veterans still call the cash-and-carry business is storage. LME rent rates are much higher than off-exchange costs, so it was no surprise that there was a collective rush to move metal out of LME sheds.
A delivery system designed to handle industrial-scale flows couldn’t cope with the load-out requirements of financiers, who were dealing in the hundreds of thousands of tonnes.
Metro, the LME warehousing operator that found itself in the eye of this aluminium storm in Detroit, decided to capitalise on its good fortune of being in the right place at the right time by using the rental income from its load-out queue to bid for more metal.
The more metal that flowed in, the more metal that was hoovered up by financiers, who then cancelled it with a view to moving it to cheaper sheds elsewhere in the city. The load-out queue grew and grew, a virtuous circle for Metro, a vicious circle for anyone else trying to buy physical aluminium.
It was inevitable that such a great money-making scheme would attract the attention of bigger players. Goldman Sachs snapped up Metro in 2010 and finessed the revolving-door warehousing strategy. Glencore, one of the power players in the aluminium market, bought its own LME warehousing operator, Pacorini, and rapidly built its own load-out queue at the Dutch port of Vlissingen.
Whatever the disputed drivers of the original disconnect between LME basis price and premium, the linkage between lengthening queues and rising premiums was indisputable.
It seemed logical then that if the LME could reduce the queues, premiums would fall.
Logical but, with hindsight, wrong.
THE INVISIBLE FLOOR
The LME’s new load-in-load-out formula has brought to an end the revolving-door warehouse model. Even though it only comes into effect next February, both Metro and Pacorini have preemptively changed their behaviour.
The load-out queue at Vlissingen has been trending lower, now at 637 calendar days, compared with 748 at the end of April. That at Detroit has been capped at around 700 days in recent months and should now start falling, given there is hardly any metal left there to cancel.
Premiums, it follows, should have topped out, if load-out queues were the primary driver.
But they haven’t.
The premium for Midwest delivery as assessed by Platts, a leading global energy, metals and petrochemicals information provider, currently stands at 23.5 cents per lb, equivalent to $518 per tonne. The cost of getting metal out of Detroit, factoring in the length of queue, the corresponding rent and the load-out charge, is $382 per tonne.
The physical premium, in other words, has itself disconnected from the queue “premium”.
That doesn’t mean that the queues are not still in the mix. It’s just that they have changed from primary driver of rising premiums to invisible floor.
There is still a “hard” arbitrage between getting metal out of the LME system and the physical market, even if it is not currently profitable.
PHYSICAL DRIVERS
But, quite evidently, other factors are now driving physical premiums over and above anything that could be explained by the length of LME load-out queues.
And, in many ways, they are the traditional drivers of physical premiums, reflecting both the cost of delivering metal to a manufacturer’s yard and the nuances of regional supply-demand dynamics.
Right now, for example, at a very local level trucking rates are rising in the United States, increasing the costs of delivery.
At a regional level, the United States and Europe are evolving into ever deeper deficit markets, reflecting the closure of smelter capacity over the last few years.
Annualised primary aluminium production in North America has fallen from 5.9 million tonnes at the end of 2007 to a current 4.5 million tonnes.
Consumption is booming and the United States is sucking in ever greater quantities of imported metal. And, because traditional sources of supply such as South America have also seen smelter capacity slashed, those imports are coming from ever further afield.
Imports from both Russia and the Middle East, in particular, are rising but the freight is significantly higher, directly impacting the cost of physical delivery.