Is the Irresistible Aluminium Price Surge Departing from its Supply & Demand ?

Summary

The LME serves as a basis on all commercial negotiations in the aluminium market. 

Authors observe how closely the LME derivatives are related to physical aluminium markets. They argue the recent increase does not reflect any shortage or a recovery in demand for aluminium, but rather the outcome of the cash and carry trade positions in the LME warehouses.

They conclude with the regulatory risk arising from the new delivery rule in 2015.

Should the LME go through the new rule in 2015, the delivery process will be more transparent and aluminium will be less prone to manipulative actions from banks. 

 The new rule would result in a liquidation of inventories and falling prices thus discriminating aluminium smelters.

Aluminium has remarkable properties: light, malleable and known for its resistance this metal is mainly used by the automotive and aerospace industry (73%).

Is the Irresistible Aluminium Price Surge Departing from the Supply & Demand of the Lightweight Metal ?

The LME (London Metal Exchange) serves a calculation basis in all trade negotiations on aluminium. In this work we observe that the LME derivatives are closely related to physical aluminium markets.

The Aluminium spot price has reached a high of $ 3000 / MT in 2007 and a low of $ 1200 / MT in 2008.

The historically high world inventories have pushed prices down in 2013. Later in 2014, a positive structure in the forward market has supported prices higher. The price of aluminium on the London market in 2014 it has stabilized in the $ 2,000/ MT.

Cash, Carry and Arbitrages at the LME

Opinion: the recent price increase does not reflect any shortage or a recovery in demand for aluminum, but rather the outcome of cash and carry positions in LME warehouses.

Banks have taken advantage of a positive structure on the forward market by storing aluminum to deliver at more expensive prices in the future to end users.

According to market observers, Goldman Sachs and JP Morgan control both warehouses and the majority of stocks on the London market.

Seeing an overproduction of aluminum following the 2008 crisis, banks have offered funding to smelters in exchange of their trading rights on future production.

The commercial control of both a significant portion of the aluminum and  LME warehouses have allowed banks to establish a position of dominance in the market, generating revenues with both storage (warrants), the arbitrage between the spot and forward market and speculative positions.

Circulating stocks from one LME warehouse to another back and forth (to make the delivery process difficult for end users), banks have squeezed the market, thus inflating the aluminium price.

The gray metal is generating a lot of value for arbitrageurs.

The congestion in the LME warehouses has generated positive basis (Spot-LME contract) premium.

For Instance during October, the Aluminium basis was US$ 420 over the LME contract while the shipping cost EU/Japan was below US$ 75/MT. But still, in order to realize the profit, you must get a hand on aluminium at first which is not easy because most of the Aluminium is tied to smelters-banks financing deals in the curve…

It seems that banks and traders were able to sell their inventories while enjoying higher prices during 2014, thanks to the positive structure of the curve. (Figure C).

Following complaints from end-users about the speculation, the LME has proposed a new rule.

Any warehouse will have to deliver a higher amount of aluminium stocks than what is received if the inventory storage time exceeds 50 days.

Conclusion

If the LME manages to implement the new rule in 2015, the delivery process will be more transparent and aluminium less prone to manipulative actions.

However, we believe that this new delivery rule would discriminate producers. Indeed, the new rule would result in a liquidation of inventories and falling prices.

Derivatives and the spot market for aluminium are intimately related. They determine the equilibrium price in the Global Aluminium market. Current Carry Cash-3 months carry is currently US$14/MT which is now making the storage strategy non-profitable. Furthermore, regulator risk at the LME will also affect the balance of Aluminium in 2015 prices.

 Authors Mamoudou Diallo and Fioloyimi Kakpo are undergrads students in Finance at Université de Moncton in Canada.

Blue and Gold Merchants' Club


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