The giant London Metal Exchange (LME) aluminium stocks carousel is spinning again.
LME-registered inventory surged by 58% to a two-year high of 1.49 million tonnes between the middle of November and the middle of December as 600,000 tonnes of metal flooded into exchange warehouses.
No sooner had it arrived than the cancellations started. A total 633,675 tonnes have been earmarked for physical load-out since Dec. 16, including another 35,075 tonnes on Monday.
Drawdowns are now accelerating. Load-outs averaged 13,330 tonnes per day last week. Monday’s tally of 15,375 tonnes was the highest daily departure rate since May last year. There are another 619,075 tonnes to follow.
None of this has anything to do with aluminium’s fundamental dynamics other than to remind us that there is a lot of metal around. Rather, it is all about the opaque, through-the-looking-glass LME storage market.
It’s why the exchange is implementing yet another raft of changes to its warehousing function.
WHAT COMES IN…
The mechanics behind the original November-December stocks surge are relatively straightforward.
The LME aluminium forward curve started tightening in September. The cash-to-three-months spread CMAL0-3 contracted from a contango of $33 per tonne early that month to a backwardation of almost $23 in early December, at which stage the structure was the tightest since July 2018.
Such a move upends the mechanics of financing metal stocks which are predicated on a sufficiently wide contango to cover the costs of insurance and storage.
The impact is accentuated for those holding short futures positions against physical long holdings, creating a financial incentive to deliver metal into the LME system.
This spreads-stocks relationship is part and parcel of LME trading and plays out across all the metals, although the effects are more dramatic in aluminium because there are literally millions of tonnes of inventory sitting in the off-exchange statistical shadows.
It may seem curious that one of the changes the LME is implementing at the start of next month is designed to encourage more metal into the system.
Particularly since the exchange will do so by relaxing the rules on load-out queues, in essence allowing warehouse operators to earn more from metal stuck in a queue so they can lift their incentives to attract more metal in.
However, right now it takes an extreme shift in the spreads, such as that seen in the fourth quarter of last year, to generate inflows.
The LME wants to allow “warehouse companies to act more commercially in offering storage terms to metal owners” the rest of the time as well. (“Consultation on warehouse reform: Feedback analysis”, November 2019)
…MUST GO OUT?
The danger, of course, is that a loosening of the rules means a return to the bad old days earlier this decade, when load-out queues stretched into years.
The LME counters that such “structural” queues are no longer possible under its revised rule-book and that warehouse companies themselves have no financial interest in “operational” queues since they represent a loss of rental income.
No surprise that the recent gyrations in LME stocks saw just such a load-out queue appear at one warehouse company in Malaysia’s Port Klang last month. Istim, which held 57,775 tonnes of cancelled metal at the end of December, had a load-out queue of 33 days.
Other operators will likely also see such flash queues develop given the recent level of cancellation activity. C. Steinweg’s Port Klang operations, for example, held even more cancelled stock, 95,704 tonnes, at the end of December.
This build-up of stocks awaiting load-out touches on the other part of the LME warehousing problem, namely the unwillingness to keep metal in the LME system.
This is in part down to the fact that LME storage is intrinsically much more expensive than off-market storage. But that simple cost consideration is compounded by the nature of some of the incentives used by warehouse companies to attract metal in the first place.
Incentives are highly opaque, given they are private deals between metal owner and warehouse operator, although the LME does itself see what is going on.
One type of incentive deal in particular, the so-called “evergreen rental”, actively encourages the outflow of metal.
The “evergreen” template allows the owner of the metal to share future rental storage with the warehouse operator as long as the metal stays on LME warrant. If someone else buys the metal, the only current way to escape such a deal is to cancel the metal and load it out.
Which may go a long way to explaining why so much recently-arrived aluminium is already turning around and heading back out of the LME system.
The LME is going to restrict such deals, also effective next month, to just the original entity placing the metal on warrant.
A QUESTION OF TRANSPARENCY
The spinning aluminium stocks carousel says everything about how the LME warehousing system currently works.
Or doesn’t work.
The aluminium contract seems stuck in a seemingly endless cycle of low stocks, spreads tightness and high stocks followed once again by low stocks as metal washes through the system.
The biggest casualty is market transparency.
Those intimately involved in the stocks game may understand the rules but to outsiders such as investment funds, LME aluminium stock movements appear random rather than meaningful in terms of market price.
Would it help if we knew how much aluminium was actually in Port Klang rather than how much is on LME warrant?
That’s the third part of the LME’s planned reform package. Effective March it will require warehouse operators to report off-warrant stock if the metal is sitting in an LME-registered shed or if it is being held under a storage agreement explicitly referencing the option of LME warranting.
The exchange says it wants to evaluate the information generated before publishing it on a monthly basis further down the line. It is also hoping that metal owners will voluntarily report their off-market holdings.
That might be overly optimistic and, like the proposals on queues and incentives, the devil will be in the detail.
To be fair to the LME, it reserves the right to amend any of the three changes depending on how things pan out.
It’s highly unclear whether the latest reforms will lift LME stocks relative to off-market stocks but the current rotation of metal, driven by storage not market dynamics, isn’t doing either the exchange or the aluminium market any favours.