UNITED KINGDOM April 07 2014 3:35 PM
LONDON (Scrap Register): The court ruling halting the application of the new LME load-out rules has surprised market participants. The renewed state of flux in rules may limit financing appetite, as in Q3 13, in turn supporting a softening in aluminium time spreads. The outlook for aluminium physical premiums is also now more balanced though, will still depend on LME delivery queue length, said Barclays in a research note.
The decision on 27 March 2014 by the UK’s High Court of Justice to quash the LME’s implementation of its new ‘linked load-in load-out rule’ has arguably provided the most significant shock to base metal market expectations so far this year, alongside the Indonesian export ban. After dominating market focus for much of last year, the assumption had been held since November that the new rules would kick in from April this year. While several effects were anticipated, the critical conclusion was that delivery queues at affected warehouses (with delivery queues over 50 calendar days) would necessarily fall over time. Given the court ruling, the situation regarding the outlook for the LME warehousing system has re-entered a period of flux.
According to Barclays, there are several conclusions one can make at this juncture:
1) Base metal markets now re-enter a period of uncertainty with regards to the LME warehousing rules. How the LME responds and the timeline of that are unclear, but a new review including delivery queue rent caps/abolition appears probable. In the meantime, the lack of clarity this creates on the outlook for physical premiums (particularly for aluminium) will likely constrain financing activity. There a similar state of play in Q3 last year between the proposal and finalisation of new LME rules. The key short-term price effect in that period was a widening in aluminium time spreads as more constrained financing activity limited forward selling pressure. The current environment could well promote a similar move in aluminium spreads until the situation is cleared up.
2) Without the medium-term assumption in place that delivery queues will decline at key LME locations such as Detroit in the US and Vlissingen in Europe, the outlook for premiums becomes more balanced. Barclays does not explicitly believe the court ruling is bullish for aluminium premiums, rather that without the new rules, there is no reason why LME delivery queues could not increase, which means there is an upside risk to premiums.
On the current delivery queue length at Detroit, we see the Midwest premium (MWP) justified at close to $350/t, which suggests some modest downside potential. In the very short term, the announcement might spur some precautionary buying from consumers in the US who in general have been running on low inventory. However, Barclays does not expect this to trigger the degree of short covering upward pressure on MWP as in January-February this year.
3) The court ruling explicitly focused on the LME consultation notice and its failure to identify the main alternative option to reducing queues, namely, banning or capping rent charged by warehouses during the delivery queue period. While it remains to be seen whether such a policy is applicable under EU competition law, the ruling at least raises the prospect of its potentially being part of any subsequent consultation and, in turn, rule implementation.
If rent caps/abolition eventually became an LME solution to delivery queues, there are two important takeaways to consider in advance. For any given queue length, lower rents should lower the cost of taking delivery of LME units so that in theory on its own, it should be bearish for aluminium premiums. As a solution in its own right, this does not offer any guarantee of premiums being supported.
However, if such a rule was signalled as possible, then in the short term premiums would be supported by a surge in warrant cancellations. This would occur because of the potential benefit of being in the delivery queue when/if rent caps were applied; in other words, there is every incentive for a warrant holder to cancel if rents will be lower once in the queue, and if progressively lower over time, it would make sense to get into the queue as early as possible. This dynamic would of course increase queue length, and if there were no constraints on re-warranting, would create a continued cycle whereby there would be little incentive not to cancel a warrant as soon as issued.
4) Finally, we do not expect this period of flux in warehousing rule application to have a significant effect on aluminium market fundamentals. Given no justification from the current delivery queue length at Detroit or Vlissingen for regional premiums to move higher, there is no obvious reason why smelter margins will be supported by the ruling and, in turn, no case for production cuts being halted or reversed. Generally, Barclays believes producers have not seen the move in premiums in Q1 this year as sustained and, hence, have not built it into their medium smelter viability assumptions.
An example was Alcoa’s announcement the day after the LME court ruling that it will curtail 147Kty of smelting capacity at its São Luís (Alumar) and Poços de Caldas smelters in Brazil by the end of May this year.