A short while ago, I wrote an article in ‘Metal Bulletin’ discussing the possible effects of the LME’s putative new regional aluminium premium contracts. I questioned whether or not there would be enough interest in providing liquidity to give them a halfway decent chance of success. I received a couple of comments which I think are worth looking at again. The first was from a former marketing man at a large (very cost-effective) smelter, who suggested that in fact the desire of smelters to sell at high premium and consumers to buy at low would result in a hedge market developing, analogous to that in the underlying metal base price. The second was from someone who runs the aluminium trading book of a large, well-respected trading house; his comment was that, while he recognised the point I was making, he was himself intending to create liquidity by trading in the forward product. Now, it would be arrogant of me to dispute what either of these two have said, given the weight of experience they have between them; I agree that the intention is that a hedge market should grow and that of course as well as producers, traders have an important role to play as providers of liquidity - which is what they have been doing for years in the underlying base price.
Forward Price Curve
My point, though, is something slightly different. If we go back to the days before aluminium was traded on the LME, there was nevertheless a perceptible forward aluminium price curve. Participants in the market may not have understood always that that was what they were part of (and indeed anecdotally I believe many of them did not really grasp the implications of contango and backwardation) but there was an active market extending beyond spot. Thus, when the LME contract came into being, it was relatively easily able to replicate what was going on in the physical OTC market. That’s pretty clear. (It did take quite a while, though, it’s worth noting in passing, for the producer element of the market to accept the new contract.)
But the regional premium contract is not in quite the same position. It’s not being introduced to replicate a forward price curve to facilitate hedging, it’s coming in to try and emulate a warrant swap, which is largely a spot business. So what the contract is attempting to do is to a) price as a forward something which is most generally priced as spot, and b) ensure that there is enough availability of specific metal to provide adequate liquidity.
My thought is not that this can’t work or won’t work but rather that it is a considerably more complex operation that a straightforward futures (or forward) hedge. Look at it this way: if I pick up an aluminium warrant today, the very strong likelihood is that it will be behind a long queue in a warehouse; seller’s option means the product tendered will (always) be of the least value. Now, I can take that warrant and swap it with somebody - probably - for one which is immediately available; in a non-queued warehouse, in other words. There will obviously be a cost, which will derive from the time that I will be out of pocket holding a warrant to which I cannot get access. Miraculously, that cost will also be pretty much the difference between the underlying LME price and the (more realistic) all-in cost of metal in the location in question. As a spot warrant swap, that all makes good sense. However, to try and shift that trade into the future and turn it into a hedge mechanism is, I think, difficult. Somebody will have to take a risk on selling the premium without knowing what they will receive - in simple terms, how long they will in fact have to wait to gain access to the queued warrant they are tendered against the swap when it becomes prompt. Now of course it is perfectly correct that a market participant - like the merchant I mentioned above who will provide liquidity - can make that trade as a speculative operation (and equally there is nothing wrong with that) but it will not function as a hedge trade because some of the parameters are so ill-defined. That doesn’t make the scheme inoperable; speculation is a natural part of the business. However, I would suggest that it may well have a restrictive effect on the liquidity attracted.
There is one other area where liquidity may be a problem. Currently, much of the stock of aluminium is locked up in fixed finance deals. For the premium contracts to work, there has to be sufficient unencumbered metal in accessible warehouses to accommodate the trade; if finance deals have to be broken in order to make this happen, things may start to get expensive - which is not going to improve the situation.
So, I’m still puzzled by this; I understand that there will be some players who want to participate and provide liquidity - after all, it’s another trading opportunity. But I’m not convinced that this is a ‘hedging’ opportunity.