As Andy Home wrote in a recent Thomson Reuters post, the previous linkage between the length of the LME aluminum load-out queues and the level of physical premium has been broken, but the LME’s warehouse problems are far from solved.
Indeed, the recent court ruling in favor of the LME allowing the exchange to implement its Load in Load out (LILO) rule early next year is just the opening salvo in what will be an extended campaign to return the LME to a point where it is fit for its purpose. And make no mistake: the LME will get there, and the challenges are many, but one of the largest is the sheer legal complexity of operating in so many different jurisdictions – what is permissible in one is not in another – making progress slow and complex.
As far as the load out rates are concerned, Home explains it has been clear for some time that warehouse operators have already changed their operating models to comply with the rule, which will penalize those that take in more metal than they load out. Metro, owned by Goldman Sachs and the dominant LME warehouse operator in Detroit, took in just 1,785 metric tons of metal between April, when the LME first started publishing per-operator stocks figures, and end-September. It loaded out 462,000 tons over the same period. Pacorini, owned by Glencore and dominant in the Dutch port of Vlissingen, last received metal in any significant volume in June, yet its net load-out rate over the April-September 2014 period was 205,000 tons.
That hasn’t stopped the load out queues expanding and contracting over the period, however; but that is not directly the fault of the operators.
The operator can control the load out rate but they cannot control the level of cancellations. As Home points out, a raid on Metro’s zinc holdings in New Orleans caused a new 71-day “flash” queue to spring up last month. The amount of “live” on-warrant metal at Metro plummeted from 76,425 tons to just 775 tons over the course of September with all that canceled metal suddenly appearing in the exit or load-out queue.
The LME will now have to look at a range of new measures to address the very existence of queues, potential remedies previously suggested include regulating the charging rent on metal in the load out queue, a move that is fraught by restrictions the EU places on companies via competition law but is one which the exchange is going to have to explore further.
The LME warehouse system is uncompetitive in terms of costs compared to off-market storage witnessed by the volumes that have left the system to be stored in the twilight zone of off-market warehouses. Operating an LME warehouse has requirements and responsibilities that add costs not necessarily incurred by off-market warehouse operators, but that defense only goes so far.
The benefits of storage in an LME warehouse should be worth some premium – an argument that is playing in the LME’s favor in China following the debacle in the Chinese port city of Qingdao this year – but the market clearly feels the level of premium is too high for the perceived benefits. No doubt companies engaged in the shadow banking sector in China felt the same way before the ownership issues arose in Qingdao but are now willing to pay more for storage in a facility operating with more rigorous management systems.
The fact remains more metal is stored outside the system than in it, a state of affairs that didn’t exist 10 years ago. The LME’s challenges are significant, arguably the most significant in the history of the exchange, but it remains by far the largest non-ferrous metal price discovery service in the world and, warts and all, provides a service the whole supply chain needs. Let’s hope they can get to grips with these issues and focus on what is best for producers, processors and consumers rather than just the financial community that has in large part distorted the workings of the exchange. The process has a long way to run.