The runway for a competitor to launch an alternative aluminum contract to the LME’s just got longer.
Last week, a judge from the UK High Court rejected the London Metal Exchange’s appeal of an earlier decision in favor of UC Rusal that would have prevented any warehouse reforms designed to shrink load-out times, reduce queues and make its physically delivered contract more efficient.
That means aluminum buyers should not expect to see any type of LME warehouse reform in coming months, most likely not until 2015, at least.
Producers like UC Rusal instead prefer the status quo – one that creates a distorted global aluminum market.
We know the market has become distorted because the LME aluminum futures contract no longer moves in tandem with the US Midwest (MW) delivered price, a long-trusted feature of global aluminum markets.
If the gap between the MW premium and the LME price has widened (which it has) and if the premium has moved in opposite directions of the LME price (which it also has), it means the LME no longer serves as an accurate price discovery vehicle for global aluminum markets, something it has effectively done since contract inception in 1978 through much of last year. We will further highlight this point in an upcoming piece.
Without an efficient price discovery vehicle, industrial metal buyers find themselves in a situation where they must kluge various mechanisms and strategies, not only for price discovery, but more importantly, for risk mitigation.
By risk mitigation, we refer specifically to margin protection.
How Aluminum Buying Used to Work
Consider the historical model (pre-2007):
LME (hedgeable) + MW Premium (stable, no hedge needed) + Conversion cost (can be negotiated fixed with suppliers) + Freight/delivery (also fixed) = Total landed cost per pound
The buyer could take out a hedge for the LME portion of the metal, tack on a historical MW premium ($0.05/lb), negotiate a fixed price conversion cost and freight/delivery charge with its suppliers and manage its volumes on an on-going basis.
In other words, a company could confidently manage nearly all of its semi-finished or finished aluminum price risk on an on-going, longer-term basis.
So how does the current model turn all of this on its head? We continue our analysis in Part Two.
Join us for a one-hour informative session featuring an aluminum market outlook (LME price + MW premium) and the potential for the CME Group’s new physically backed ALI contract scheduled to debut May 6, 2014.