The London Metal Exchange (LME) published proposed changes to warehouse rules on July 1 and invited market participants to submit comments by today. Novelis collaborated with aluminum consumers in the Aluminum User Group (AUG) to develop a response to the LME proposals and offer further ideas to address the situation. This group covers aluminum consumers representing global companies in the beverage, flexible packaging and automotive sectors. The AUG submitted its feedback on September 9 and you can read our submission here.
Novelis gave our reaction to the LME proposals in a previous blog posting in July. We believe that the changes would bring more balance between the load-in capability and the load-out obligation for the warehouses with delivery times of greater than 100 days and would gradually shift the market in the right direction. However, these changes would be difficult to administer and enforce and would take too long.
Reminder of the complaint
As a recap, it is our view that the existence of the long delivery times creates supply chain risk and has led to the highest local market premiums in history at the same time as we are seeing the highest stock levels in history. The premiums have escalated because LME warehouses have competed for metal alongside consumers and traders. The warehouses’ offer is based on the length of time the warehouse can expect the metal to remain in their premises and the rental income the warehouse can consequently expect to earn. As the load-out delays lengthened, the period over which the metal would be stored increased and this allowed them to raise their bids. It is our view that this is the main driver of the higher premium levels.
No delivery delay is acceptable because it leads to a divergence between a derivatives market and the underlying commodity market. When a buyer of a commodity has paid for the goods and requested access, the commodity should be immediately available and not available 19 months later. And when there is a delay, it makes little sense that the owner of the commodity should pay rent whilst waiting for access to the material. Think about it. Imagine if you bought a soft perishable commodity like wheat and were told you could come and collect it 19 months later, and pay rent whilst you were waiting. Would you accept those terms?
This is the principle that lies at the heart of the AUG’s recommendations. We have also asked for increased transparency through the implementation of a commitment of traders report together with improved visibility of LME rules; enhanced firewalls in institutions with potential conflicts of interests; and increased scrutiny of warehouse capacity and monopolization of delivery locations. We need more balanced representation on committees and a clearly defined dispute resolution process, managed by an independent, third party.
Finally, as I mentioned in my July blog, there needs to be greater regulatory oversight over the warehousing activities. Initial discussions with regulators in Europe and the U.S. have indicated that the warehouses were believed to be outside the scope of market regulators. We are pleased that the U.S. Commodity Futures Trading Commission (CFTC) decided to investigate the issue in July and we believe that this, together with inquiries launched by other regulators and governmental agencies, will ultimately bring closure to this issue.
As you might expect, there are others who have very different views on this issue than we do. Why would these companies have such a different perspective? Aluminum consumers have estimated that they are paying $3 billion in excess premiums currently. This is estimated simply by multiplying aluminum production outside China (about 25 million tonnes) by $120/t which is an estimate of the degree to which premiums are artificially inflated. This is directly linked to the warehousing issue. This is very conservative, because in reality, all aluminum in warehouse stocks, finance deals and even scrap is impacted by the higher premiums. The beneficiaries are the companies who produce or own aluminum in storage. It has always been my belief that if the warehouses could no longer offer incentives, premiums would return to normal levels and this would impact all the “longs” in the market. We see this happening today, even before a rule change.
Masking a bigger issue
The inflated premiums have compensated for lower aluminum prices over the last couple of years. The LME price today is about $1800/t. There have been comparisons with 2008 when the LME price peaked at over $3300/t, arguing that the net price of aluminum is historically low. Interestingly, the average nominal price over the last 20 years is about $1800/t. I believe it is unreasonable to make comparisons with the highest price in the last 20 years. The real issue is that the world is grossly oversupplied with primary aluminum and this is reflected in the current LME price.
The real challenge is that primary production outside China has increased to support expected demand in that nation, but Chinese domestic production itself has expanded to balance the growth and consequently the rest of the world is today structurally over-supplied. The inflated premium has kept some high cost smelters on life support over the last few years and these continue to add to the surplus. The high contango and appetite among financial institutions to buy metal to support financing deals have provided an outlet for the excess production, but this is simply prolonging the inevitable restructuring needed in the primary aluminum industry outside China.
The entire metals industry is under a spotlight today. The activities of banks in commodity markets and the operation of the LME are being challenged. Where will it all lead? If the LME adopts some of the recommendations of the AUG, warehouses will no longer be able to offer significant incentives and premiums should return to normal levels. There is, of course, a risk that the metal will be withdrawn from the LME and shifted to non-LME warehouses where it will disappear from the radar and continue to be withheld from the market. So the supply chain risk might remain.
However, if there are also constraints established around banks’ ownership of commodities, millions of tonnes of aluminum could be released to the market, paralleling the issues in the early ‘90s when former CIS metal was exported to the West leading to a three year depression in aluminum prices. Some market participants want to maintain the status quo and hope that consumption growth will eat-up the surplus in storage over the next few years. But this scenario is likely to delay the recovery in the primary sector for two to three years. Perhaps the industry needs to reflect on the success of the memorandum of understanding (MOU) between producers 20 years ago and take bold moves today to restore the market balance now and not rely on external factors and wishful thinking to save the day.