Aluminum Inventory: The Elephant in the Commodity Metals Room

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OK, so what’s happening on the LME’s largest contract, primary aluminum? The cash to three months spread is down to just $17/ton and 118,850 tons of metal sitting in the exit queue at Vlissingen, Netherlands, has just been put back on the market according to a Thomson Reuters report by Andy Home.

According to Home’s report, the front part of the LME curve has been tightening for several weeks now, to the point that the shortest-dated spreads are currently in backwardation. The LME is periodically distorted by major players taking massive positions on certain key dates and manipulating prices as a result.

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You can’t help feeling some years from now we will be hearing howls of protest at these tactics, calling it market manipulation in the same way that warehouse operators are facing litigation for allegedly manipulating physical delivery premiums for their own benefit. According to Home, the exchange’s market positioning reports currently show one entity controlling 30-40% of available tonnage in the LME system, a grip that increases to 50-80% once cash positions are included. How can this be right for the market in terms of fair price discovery? Anyway, getting off my high horse and back to the point of this article, the flattening of the forward curve has been going on for some time and potentially could have profound consequences for the future of the stock and finance trade on which it is based, and in the process the continued quarantining of some 5 million tons of LME inventory.

Al Stock and Spreads

According to Home the gross rate of return on a one-year carry, excluding any cost of storage or finance, was just 2.1% this week, compared with 6.1% three months ago and 7.1% six months ago.

Al Forward Curve

According to Macquarie Bank, “On our calculations, rolling forward at full LME rent has been consistently unprofitable over 2014,” and raises the question if new deals are no longer profitable what would it take for existing deals to unwind, for the material locked up in current deals to bleed back into the market when they come up to maturity?

Some would suggest that is what we have been seeing in the significant outflows of metal this year and the unprecedented volume of metal sitting in the exit queues at Detroit and Vlissingen, but the physical delivery premiums remain at elevated levels, suggesting that metal is not finding its way onto the open market in any volume. As the article points out, the CME’s September contract for the Midwest aluminum premium is currently quoted at 20.5 cents per pound with no signs of weakness in either the European or the Asian markets.

We could be on the cusp of a significant change. If the forward curve stays flat, the stock and finance trade cannot come back as it has in the past. In such a situation, metal will be either sold onto the physical market or back onto the exchange when deals come up for roll-over. For metal locked up in exit queues, sale back to the market seems most likely. For metal sitting off-market in non-LME warehouses, sale into the physical market, taking advantage of continuing high physical delivery premiums, is a more attractive option.

Provided it was gradual, that scenario is somewhat attractive. It would push down premiums and improve availability for consumers. It is unlikely to be a flood, and with demand robust and new production in deficit, it would have the effect of capping pressure for price rises in Q4 this and Q1 next year. Home seems to agree, saying the market has gone through these periodic distortions before and the forward curve has recovered, but a strong forward curve is usually a sign of a well-supplied market, that is less the case now than at any time since the 2008 financial crisis. While a structural change to the market is unlikely, it can’t be ruled out, as nothing stays the same forever. Watch that forward curve.

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