The aluminium market’s issues could be fixed by new regional premium contracts and transparent data reporting, not by the proposed changes to London Metal Exchange warehousing rules which will only complicate and prolong the situation, according to US producer Alcoa.
The company called on the LME to establish regional premium contracts for four locations – The US Midwest, Rotterdam duty paid, Rotterdam duty unpaid, and cif Japan.
It also reiterated its call for the LME to improve its transparency by establishing a Commitments of Traders style report, similar to that established by US regulator the Commodity Futures Trading Commission (CFTC).
In a letter sent to the LME, Tim Reyes, Alcoa’s president of Materials Management, said that the growing spread between the LME price and premiums are the real problem, not the amount of time it takes to get material out of storage.
“While satisfying a short term public relations need, imposing this rules change will have serious short and long term impacts – encouraging the movement of LME inventory to invisible, off warrant inventory, increasing the call for regulation of the LME and undermining confidence in the HKEx, its understanding of the aluminium industry and its motivation for purchasing the LME,” Reyes said in the letter.
“We believe that the proposed changes constitute a major market intervention that will aggravate the lack of transparency that has had a damaging impact on the aluminium industry and will do nothing to help our customers manage their exposure to aluminium pricing,” he added.
Alcoa’s letter comes in response to proposed changes to the LME’s warehousing rules, designed to cut queues to access metal in storage and reduce premiums paid for physical delivery.
Those proposals, which impose additional load-out requirements on warehouses with wait times of over 100 days, are set to be voted on at the next meeting of the LME board in October.
The letter was addressed to Matt Chamberlain, the principal architect of the current warehouse proposals and new LME head of business development.
“We encourage market users to contact us with their views,” LME spokeswoman Miriam Heywood said, adding that the exchange had no further comment to make until the conclusion of the consultation.
Alcoa ceo Klaus Kleinfeld said the proposed changes to the LME warehousing rules “are trying to solve a non-existent metal availability problem.”
Company analysis of the situation shows that metal is readily available and consumers are not waiting in queues.
The main problems with the proposals include the potential for higher warehouse rents and handling fees, along with the movement of metal off-warrant and out of regulatory oversight.
Metal leaving warehouses with queues beyond 100 days would also likely go to locations with lower queues, and stay there invisibly until it was placed on warrant.
The letter also noted that material could shuffle between warehouses, while logistically constrained warehouses might be forced to refuse metal, creating an artificial tightness creating backwardations even at a time of market surplus.
Alcoa’s analysis also noted that the credibility of HKEx would be at stake if it acted “carelessly” to make snap decisions.
“A quick and narrowly focused market intervention like the warehouse rules changes will undermine confidence that the new LME owners have broad understanding of market drivers at the very time HKEx plans to make the LME more friendly for electronic trading and build it out as a gateway for China’s commodity trading with the West,” the company said.
“Instead of taking such a questionable action that massively interferes with supply and demand market dynamics, to maintain the credibility necessary to achieve those growth goals the LME needs to address pricing transparency immediately,” Alcoa said. “If the proposed warehouse rule changes are implemented, it will say to existing and potential users of the exchange that the HKEx is willing to act carelessly and that the LME may not be the correct forum for their price discovery process.”
The basic problem is that aluminium premiums, which rose to record highs at the same time as queues to access material soared to sometimes 18 months, are difficult to hedge in the current marketplace, Alcoa said.
“The current alternatives available to hedge premium exposure are illiquid and only available in the over-the-counter market. Credit exposure to financial premium swap counterparties limits liquidity and there are no visible benchmarks for forward premium prices necessary for valuing forward positions,” Alcoa noted in the letter.
At the same time, the price discovery process in the current OTC market is not transparent, with poor visibility and liquidity of forward premiums. This makes it difficult for those with exposure to hedge effectively and to value forward exposure, Alcoa said.
“Credit worthiness limits the number of counterparties to trade within the OTC market,” Alcoa added.
The warehouse queue issue is a “red herring” driven by claims that it would reduce prices, despite the reality that aluminium prices have declined 40% in the past 5 years, according to Reyes, and by claims that it would increase supply – despite a surplus of physical aluminium available to end market consumers.
The current LME system of warehousing bases delivery upon the seller’s option; the buyer of an LME warrant does not know which location it will get in advance.
This deters consumers from using it irrespective of the queues, Alcoa noted.
According to Alcoa, it is time for a physical market the size of aluminium to move beyond being based on a US Midwest benchmark.
“Today’s method for setting regional prices, by publication surveys, does not allow risk holders to effectively hedge their position,” the company said.
“An exchange-traded premium contract will address the call for more transparency in how premiums are set. And a clearing system would enhance liquidity in the marketplace by allowing a greater portion of the market to participate,” it added.
Alcoa called on the LME to use its forum, platform, and technology to “offer a transparent marketplace for these products to trade in the open market.”
“Through premium contracts, users will have the ability to trade a transparent, clearinghouse-backed product and value their forward positions on a daily basis,” Alcoa added.
Increased speculative trading with zero interest in physical metal delivery means the LME aluminium price doesn’t reflect the fundamentals of the industry, Alcoa’s letter said.
Instead, the price is being driven by short-term macro-events: historically low interest rates and metal price contango, combined with the increased attractiveness of metal and other commodities as an asset class.
Alcoa’s repeated calls for transparency focuses on its desire to have clarity on the effects and relative influence financial investors have on the price discovery process.
“Activity from this sector has driven overall trading volume in the aluminium contract to 37 times the physical market. Today’s antiquated reporting structure of the LME is not providing the pricing transparency by differentiating between fast money investors and those that are interested in physical metal supply raising questions about the validity of the price determination,” the letter said.