UNITED STATES March 24 2014 6:05 PM
NEW YORK (Scrap Register): The CRU aluminium conference has provided the setting for the launch of the CME’s ‘all-in’ North American aluminium contract, geared towards solving the hedging challenge created by the surge in physical premiums.
Barclays does not believe this contract will have any near-term effect on premiums. However, if financial and physical liquidity can be achieved alongside a lack of delivery queue issues, then the LME will have a serious competitor in the North American market.
Barclays attended the CRU North American Aluminium Trends conference, which offered a prime opportunity to meet with the regional consumer community in particular, and discuss developments in the aluminium market. Given the recent extreme turbulence in aluminium physical premiums, the main focus of discussion was the CME announcement of a new North American ‘all-in’ aluminium contract to be launched this May.
The main conclusion from the largely consumer audience was that they welcomed the contract, most importantly in terms of the possible benefit regarding hedge accounting, which needs to be understood in the context of the increasingly sizeable un-hedged premia price component when using the LME benchmark. There was a general acceptance, however, that achieving enough liquidity and participation to support its contractual usage along the aluminium supply chain versus the long dominant LME benchmark would likely take at least several years.
In that context, consumers believed the contract’s successful uptake would require a setup providing immediate access to cancelled metal in CME warehouses, versus the current long delivery queue at LME’s Detroit location, where wait times have extended to over two years. In this respect, the CME stated that if queues are longer than 20 business days at any delivery point, then the warehouse would need to justify the queue to an independent CME committee (with no financial link to warehouse rents). If that is not achieved, then either they will need to stop charging rent or stop accepting metal deliveries.
In Barclays understanding, any delivery queue over 50 business days would not be allowed full stop, irrespective of the warehouse’s explanation. However, even the CME contract setup would not remove the entire possibility of some lead time in taking delivery of metal, although clearly significantly shorter than currently at certain LME warehousing locations.
The main uncertainties expressed were in regards to whether: 1) the contract would actually gain critical mass in liquidity, both financially and physically; and 2) whether there would be any effect on the Midwest premia (MWP).
In regards to 1), recent history would suggest a skeptical standpoint as appropriate. The CME has attempted aluminium contracts twice in the past, both of which ended in failure, while new contracts attempted by the LME in plastics and steel have also proved unsuccessful. This new effort may have better grounds for success in the context of dissatisfaction, with the significant proportion of the total aluminium price that premiums make up (close to 20% in the US currently) rather than simply being in straight-up competition with the LME contract.
Producer and trading house participation was seen as vital in liquidity generation as well as in terms of attracting metal deliveries. Potentially, the CME may employ a market maker incentive programme to support liquidity. There was also a belief that physical deliveries could be achieved, particularly in the context of significant metal currently being cancelled from LME warehouses and financed off-warrant (in other words, metal that is flowing off the LME and then will have optionality on LME/CME delivery when financing economics compress to pull the metal back on exchange). In this respect, liquidity along the proposed CME all-in aluminium forward curve to support financing activity would be a vital component to achieve a sustained pull of units.
In terms of 2), Barclays sees little reason to consider the CME contract as a near-term factor in regards to physical premium levels. Aside from the disorderly positioning correction that drove the MWP to record levels in February this year, the critical driver over the past three years has been the cost of delivery of LME metal from Detroit. This has been the source of the highest cost required to solve the US regional supply-demand balance, which Barclays expects to continue in the foreseeable future. In that sense, it is only as the new LME rules reduce delivery queue length that the MWP will be pressured to fall over H2 2014 and into 2015.