LME Warehouse and Product Changes Move Forward, Aluminum Queues Still There

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The London Metal Exchange continues to move forward with reform of its warehouse rules even if, for those unfamiliar with the situation, the reform appears to be going at a glacial pace.

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The challenge the 138-year-old exchange faces is primarily one of trying to balance competition law across the 37 international locations in which it operates – what is legally enforceable in Baltimore may not be in Bremen or Busan. The LME has to move cautiously, give all parties the opportunity to discuss, review and agree to changes and, above all, try to avoid getting dragged into London’s High Court as Rusal so cynically did last year in an attempt to stall changes which it saw potentially damaging to the aluminum price.

Still in the cards are new rules to cap or ban rents for metal held up in exit queues, a move that, most agree, would result in a rapid deterioration of the load out queue as any incentive to keep the queue in place would evaporate the moment the rule change went into force. There is also discussion about capping the level of daily rents, possibly in recognition that millions of tons have been lost to the LME system as metal has flowed into non-LME warehouses under the stock and finance trade.

Not only is this a loss of revenue to warehouse companies, but also the LME in terms of the revenue it earns from those companies and, maybe most importantly, the opacity that is a result of metal being held out of view of the market. The size, scope and location of this inventory is a huge unknown for the market and markets hate unknowns, it increases volatility, reduces confidence and arguably the ability for accurate price discovery.

The LME rightly points out in a recent Press release that the simple announcement of planned changes to rules has had a beneficial impact on the market as warehouse operator behavior has tended to converge with the intended rule changes long before they have been able to come into force. The LME is managing to nudge the market into change even though the consultation process is making actual rule changes much slower to implement than they would like.

A definition has been accepted on what load out means – you wouldn’t think it was that hard would you, but the problem has been that some warehouses loaded out from one shed and loaded back in to another.  As a result, queues effectively remained the same. That has now been banned, metal must be shipped to another warehouse operator, or to another consumer within the same warehouse, or to the outside market, but cannot be merry-go-rounded within the same facility and by the same owner.

The launch date for the long heralded aluminum premium contract has been set as October 26, a year or two too late for most consumers but better late than never. It will be interesting to see what uptake is like and whether its arrival has any impact on delivery premiums that latest data suggests may have peaked and be set to fall this year.

What LME Steel Billet Has to Do With Aluminum

Do you follow the steel billet contract? No? Well, you have probably been in good company in the past. The LME has struggled to make the steel billet contract work. In theory it was a splendid idea, steel billet is a ubiquitous commodity product that can be produced to a common set of standards accepted around the world and its price provides a good benchmark for long product supply and regional demand.

It also correlates well to scrap supply as many billet mills are electric arc furnace-based scrap consumers. Unfortunately, after initial interest the market shunned the contract and it became completely divorced from the physical market it was designed to reflect. However, the LME has made further changes and interestingly the price has dropped out of bed as this graph shows:

Source: Quandl

Source: Quandl.com.

This is actually a good thing, it suggests the market has reacted to changes the LME has made and maybe has the potential to become a fair price discovery product again. The LME is introducing cash settled rebar and scrap contracts in October to run alongside the physically delivered steel billet contract. It will be interesting to see how this new troika plays out.

So as the physical delivery premiums ease and changes in load-out rules move slowly forward, could we be seeing the end of the elevated physical delivery premium? Not in the short term; the western world is too tight for the premium to revert to pre-crisis levels but we could be seeing the beginning of the end. Given increased supply from China and outflows from the currently moribund stock and finance trade, supply to western consumers could increase over time – ironically just as products become more widely available to manage the risk.

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