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02 April 2014

Rusal, the LME...and the Aluminium Market



Elsewhere( http://bit.ly/1s3tDON ) I have written about the LME and the recent High Court finding in favour of Rusal over warehouse rule changes, but there is of course another dimension to this issue; not just the LME, but what it means for the aluminium market itself, of which the LME is only one facet. It’s the real physical price paid by consumers and received by producers which represents the genuine economic impact of the product. In a completely rational world, the price on a physically-deliverable futures (or forwards) exchange and the physical spot market price for the same product will converge at the point of delivery. That’s a pretty simple concept to grasp; if you can take delivery either from a physical supplier or the exchange of the same product, then the base prices will converge at the same level so that one does not have any (unjustifiable) advantage over the other. There is a small wrinkle on the LME because delivery is at seller’s option, and the warehouse network is wide, so a there will be a (small) location adjustment, but in principle if you buy the same producer’s metal direct or from the exchange, the price will basically be the same.

Un-Aligned Prices

In the aluminium market at the moment, that simple equation is not working properly. For physical metal now, consumers are paying the underlying LME price plus a premium which has reached in some instances getting on for twenty-five percent of the base level. Now, you could look at that in two ways. You could say that the physical price is too high, and that there is somehow an unfairness in there that results in consumers having to pay too much. Or, you could say the price for physical delivery is the real one - because that’s the one at which producer/consumer trades happen, and that the LME price, for some reason, is out of line - by being too low. The second of those concepts is the more attractive one; it must be, because the all-in (LME base plus premium) is the price at which the physical market clears, and that is surely the definition of the spot price? So currently, the LME price is the ‘real’ price, minus a cost (represented by ‘the premium’) which reflects the fact that the metal is not immediately available to the buyer. So far, I think that’s all pretty clear logic.

All-in Price Should Drop

The consumer argument is that if the metal held on LME warrant but not immediately available were to become so, then the overall price would fall. (And as physical and LME prices converged again, the operation of hedging would be more effective.) I’ve got quite a lot of sympathy with that view; overall, as I’ve commented before, I think there are serious questions about the aluminium price in the face of the current supply/demand picture, of which global stock levels represent a big part. Up to this point, the logic is still clear. If the five million tonnes of LME stock and the (at least equal volume of) non-LME stock were released into the market, it’s almost inevitable that the price would drop, resulting in end consumers paying less for products. Incidentally, the counter-argument I’ve heard put forward that it wouldn’t have that effect, because it is already hedged into the market and is therefore ‘in the price’ is fallacious; if it becomes available, it’s an extra multi-million tonne chunk of metal for consumers to use. Clearly, that affects the price. 

Trying to Resolve the Issue

So the argument that prices are sustained at higher levels than would otherwise be the case by the locking away of stocks is a good one; the sticking point is in the way to resolve the problem. Clearly, what the LME tried to do has fallen foul of the courts. I think that’s a good thing, which is where I begin to diverge from the generic ‘consumer’ case. My reason is simply that I don’t think it would work; playing around with load in/load out rates is no more than adding layers of complication, whereas in general simplicity is more effective. All the proposals around this are just picking arbitrary numbers, and hoping they work. The option the LME didn’t properly consider - that of capping rents once warrants have been cancelled is attractive, but may be subject to challenge under competition law - but that doesn't mean it's not worth pursuing further. The best solution, though, would surely be to look at the root cause of the problem, and try and treat that rather than fudge around the edges. Aluminium is popular amongst financiers essentially for two reasons - it’s available and as government policy has deliberately devalued money, it represents one way of protecting value.

Broader Picture

Everybody’s right that the price is artificial at the moment; everybody’s wrong in believing it can be solved before the economic picture changes. When supply and demand come back into balance and interest rates raise the hurdle for financiers, we can look for rationality to return. In the meanwhile, the best short-term fix would be a product which enabled the premium to be hedged; maybe the CME contract will help, but I doubt it. It’s a global problem, not a regional one and needs a global solution.

Coffee and Cocoa

Incidentally, it seems there may be knock-on effects from the Rusal case; I understand that the European Warehousekeepers Federation is consulting its lawyers over the Intercontinental Exchange (ICE) rules concerning rent on coffee and cocoa, the delivery of which has been delayed beyond a specified time. Metal financing models have spread across to the softs markets. The warehousing arguments look set to run and run.  

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