Stuart Burns

Usually, articles about the share price of specific companies bear some kind of footnote concerning the authors own exposure to the shares, whether they are a direct investor or via a fund, in the company in question.

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I can say, with some relief, that I am not, to my knowledge and fervent hope, an investor in BHP Billiton nor, at least in the short term, am I likely to be in the mining sector as a whole. I would accept there is an argument that some commodities could have hit bottom. If I was a betting man I might permit a small punt, but I am not and I won’t.

Caution: Watch for Falling Assets

Mick Davis looks like he may make a contrarian bet and buy Rio Tinto Group’s Australian coal business but that may have as much to do with the fact he has been sitting on a cash pile of investors’ money burning a hole in his pocket than coal is suddenly a great bet, even at these depressed asset prices.

Having spun off a chunk of mining assets under the trendy sounding name of South32 earlier this year, BHP probably hoped the worst of its write downs was behind it. South32 is a collection of alumina, aluminum, coal, manganese, nickel, silver, lead and zinc assets formerly known as Billiton. No one wanted the post-merger assets and BHP — formerly known as the Broken Hill Proprietary Company Ltd. — couldn’t sell them, so the firm wrapped them up into a bundle and gave them to their shareholders. Since May, the share price of South32 has, well… gone south. There’s no doubt BHP knew it would, but at least it got them off the company’s books.

Screen Shot 2015-07-20 at 17.59.10

Source: Financial Times

Not that BHP is alone, even the strategically savvy and fleet of foot Glencore PLC had trouble finding a buyer for its shares in platinum miner Lonmin and ended up doing the same thing, giving those shares to shareholders. Glencore is well shot of it, according to an FT report, the share price has collapsed from £40 each in 2007 to £1.08 today.

Back to BHP, though. Like its competitor, Rio, BHP has a history of buying assets at the wrong time or for the wrong reasons. Bigger isn’t always better and timing is everything. BHP moved into US shale gas too late only to see the price collapse. In 2011 the firm bought US gas operator Petrohawk for $12 billion only to take a $2.84 billion hit writing down goodwill as the value fell. The Telegraph reports the firm has taken a further $2 billion on its Hawkville gas project in Texas as geology complexity slows and complicates the development of the field.

What Does This Mean for Gas, Oil and Metal Buyers?

BHP, Rio and the rest of the major miners are big enough to weather the storm of low commodity prices, but with little on the horizon to suggest commodity prices are likely to rise significantly in the medium term and evidence that some may have further to fall, the companies dividend policies are going to come under pressure. A PriceWaterhouseCoopers report on the industry, covered by the FT, says their policy of borrowing money to pay consistent levels of dividends on their shares is unsustainable.

Dividends paid by the top 40 miners in 2014 consumed all their available cash, reducing their balance sheet flexibility in continuing tough times. Capex has been cut, for the top 40 by 20% in 2014, and exploration budgets fell to $4.9 billion last year, half the level of just two years ago. The maxim that today’s shortage is tomorrow’s glut is writ large in the minds of mining executives, but with investment falling so markedly we can be sure as the decade unfolds the reverse will become true. Whether the current crop of executives will be around to see it is another matter.

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As always, ThomsonReuters’ Andy Home turns out some excellent commentary backed by solid statistics.

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In a recent article, he reviews comments made by Alcoa Inc.’s Klaus Kleinfeld about China’s primary aluminum production leaking out of the country under the cover of the burgeoning export trade in semi-finished products. As the article explains, China exported 2.5 million metric tons of unwrought aluminum and aluminum products in the first half of the year. That was 35% or a 650,000-mt increase over the same period last year.

Untaxed Semis, Taxed Ingots

The temptation for Chinese producers to ship primary metal for export is significant in a domestic market oversupplied with unwrought primary metal, but producers are dissuaded from exporting ingot by a 15% export tax and a negative treatment on the value-added tax which is set at 13%.

Rightly in a country with high power costs, China sees exports of low-value primary aluminum as a wasteful export of energy-intensive material. Producers, though, are desperate to shift metal and the article suggests (and to Klaus Kleinfeld’s point) that a large part of this tidal wave of “semis” exports is not really semi-finished product at all, but simply primary metal either misrepresented on export paperwork or marginally re-worked to qualify it as a semi-finished product.

Many point to the fall in aluminum physical delivery premiums as support for the argument that Chinese exports of this primary-masquerading-as-semi-finished metal are a significant contributory factor to greater primary metal availability outside China.

What Does This Mean for Metal Buyers?

We have our doubts that the export of Chinese semis is causing a massive disruption in the marketplace. Chinese semi-finished product is being offered aggressively all over Asia and Europe. Chinese producers – aided by changes in export taxes and a falling Shanghai Futures Exchange base price relative to the London Metal Exchange – are able to compete in the semis market now to an extent they were not able to 12-18 months ago.

We are seeing increased market penetration and volumes hitting the European distributor and end-user markets this year. We are seeing European and Asian manufacturers lead times come down, in some cases to days, for extruded products, suggesting order books are weak.

Under such circumstances converters outside of China will not be buying as much primary metal and billet. Couple that with new Middle East smelter start-ups and metal coming off long-term financing deals earlier this year and there is enough to justify the fall in physical delivery premiums without some vast confidence trick going on in misrepresented metal exports from China. We are not saying Alcoa is wrong in making their assertions regarding this trade, no doubt there are situations in which it has happened, we just doubt it is as significant or is having as much impact as they suggest.

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The statistics illustrate the dire state of the Chinese steel market only too clearly.


Excess Chinese steel capacity has nowhere to go but export markets.

Crude steel output dropped in June by 0.8% from a year earlier while apparent consumption of steel for the first five months declined by 5.1%, according to Reuters. Meanwhile, steel prices are at their lowest in more than 20 years. In spite of weaker iron ore prices, large steelmakers’ losses on their core business more than doubled for the January-May period from a year earlier.

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Steel prices have been sliding as construction activity has remained weak, rebar futures on the Shanghai Futures Exchange have lost about 25% so far this year, on top of losing 28% across the whole of 2014.

Market Share at Risk

Steel mills have talked about bringing forward maintenance and refurbishment work this summer in an effort to curb the over-production and stabilize prices, but, so far, there has been little sign anyone wants to be the first to risk losing market share.

Rather, exports of steel products surged 28% to 52.4 million metric tons in the first six months of the year as mills dump excess production overseas. According to Reuters, CISA members (who comprise the top 100 mills) posted a loss of 16.48 billion CNY ($2.65 billion) for their steelmaking businesses in the June-May period, up from a loss of “just” 6.12 billion CNY ($984 million) for the same period last year.

The Chinese economy, in broad GDP terms, has been slowing. Depending on which numbers you look at (nominal or inflation adjusted) it is 5.8% or 7%. The inflation adjustment is a Beijing black box fudge factor and you can take it or leave it, but the underlying trend has been down earlier this year and is, at best, steady today.

Manufacturing, Construction Worse Off

Within that, though, manufacturing is suffering more than the wider economy. According to CNBC, Chinese industrial output for June rose a nominal 6.8% year-on-year, while last month’s retail sales climbed 10.6%.

The booming stock market in the first six months of the year will have contributed to that service sector GDP number and doubts must be raised over the near-term prospects for a stock market that was being propped up only by government intervention. Chinese stocks are still suffering from last week’s market shock.

If prices return to falling, as they surely would without Beijing’s life support, then both financial sector activity and consumer sentiment could suffer in the second half. Under such circumstances, an increase in steel demand seems even more remote and steel mill closures more likely. In the meantime, expect export markets to continue to be the destination of choice for unwanted production. If mills don’t mothball production and demand doesn’t pick up, it’s the only game in town.


A quiet revolution is going on in the US power generation market, and it may be giving a lesson for those countries dithering over whether to allow hydraulic fracturing (fracking) of oil and natural gas deposits identified but not yet proven.

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According to the FT, April was the first month in US history that gas-fired electricity generation surpassed coal-fired generation, (although it came close in 2012 when gas prices were also very weak). By comparison, in 2010 coal provided 45% of US power. In April of this year 31% of US electricity was generated by natural gas compared to 30% for coal, and the trend continues.

Watts Up

In gigawatt terms, wind power is growing even faster than natural gas, flattening the latter in the league tables. US coal capacity dropped by about 3.3 GW during 2014, and the US Energy Information Association predicts it will shrink by a further 12.9 GW this year, while wind power capacity rose by 9.8 GW and gas by 4.3 GW.

Source FT

Source: Financial Times

The reasons are more complex than simply low natural gas prices, although that, undoubtedly, is a major factor. The Environmental Protection Agency’s failed attempt to force environmental compliance by the back door this year encouraged some coal-fired utilities to see the writing on the wall and either mothball plants or invest in new technology to accommodate the mercury emission and other pollution targets, raising costs.

Brett Blankenship of Wood Mackenzie is quoted by the FT as saying, “low gas prices mean coal plants are running less, and when they run their margins are typically compressed. So companies find it difficult to make the investments needed to comply with regulations and keep those plants running.”

The Imitation/Substitution Game

It’s a vicious downward spiral in the face of lower-priced and less-polluting competitor fuels. Although natural gas makes a better swing fuel source to balance wind and solar renewables variability, not all utilities are blessed with an abundance of such spare generating capacity so they rely on their coal power plants to step in at times of peak demand. Unfortunately, running a coal plant at anything other than full or near-full load on a continuous basis brings per-gigawatt operating costs up AND per-gigawatt emissions of pollutants.

Not surprisingly, coal producers share prices have fared even worse than shale gas companies. Peabody Energy’s share price, the largest US coal producer, has fallen 98% since April 2011, while those of Arch Coal have dropped 99.2% and of Alpha Natural Resources by 99.6%, while their debt is so devalued it is yielding 17.9% for Peabody suggesting investors are expecting default.

With natural gas prices set to stay low for some years to come and renewable costs falling steadily the writing is on the wall for all but the latest and most efficient coal-powered electricity production. At least the environmental lobby will be pleased and the EPA may have achieved much of what it set out to do, Supreme Court slap down or not.

This September: SMU Steel Summit 2015


Looking purely at the aluminum price one might have expected Alcoa, Inc., to report a dire set of results in its latest second quarter earnings announcements but quite the contrary. While facing considerable “headwinds” according to Klaus Kleinfeld, the company’s chief executive, the firm has put out a decent set of results.

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Further, while the aluminum price has continued to show ongoing weakness, he is quoted by an FT article as saying he still expected that 2015 “could be a decent year like the one we saw last year.”


Alcoa’s business now goes far beyond traditional aluminum smelting.

Alcoa’s strategy of closing high-cost smelters, migrating to lower cost primary production in the Middle East, and diversifying into other alloys and downstream higher value-add products has clearly paid dividends for the New York-based multinational . Underlying earnings per share of 19 cents, excluding one-off items, were 6% higher than for the equivalent period of 2014, although analysts had optimistically forecast higher.

Diversification Paying Off

True, the share price is down 33% for the year, but for a business so exposed to the aluminum price, a quarter of Alcoa’s revenue comes from primary aluminum production most of which outside the Middle East must be close to loss making, and that is not unexpected.

Indeed, revenues —boosted by acquisitions and value-add investments — were slightly stronger than expected at $5.9 billion, up 1%, compared with an average forecast of $5.8 billion. Alcoa still made a profit from primary smelting overall. Its upstream activities made $67 million after taxes, down from $97 million for the same period in 2014. A strong performance from the alumina division added a further $215 million of net income compared to $210 million for the specialized metals and components business. Alcoa may be gradually exiting the smelter business, at least outside of it’s low-cost Middle East operations, but it’s not going to want to exit the stellar alumina business.

Future Growth

Looking forward, the firm sees good growth in the US market, with Europe gradually improving — assuming the Greek crisis continues to improve as expected now that a bailout deal is at hand. Slower growth in China and South America is still expected. Some markets, such as global heavy truck demand, are seen by the firm as likely to remain depressed but aerospace and construction are expected to continue to do well.

Although Alcoa operates in a highly dynamic cost environment, it continues to perform well despite an appalling primary metal price. Its strategy of downstream investment and alloy diversification is ensuring it remains a viable long-term business in spite of the current state of the market.

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Among the top three aerospace engine manufacturers in the world, ahead of Pratt & Witney but behind General Electric, Rolls Royce is the only viable major alternative to American dominance in the space.

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Aircraft builders such as Boeing and Airbus, not to mention a number of smaller firms specify one of the three for all their large aircraft and many smaller models. The aircraft industry has been on a roll for years, driven by rapidly expanding global trade in Asia and the Middle East and high oil prices causing considerable pain for airlines in fuel costs.

Trent 7000 infographic.indd

Rolls Royce is counting on sales of engines such as the Trent 7000 to move its business from maintenance-focused to new sales-focused. Infographic: Rolls Royce

Aircraft makers have enjoyed bumper order books stretching out into the next decade. As a result, one would think all is well with the engine manufacturers. Every plane needs engines, right?

Production vs. Maintenance

Well, yes and no. Yes they all need engines and firms like Rolls make as much from service and maintenance as they do from selling new engines. Even more, probably. Yet timing is everything even in this business and Rolls has hit turbulence that has resulted in a fall in its share price and a third profit warning in 18 months.

Although Rolls is still predominantly an aircraft engine maker, the company makes about 70% of revenue and profit from the civilian and defense aerospace market, it also makes marine engines for supply vessels and power systems for oil rigs – a market that has tanked since the oil price collapsed and capital expenditures have been slashed.

Rolls’ main woes, though, have come from the aerospace side. According to the London Telegraph, the civil aviation industry is moving from fleets of smaller planes with less efficient engines (servicing and maintenance of which is highly cash-generative business for Rolls) to a new generation of larger planes with more efficient engines.

It has been estimated by analysts that cash and profits from engine contracts on the 747, 757 and 777 generation of jets will fall during the next two years. At the same time, the Telegraph says, the transition to new cash-flows from the delivery of the Trent 700 engine on the A330 are now lower than expected, as customers wait for the improved Trent 7000 engine to be fitted to the more fuel efficient A330neo, still a year or two away from production.

Counting on New Orders

The company is also waiting for a ramp-up of the Trent XWB engines for the new A380 and A350 programs, both of which are behind schedule.

Rolls isn’t going to go bust by any means, but the firm’s cancellation of its share buyback program and its third profit warning has supported calls for the marine and aerospace sectors to be split. Or for the marine business to be sold off with some suggesting that would see up to a 20% increase in its share price in the event of a split or raise up to $6 billion if marine was sold, which short-term investors are hoping could be returned to shareholders.

A Common Aviation Problem

Rolls’ problems probably mirror the rest of the engine makers. A full order book is not, in itself, a guarantee of consistently strong returns. Projects wax and wain, and if external pressures such as oil prices hasten the end of one contract before the next is ready to take off, suppliers suffer.

There will likely be something of a knock-on effect for material suppliers. Tier ones, of course, usually have good visibility into their principals’ programs. Those further down the food chain are sometimes not so lucky.

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In the US, steelmakers have won a major concession in terms of blocking unfairly priced or “dumped” steel imports.

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In the recently signed Trade Promotion Authority law, designed to aid workers displaced by imports, there is wording to reduce the hurdle producers have to overcome to prove material injury from imports.


The US steel industry has received the support it has long desired to prove dumping allegations.

Previously, domestic producers had to show two consecutive quarters of losses. Now, losing money is not a requirement to justify countervailing duties and anti-dumping actions. The change in language will make it easier for steelmakers to protect their home markets from imports deemed unfairly priced.

Bully for the US steel industry, but spare a thought for producers elsewhere. For example, in Mexico producers are forced to sack workers to force the government to take action. Altos Hornos de Mexico (AHMSA) , DeAcero and ArcelorMittal’s Mexican unit warned in a statement that if Mexico continues to import steel products at what it called “dumping prices,” the number of job cuts will rise, according to Business Insider.

AHMSA said in June it would cut its workforce by 20%, around 4,500 jobs, and suspend investments. DeAcero said it had fired 2,500 workers and suspended operations at one plant while, according to the newspaper, ArcelorMittal will cut 2,800 jobs at its Mexico operations. The producers named Russia, China and Turkey as dumping steel on markets at levels below production costs in their appeal to the government to take action.

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Never mind physical demand from end users, the omens for copper demand from the financial sector are arguably even worse if a recent paper covered by the Financial Times is correct.

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“Carry Trade Dynamics under Capital Controls: The Case of China” by Zhang Xiao, a fixed-income analyst with BNP Paribas, and Christopher Balding, associate professor at the HSBC Business School at Peking University’s Graduate School in Shenzhen, finds strong evidence that Chinese copper stocks were being used “primarily to facilitate a carry trade under capital controls.”

A roll of copper wire

Soon, in China, this will now be just a roll of copper and no longer an investment vehicle.

It is no secret that because of higher interest rates in China, compared to the rest of the world, Chinese investors have borrowed money offshore using a letter of credit from a bank to import copper. This was among other metals used but copper was the favorite. This was the scheme: Put the metal in a warehouse, and then invest the money in higher-yielding assets like property, financial products, or invest in manufacturing facilities.

More Than Half of Copper Used for Financing

The FT reports that some Chinese executives estimate that as much as 70% of China’s imports of refined copper were used to obtain financing rather than for actual consumption.

If the research backing the report is correct, the closer alignment of Chinese interest rates to global rates will negate the demand for this form of shadow financing and naturally reduce copper demand as a result. There is already considerable evidence to suggest this is already happening.

Chinese copper imports have been falling. Chinese interest rates have been reduced four times in the last eight months with the current rate at a record low of 4.85%. With investment depressed and the Chinese stock market tanking, there seems little prospect for interest rates other than to continue to fall, don’t bet on a significant pick up in copper anytime soon.

Chile Drops the Supply Side Ball

On the supply side, high-quality copper concentrate shrank more than expected in the first half of this year due to output delays from top mining nation Chile.

This may support prices later in 2015 but, if the Chinese carry trade demand is as high as the FT suggests, then it would likely outstrip any shortage in concentrate.

Production from two of four mines in Chile that churn out clean, standard concentrate was stalled in the first half as the country was hit by floods. The world’s top mine Escondida, has not tendered surplus concentrate for months, according to Reuters.

Smelters blend clean concentrates with supply from mines that have mpurities such as arsenic, which have become more common as miners dig deeper into the earth’s crust in Chile.

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It’s no secret that China’s growth is slowing. Iron ore and copper prices are screaming reduced demand from the rooftops and China’s GDP figures have been gradually declining for the last few years.

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Officially, the country is on track for 7% growth this year, stellar by most other countries’ standards, but in China’s case they have millions to lift out of comparative poverty and the lower the GDP growth, the less wealth generation there will be to achieve that aim. China’s per capita GDP is still a fraction of the US’ despite being the second-largest economy in the world.

NBS: Growth Exaggerated?

Recent data from China’s National Bureau of Statistics (NBS), though, suggests growth may, in reality, be even slower than headline figures suggest, according to the FT this week.

Reviewing the first quarter numbers in more detail, the FT suggests the 7% growth figures the NBS is quoting are hiding a marked slowdown in investment and consumption. GDP growth is measured by three components the paper says – consumption, investment and net exports.

Net exports add to national expansion to the extent that the country exports more than it imports, but the contribution has traditionally been a very small part of China’s GDP number in spite of the country running a massive export-orientated economy for the last decade or more. Investment and consumption make up the majority of China’s GDP, for the whole of 2014 net exports contributed just 0.1% of the 7.4% growth reported for the year, already China’s slowest annual rate of expansion in a quarter-century.

Exports Up, Growth Actually Down

In the first quarter of this year, however, net exports contributed 1.3% of the headline 7% growth, while consumption and investment accounted for 4.5% and 1.2%, respectively. Without the boost from net exports, therefore, first-quarter growth would have been much lower — at about 5.7%.

Nor is the growth in net exports due to a strong export performance, it is due to a fall in import costs as commodity prices have slumped. First-quarter exports were up only 4.9% on the same period last year, but the collapse in global commodity prices meant that the value of China’s imports over the first three months of the year fell 17%, resulting in a large surplus. Unless commodity prices continue to fall in the second half of the year that contribution may disappear toward year end.

Source: The Financial Times

Source: The Financial Times

Beijing is aware of this. Interest rates have been cut four times since November in an effort to boost consumption and investment, but the collapse of an overheated stock-market is not helping the situation.

How to Fix Debt-Created Growth?

The Shanghai and Shenzhen stock exchanges, which have lost about 30% of their value since hitting seven-year highs last month, are looking increasingly vulnerable to further falls, adding to worries that Q2 growth may be even lower.

According to the FT, Chinese authorities have also instructed banks to continue to lend to infrastructure projects even if they might be insolvent and eased standards for local government bond issues — part of a larger plan to roll over some of the CNY 22 trillion ($3.5 trillion) in debt accumulated by local government finance vehicles.

With investors’ concerns very much focused on Greece in recent weeks, there hasn’t been a great deal of attention given to the deteriorating situation in China. Many investors have been betting on a stimulus package from Beijing to boost activity for the last twelve months, but so far it has not materialized and existing problems with excessive debt will probably dissuade the government from embarking on anything like we have seen in the past. When the focus on Greece subsides, investors will have a new cause for concern, expect Q2 to be worse than Q1 for China’s GDP.

This September: SMU Steel Summit 2015


The London Metal Exchange is treading cautiously in making rule changes to the way its warehouse system works.

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Part of the reason is to be found in that phrase, particularly “warehouse system.” Independent operators run the warehouses; they are licensed or approved by the LME but they are not owned by the exchange. In addition the warehouses are located in different continents, in multiple legal jurisdictions and changes permissible at one may be considered illegal in another.

Legal Challenges

To add further complication, the legal challenges to rule changes in the past have come from primary producers such as UC Rusal and end users such as MillerCoors and Coca-Cola. So, the LME moves cautiously. This week’s announcement of an industry-wide consultation is to review two proposed changes that the exchange hopes will both increase the decay of existing queues and prevent the build up of new ones.


These aluminum ingots just want to leave Detroit an Vlissingen.

The first is to increase the minimum load-out rate warehouse operators are obliged to achieve, the minimum, as considered by some operators, is the maximum and they believe it is set far too low. For operators holding more than 900,000 metric tons of metal, they are currently loading out only 3,000 mt per day, yet the same warehouse will take IN tens of thousands of tons.

Load-Out Reform

The new minimum daily load-outs proposed for warehouses storing between 150,000 mt and more than 900,000 mt range between 2,000 mt and 4,000 mt a day, scaled according to the amount of metal stored. It’s hardly a transformational change as the two remaining warehouses with extended queues are still potentially out to a year on a 3,000 mt/day minimum.

According to Reuters the LME’s warehouse report shows queues to load out at Vlissingen, Netherlands, were 365 days in May and at Detroit were 387 days. With rents at these warehouses on average about 0.50/mt per day, that remains a massive financial burden for metal owners waiting in the queue. The change will do little to reduce delays in the short term.

Rent Capping

Of more significance is the move to cap rents for metal while it is in the queue. This is a suggestion we have long held as being the most practical to implement and the most effective to encourage early load out. If operators do not receive rent for metal in the queue, they will work to remove it as quickly as possible and replace it with metal they can earn rent on.

Specifically, the proposal reads warehouse companies that fail to deliver out-queued metal within 30 calendar days would be required to halve the maximum published rent charged to the affected metal owners. After 50 calendar days, no rent could be charged at all. It’s still a far cry from when I started in the trade and we could take physical delivery in 48 hours, but 30 days is better than 300.

So, some tough changes for the warehouse operators then? Well, no, not really. For one thing, 90% of LME warehouses do not exhibit any queues, so changes will not make any difference to them, and even for the two remaining problem locations — Detroit and Vlissingen — the changes are not going to be introduced before next May, by which time their queues will have decayed to no more than about 50 days based on current trends.

The changes will, however, inhibit the build up of new queues if the stock and finance trade roars back. For the time being, the physical delivery premiums have fallen back to “normal” levels and the market shows no signs of the shortages that could drive competition for metal, but the LME’s forward curve for aluminum does support the return of the stock and finance trade. The difference now compared to 2010-12 is the use of off-market rather than LME warehouses for the trade. Let’s hope the combination of rules and trade changes combine to avoid a repetition of queues in the future. The LME changes are a step in the right direction.

This September: SMU Steel Summit 2015