HOTTER ON METALS: It's the carry, stupid

It’s the carry, stupid. Although Goldman Sachs was a lot more polite when explaining why it believes long queues to access metal stored in warehouses developed.

It’s the carry, stupid. Although Goldman Sachs was a lot more polite when explaining why it believes long queues to access metal stored in warehouses developed.

But pleasantries aside, the message of a document spelling out the background to its physical commodities activities, including in aluminium and warehousing, was pretty clear.

It’s all down to a confluence of fundamental market conditions, which made the storage of metal exceedingly attractive.

What those conditions are has been listed numerous times by banks, traders, analysts and even the former ceo of the London Metal Exchange, Martin Abbott.

But Goldman Sachs was explaining the dynamics of the aluminium market ahead of a testimony to a group of US senators, whose knowledge on the matter is, understandably, a little less robust.

The bank’s document does a pretty good job.

Investment
The gist of its argument is that when aluminium demand collapsed in the economic downturn, the market slipped into a surplus and has stayed there ever since.

It hasn’t been helped by the producer community which, aside from some crucial cutbacks from the likes of US Rusal, Alcoa and Rio Tinto Alcan, has resisted making much-needed cuts.

Goldman Sachs spotted this trend and made the decision to buy Metro International Services in 2010.

This decision was based, it says, “on the investment thesis that the aluminium storage business would perform well given the substantial reduction in demand for aluminium resulting from the global recession and the historical propensity of aluminium producers to resist cuts in production as long as possible”.

As the bank itself says, its investment thesis “proved correct”.

When it bought the company Metro already had more than 800,000 tonnes of aluminium in its warehouses, largely in Detroit, the heart of the depressed motor industry and near to centres of production.

That continued to rise as the other key and more important factor took its toll: the carry trade.

Carry
As the bank notes, prices of surplus commodities like aluminium reflect carry dynamics, meaning that spot prices are lower than prices for forward delivery.

Where the difference between the spot purchase price and forward sale price is sufficiently large, financial entities cover the costs of funding a purchase and storing the commodity through the forward sale while still earning a low-risk return.

As Goldman Sachs notes, aluminium has been in carry for most of the period since 2008, making it an ideal target, not for consumers seeking to buy metal for spot delivery, but for dozens of banks, traders, hedge funds and merchants who knew a good deal when they saw one.

Low interest rates that have persisted throughout the period helped seal the fate of aluminium as the darling of the financing community.

These deals aren’t new, nor have they vanished.

Those favourable financing conditions still exist today – except the vast majority of the metal being stored as a result is off-warrant, meaning it doesn’t show up in official stock data.

Goldman Sachs estimates this figure to be about 8 million tonnes, almost double the amount stored on-warrant in LME warehouses.

This reflects the fact that – even with premiums at record highs – the carry trade is more profitable than selling at available market prices, the bank says.

Allegations
Goldman Sachs also addresses a series of allegations it has had flung at it over the past couple of years.

Incentive payments didn't create the queues, it says; they are paid by everyone trying to run a warehouse business and keep metal in their system.

Nether did Metro drive aluminium around Detroit from one warehouse to another in what the New York Times described in July 2013 as a ‘merry-go-round of metal’, as it is the owner of the metal that decides whether it moves it on- or off-warrant. 

Nor did Metro slow down deliveries to make queues even longer and delivery premiums stronger; it delivered out 600,000 tonnes of aluminium more than it loaded in over the past 12 months.

Its Detroit warehouse queue is falling and yet US aluminium premiums are at record highs and showing no sign of falling.

It doesn't matter that Goldman Sachs owned the warehouse with the biggest queue in the USA; it has strict Chinese Walls and other information barriers preventing it from using client information.

Focus, instead, on the carry trade, the bank says, because that is what is keeping these financing deals going.

It’s a tough argument to dispute, as any trader, merchant or hedge fund involved in financing millions of tonnes of aluminium will tell you. 

Andrea Hotter 
ahotter@metalbulletin.com
Twitter: @andreahotter 

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