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With forward spreads tightening as stocks fall, traders and analysts have warned that off-warrant inventories could come flooding back to the LME as market participants look to steer clear of losses arising from holding stock through backwardations.
For the time being, the contango in longer-dated spreads is large enough to allow stockholders to finance inventories off-warrant without making a loss, but volatility at the front end of the curve could cause problems for any party looking to roll hedges against physical inventories forward on a shorter-term basis, according to trade sources and analysts.
“If one of the major holders got into some difficulty and had to float, that’s the risk. It’s always been the risk since it started to unwind two years ago,” Vivienne Lloyd, senior commodities analyst at Macquarie, said in a media briefing last week.
“That’s why we’ve maintained a structurally bearish aluminium view, because it’s got this Damocles sword hanging over it; it always has,” she said.
At 2.2 million tonnes, headline LME inventories are now hovering around lows last seen in 2008, while on-warrant inventories – stocks that have not been ordered for withdrawal – last month fell to 1.25 million tonnes, also at an eight-year low and 74% below a peak seen in 2011.
And as the amount of available stock has fallen, the forward price curve has been flattening out, as those looking to buy stock or borrow spreads have found that there are fewer willing sellers and lenders in the market.
Tightness in the forward curve was particularly acute on September 21, when the tom/next spread traded in a $10 backwardation – equalling peaks last seen in 2014. The spike marked the peak of a period of heightened volatility in the aluminium forward curve, with the tom/next spread closing in a backwardation on seven occasions since mid-September.
These backwardations in nearby spreads are painful for anyone with expiring hedges against physical inventories, as their short positions must be bought back and carried over to a later date at a loss.
Rolling a 250-lot short hedge over by a day on September 21, for example, would have cost $62,500, or 0.6% of the value of the position, before storage and finance costs are taken into account, according to Metal Bulletin’s calculations.
But falling stocks are an issue for the LME too, as open interest tends to ebb and flow in line with changes in inventories.
As Metal Bulletin reported earlier this year, falling stocks have contributed to a slump in tom/next trading volumes, with aluminium tom/next volumes falling by 77% in the three years to June, while copper and zinc volumes dropped 40% and 56%, respectively.
As tom/next twisted into a $10 back on September 21, market open interest also fell to 893,000 contracts, the lowest level since August 2007 and down from a peak of 1.597 million contracts seen on December 16, 2011, when live inventories were near their peak.
While the industry coped well enough the last time LME inventories and open interest were that low in 2007 and 2008, it may struggle to do so now for two reasons, sources have warned.
Firstly, the global aluminium market has grown by more than 50% since 2008, with data from the International Aluminium Institute showing the industry producing at an annualised rate of nearly 63 million tpy in the first nine months of the year, compared with 40 million tonnes in 2008.
Secondly, until recently, the surge in production has not been matched by increases in demand, and over the years this has led to a surplus in global inventories that analysts claim runs into several millions of tonnes.
Citi estimates that global aluminium inventories – including producer, consumer, exchange and private stocks – stand at about 15 million tonnes, and estimates range from 10 million to 17 million tonnes, as the bank’s commodities analyst David Wilson told Metal Bulletin.
Those two factors mean that the volume of physical aluminium that needs to be hedged on the LME is far larger than it was eight years ago. If stocks and market open interest continue to fall on the LME, it may be increasingly difficult to manage those short hedges, Wilson suggested.
“Lower inventories will make it more difficult for anyone trying to sell the market. It will make things interesting for CTAs who go long/short if the shorts become more difficult to get out of, and it could also make it very expensive for anyone trying to hedge physical,” he said.
“As the spreads flatten out, anyone sitting on physical is going to come under pressure,” he said.
Many stockholders experienced this strain when the spreads flattened out in the first quarter, and LME stocks jumped by 125,000 tonnes in March as a result, he noted.
Now, there are signs that some stockholders are getting caught out again, with LME on-warrant inventories jumping by 112,000 tonnes in the ten days to October 24.
As the aluminium industry convenes in London, one question looms large: how much more is there to come?