Re-Convergeance and Non-Convergeance of the LME and Off-Exchange Markets in the Aluminium Market

reconvergeance and non convergence of the aluminium markets

Two of our finance students in Derivatives Products at Université de Moncton did a work on Aluminium during last fall that you can read here. They were not only right, they timed it, which the mother of all bombs (ask a trader).*

They concluded their work with this:

“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.”

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

[NOVEMBER 3, 2014]

Aluminium LME Stocks are currently at their lowest since April 2008 [1]

LME price vs inventory

Credit: LME

Commodity Merchant Trading and Shipping Advisory Services

lme-big

Credit: Platts

The first observation on the chart above is that once new LME rules have kicked-in, the (the All-in price minus LME spot premium) over the LME warrant has melted.

Banks: White Knights

During the mid-2000s, China entered the aluminum industry in a big way, flooding the market with cheap metal.

Then came the global recession and financial crisis: Aluminium producers were hit and had excess production and inventories. Market carry spread started to build-up and Central Banks were lowering interest rates. Banks like GS sized up this opportunity to enter a market to fill a financing & trading gap, complementing their existing prop trading portfolios.

Just to let you know that back then, Banks were greeted as White Knights by the metal community.

– During the last marketing year, All-IN Alu prices were rich and banks were kind to finance mega-aluminium deals with producers. ( and to paraphrase my students, the London Metal Exchange Market Structure was also discriminating cash buyers….)[2]

-Warrants stocks were cancelled and re-cancelled creating load-out waiting queues at wrs. This has created a logistics premium in the All-In Prices across the globe.

-During February 2015, the new rule kicked in with the aim of reducing what was deemed as artificial congestion within the LME wrs.

Banks: Evils 

-The existence of congestion premia created difficulties for the metals community in respect of both discovery and hedging of the “all-in” price. (Banks are now Evils)**

-This year falling carry spreads & all-in premiums mean financing deals structured with aluminium producers become no longer attractive for Banks. The absence of financing for excess stocks means that aluminium is ending up returning on the non-warrant market, off-exchange market.

Re-Convergeance and Non-Convergeance of the LME and Off-Exchange Markets in the Aluminium

The next chart shows a less obvious observation: a divergence has appeared in the aluminium market. [he All-in price is going down while the LME (Forward and Spot) is going up]. [3]

ALL-IN-PRICE= LME cash price + premium. 

LME CASH PRICE: based on the LME Warrant, buyer may receive metal of a brand different to that desired, in a location different to that desired, and will have to pay a free-on-truck (“FoT”) charge to remove the metal from a warehouse.

Matt Levine refers the LME cash price as an “abstract aluminum market”. [4]

“You can just think of it as: There’s a market for people to buy and sell hunks of aluminum in Detroit, and there’s a different market for people to buy and sell abstract aluminum claims in Abstract Aluminum Space, and those markets have different prices. But the point of the abstract market is to help set and hedge the price in the local market (and lots of other local markets elsewhere), so if they get too far out of whack — if the Midwest Premium gets too high, or fluctuates too much — then the abstract market isn’t doing its job well. The more closely the local price tracks the abstract price, the better the abstract market is doing.” 

PREMIUM: The Premium is not a separate cost but is rather the arithmetic result of subtracting real prices observed on the LME from real prices observed in the region market (say Midwest).

smart-lme-aluminum-cash-price-vs-all-in

Credit: Platts

To me the divergence comes from the traders’ prints, nothing else.

-Aluminium Marketers and LME warrant traders did a lot of outbound Forward Sales taking delivery from the LME WRS knowing the LME WRS Rule was changing (thus correctly anticipating opportunities with premium plays on a short and longer term basis).

-What we see in the Alu market is the unfolding of previous trades tied to inventory financing.

-It is when they close these positions that they lift the LME Spot or Forward prices (creating a mini rally) despite the All-In price is still deflating.

Break-evens and Margins enhancements

Despite we are touching the so-called Aluminium Breakeven/MT produced (the black dotted line on Platts Chart no.2), this warrant/non-warrant trading activities offer a real chance to complement low-margin production/ less efficient smelters. It will certainly help maintain the profitability of the industry during Q2 and so forth.

A semi arbitrage also exists between Power and Aluminium Markets. Aluminium is basically a way to store and export energy and nothing stop aluminum smelters to stop metal production and sell back power from their low-cost.

Alcoa or Rio Tinto can shut some smelting capacity and sell the POWER back into the open market to enhance margins.

They can do it only because they bought at low preferential rates (often hydro) under long-term power purchase agreements.

  © 2015 Navigating the commodity markets with Freight and Spread

For a thorough understanding of exchange delivery commodity contracts, forward curves and carry economics, warehousing economics and an experience of working with trading companies in commodities. Contact 

massif

Commodity Merchant Trading and Shipping Advisory Services

Notes:

* One of the student is set to start an internship  in commercial management  at an Aluminium co. this summer.

** Contentious see [4]

[1] LME

[2] Is the Irresistible Aluminium Price Surge Departing from its Supply & Demand ? http://wp.me/p3k7lL-25D

[3] European producers under pressure on softer aluminum ‘all-in’ price, Platts The Barrel

[4] The Goldman Sachs Aluminium Conspiracy Lawsuit is Over, Matt Levine, Bloomberg, it is absolutely a good read.

Advertisements

Leave your comment

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s