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09 March 2016

2016 - Back to a Different Future



It used to be relatively straightforward to predict aluminium prices. You could look at demand in the west, then estimate supply and come up with a reasonable forecast – both forward prices on the London Metal Exchange and spot premium prices established by Metal Bulletin or Platts. The advent of the Chinese in the market complicated calculations, not least due to the unreliability of data from the region, a point underscored by last month’s revelation that the Chinese somehow forgot to account for four million tonnes of production between 2011 and 2014. What has really killed the predictions game, though, has been the huge tonnage of metal sitting outside LME warehouses on finance deals. That tonnage has completely changed how we must look at the market and shows that the old rules – and the rules that still mostly apply to other LME metals – have become less relevant for aluminium.

Jarring...

Looking at aluminium prices today, what is most immediately jarring is that there is a backwardation. At a stroke, normal rules of supply and demand have been overturned. How can it be, that a market with a surplus of stock by some estimates of 10 million tonnes is in backwardation? With such stocks in the market, nearby prices should be much lower than prices further forward. Put simply, if there’s too much of something, its price should be lower – surely?

It’s very hard to gauge how much inventory is out there. Changes in warehousing rules at the LME have made it more attractive to hold metal in unregulated and invisible stockpiles rather than on expensive LME warrants. For now, it appears that the metal will remain where it is. Under the old rules, a backwardation on the LME would bring metal into LME warehouses, as those holding metal would take the opportunity of higher spot prices to make a quick profit. In aluminium today there appear to be a number of issues that are preventing this from happening.

Backwardation and Premium

First, the back – in part sustained by a long position that first became evident in the second half of 2014  and has subsequently increased in dominance to account now for 80 percent of nearby positions – has not yet flared out to levels attractive enough for those holding metal to break their financing deals. The back itself is likely to bump around at these levels for some time as one side effect of the LME warehousing reforms has been to reduce the amount of free floating warrants that could be delivered, thereby exacerbating the nearby squeeze. Second, there is still money to be made from financing aluminium stocks. It’s certainly more difficult than 2010 when the trade really took off, but not impossible. That applies especially to some of the metal that is already tied up in deals: the back may have flattened the forward curve but those hunting contangos further along the curve can still secure a decent enough return. Third, breaking deals and delivering now when there are lower premiums than a few years ago could crystallise losses for some holders of aluminium, making it more likely that they will keep their positions for now.

Stock financing has not just disrupted old certainties about the forwards market, it has also created turmoil in the spot market. The increase in premiums to almost a third of the underlying price as aluminium was scooped up in financing deals wrongfooted many buyers and sellers. Bad trades aplenty have been done, back when there was the initial explosion of surplus metal in the Financial Crisis and notably when the LME began to tighten its warehousing rules in 2013. In determining premium trends for the next six months, the market could again struggle to find a guide.

The old market axiom used to be that if you got the back you didn’t get the premium. As backs flared out, premiums would come in, and, conversely, premiums would rise if the market were in contango. That basic pattern is discernible in the LME’s other contracts such as copper, where premiums and spreads have continued mostly to correlate in recent years. That correlation was true for aluminium until 2008, but much less so now.

Prying Eyes...

Since vast swathes of stocks moved off LME warrant and into private warehouses away from prying eyes, the relationship between LME prices and spot premiums has broken down. It used to be that LME stocks and spreads would act as a compass for the market and in particular premiums. Aluminium now is in unchartered waters. By way of illustration, premiums ticked up in February despite the persistent backwardation.

To understand properly the potential impact on premiums that unwinding the excess inventories would have, market analysts would need to know more about the structure of those financing deals – information that is hard to come by. For now, the only certainty the market has is that at the current level of forward contango financing of stocks will continue, which should be broadly supportive of premiums at today’s levels. Meanwhile, at the current level of backwardation, stocks may continue to trickle into the market but the trickle is unlikely to become a deluge.

This article was written by Chris Evans. All views and opinions expressed are his own. 

 


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