UNITED STATES November 10 2013 12:14 AM
LONDON (Scrap Register): The LME’s decision to go ahead with a new warehouse policy as of 1 April 2014 means there could be more volatility in front-end time spreads (aluminium in particular), more metal held off-warrant and lower physical premiums (after possibly rising initially), resulting in further production cuts and ultimately a tightening in the ex-China aluminium market that we already forecast to swing into deficit in 2014.
According to Barclays, the LME has cut the threshold for warehouse queues that will be subject to the new loadout rules, from 100 days to 50 days. This change means that a few more warehouses will fall under the new load-out rules than would have been the case under the first proposal and, thus, the volume of metal leaving warehouses will be marginally quicker. The LME itself acknowledges this is a concession to consumers with “50 days allowing the LME to better deliver a market of last resort to physical metals users”. Based on current queue levels, there are seven locations that have so-called “affected warehouses”. The first additional material that will be made available as a result of the new policy will be on 1 May 2014 through to 31 July 2014.
If industry participants react to the proposals by rushing to get metal out of LME warehouses, there could be a sudden surge in cancelled warrants. This would reduce tradable warrants, which could lead to bouts of front-end spread tightness – as witnessed before, especially in the lead market. Furthermore, a symptom of the warehouse policy and differentials between rents means more metal could be moved from on-exchange to offexchange; this would also reduce tradable warrants and again potentially lead to bouts of front-end spread tightness. This is especially the case if this off-exchange material is hedged on-exchange since, as the LME itself acknowledges, individual warehouses could refuse to take delivery of material against a short future position if it subsequently affected its loadout rate. Such an event could lead to exaggerated backwardations if the short futures leg of the trade had to be rolled while material was moved to a location that would take delivery.
“We also see potential for some upside risk to physical premiums in the short term if industry participants react by rushing to get metal out of LME warehouses. A sudden surge in LME cancelled warrants could boost queues temporarily, causing physical premiums to go higher. However, we ultimately expect physical premiums to continue to drift lower as a function of reduced queue lengths on the LME and reduced incentive affordability as material is held off-warrant,” Barclays added.
Weaker physical premiums would reduce the take-home price for producers (especially aluminium smelters) unless it was offset by an increase in the flat price. We think premiums are more likely to fall before prices rise, so initially there could be more supply rationing, with high premiums having been a lifeline for higher cost aluminium producers in North America and Europe in particular (European smelters likely to suffer most from weaker aluminium premiums). However, further down the line, this should be price-positive, especially since the ex-China aluminium market has swung from a 1.4Mt surplus in 2011 to a forecast 1Mt deficit in 2014.
The LME also intends to provide new delayed data on a per-warehouse basis and will look into publishing a “commitment of traders” report, both of which would increase transparency of the market.