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08 April 2014

Gold and Aluminium: Physical and Futures

In an article on here last week, I talked about some of the issues surrounding the LME warehousing system and the aluminium market in the wake of the recent High Court ruling in favour of Rusal in their complaint against the LME’s proposed implementation of changes. That prompted a reply on the website from a reader who raised the question of the relative prices of paper (futures and forwards) markets and the physical markets in the same commodities. Rather than post a reply there to that myself, I thought I would consider some of the issues here in a full piece. 

First, I should say that I do not agree with my respondent’s suggestion that the LME have somehow ‘come unstuck by supporting the warehouses and their unethical profiteering.’ My view on that is, as it has always been, that the LME’s error has been to misunderstand the extent of the issue and to try to cure the symptom rather than the disease. I don’t think it is necessary to repeat that argument again here.

Paper and Physical Price Disconnect

However, my correspondent does also mention the more general issue of a disconnect between paper and physical prices. Two markets where that disconnect has drawn a great deal of attention are aluminium and gold. In both cases, the physical delivery premium has, in relatively recent times, become a far greater percentage of the all-in price than has previously been the case. In other words, however attractive you may find the paper price, if you want physical delivery of metal, there is a substantial added cost. We can also note in passing that this phenomenon creates problems for the smooth operation of many hedging strategies, since the gap in price is difficult to protect. High physical premiums over the paper price feature in both markets, and yet the reasons behind them seem very different.

The Aluminium Issue

The global aluminium market is over-supplied; not necessarily (although I would contend it is) in new production, but by the mass of stock which has accumulated in both LME and non-LME warehouses since the financial crisis of 2008. The rate of that accumulation increased dramatically when (mainly western) governments cut interest rates to historically minimal levels and started boosting the money supply with QE. That sudden inflow of cheap money looking for a home enabled aluminium smelters to keep on producing, even in the face of reduced demand, since financiers saw the opportunity to put the two things together. Without the excess metal which could be taken into stock, the financing game would have struggled to reach its current size, since a more balanced market would have left far less material available. So oversupply set this trade in motion; the high premium derives from the exploitation of the physical constraints of warehousing - in other words, it’s far easier to put metal into store than it is to take it out. That’s not the only reason for queues, but it is a major contributor. So once the queues became established, the inevitable happened; the paper - LME - price diverged from the ‘true’ all-in price at which physical transactions take place. The LME price became lower, because it does not necessarily currently represent metal you can take from warehouse and use immediately. It’s a price for something you can have at some date in the future, versus metal delivered now to your plant. The premium is there, because despite excess metal existing, the particular circumstances render it inaccessible. (Strictly, of course, to be accurate we should describe the LME as at a discount to the ‘real’ all-in price, rather than the latter as at a premium to the LME, but that’s really a matter of semantics.

Gold - a Different Logic

In the gold market, though the end result looks the same, the logic behind it is not. Describing supply and demand in gold is actually quite difficult, because of its dual nature. It is used, by the jewellery and electronic industries for example, and that usage is relatively straightforward for the analysts to assess. But lots of gold is mined, smelted and buried again - investment demand, and that’s far more difficult to get to grips with. For a large part of the second half of the twentieth century, investment demand was restricted to central banks, and even they - witness Gordon Brown - were at times not that enthused. Private investors looked for returns elsewhere. However, in more recent years, the investment world has turned around, and the demand for gold has soared, with China being in the forefront. 

Now, consumption is also a particular concept, since the high value dictates that recycling of gold is always at a very high level, so in reality by the far the lion’s share of what has ever been mined is still in existence. Most of that is held in very strong hands, and isn’t going anywhere. The bit we should concentrate on is the floating quantity, the fraction of the world’s total supply which in the days of the gold standard was held for international settlement, mostly in New York or London. That’s if you like the swing quantity which will determine the price. And that’s the bit which now looks as if it’s under pressure. I’m not by nature a conspiracy theorist, but there are some slightly disturbing signs. The Bundesbank has been trying for a while now to repatriate it’s gold (part of this swing quantity) from New York; it has had very little success, with the quantity actually returned a tiny fraction of the whole wanted. Mints around the world which produce investment coins report that they struggle to keep pace with demand.  China - both governmentally and privately - has been sucking gold in, not least because the government perceives that public gold purchases help absorb the trade surplus and also insulate Chinese investors from international currency fluctuations.

Pressure on Availability

So it is a reasonable assumption that all of these factors are putting pressure on that ‘floating’ gold availability. In crude terms, it’s moving, mostly eastwards, creating a disconnect between the paper and physical prices. The more the perception grows that what is really in the vaults may not actually satisfy the demand - and this is reflected by the case of the Bundesbank - the more investors will chase it. The gold ETF may have been a good idea, but in the end, it’s just another paper derivative. If you own gold, you want it to be physical, allocated and in a secure storage. That’s the message the market is giving us.

Clear or Opaque?

So, two different markets, both highlighting the disconnect between paper and physical price. Different reasons, but a similar outcome. Aluminium - actually fairly transparent, if not to everyone’s liking; gold - pretty opaque and the conspiracy theorists’ delight. Is one more worrying than the other? Unhesitatingly, you would have to say gold; it seems to be suggesting the crises are not over. 

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