COLUMN-Bazooka time for LME's log-jammed warehouses: Andy Home

(The opinions expressed here are those of the author, a columnist for Reuters.)

By Andy Home

LONDON, March 6 (Reuters) - It's over two years since Charles Li, chief executive of Hong Kong Exchanges and Clearing (HKEx), threatened to use a "bazooka" on the long load-out queues at his new purchase, the London Metal Exchange (LME).

And that's about the time it still takes to get aluminium out of Detroit or Vlissingen, the two LME locations with embedded queues.

The waiting time at Detroit was 573 days and that at the Dutch port 579 days at the end of January. Calendar days. LME warehousers don't work at weekends or on holidays, so cancel aluminium today at either location and you should get it some time in 2017.

The queues should start to shorten as the LME's new rule, stipulating warehouse operators in those locations load out more than they load in, kicks in from June.

The aim is to reduce the queues to under 50 days.

But it's going to take time. A failed legal challenge to the so-called LILO rule by Russian aluminium producer Rusal (HKSE: 0486-OL.HK - news) has already pushed back implementation by 10 months and if warehouse operators flex the model to the maximum, it could be four years before the queues disappear.

So the LME is proposing to tweak its formula to double the queue "decay" rate.

But even then it's still going to take time. Over two years, according to Matt Chamberlain, LME head of business development.

And that's too long.

Time (NYSE: TIME - news) then for the "bazooka". The LME has finally unveiled its full armoury of heavy weapons to tackle both queues and the ever-spiralling cost of exchange storage relative to off-market storage.

Each of them risks causing collateral damage, so the LME has issued a discussion paper, in effect asking its members and users which weapon or weapons they think should be used.

HEAVY REGULATION

Doing nothing is not an option.

"The LME notes comments from stakeholders that - particularly given the delay to the introduction of LILO caused by judicial review proceedings - the rate at which queues are expected to fall under LILO is unlikely to be sufficiently rapid."

And lest anyone be in any doubt about which particular "stakeholder" is pushing for more drastic action, the exchange goes on to warn that "not taking action to address existing queues and the continued persistence of such queues could call into question the LME's continued compliance with its regulatory obligations."

Indeed, UK financial regulator The Financial Conduct Authority (FCA) gets a lot of name-checks in both the discussion paper and the spate of warehousing-related notices issued on Monday.

The new warehousing agreement will pull the LME's delivery network into the FCA's market abuse regime. Complaints that this amounts to regulatory over-reach were rejected.

"It is appropriate and proportionate, given the importance of warehouses to the orderly operation of the LME's market, that warehouses take account of FCA principles."

And the regulatory guns are now being turned on the two key outstanding problems, those persistent queues at Detroit and Vlissingen and the high cost of LME storage. The latter, of course, is why there are queues in the first place. Most, if not all, of that metal waiting to leave LME sheds is heading for off-market storage, which comes at a fraction of the cost.

So at least one of the heavy weapons, or maybe a combination of them, is "likely" to be used "to provide assurance to the FCA" the exchange is fulfilling its own front-line regulatory duties.

HEAVY WEAPONS

But which one? There are eight in total, all of which would operate in tandem with the new LILO rule.

Two are specifically aimed at reducing faster the existing queues.

The first would be another increase in minimum load-out requirements, dropping the threshold to warehouses storing over 150,000 tonnes of metal from the current 300,000-tonne mark, and lifting load-out rates by up to 1,000 tonne per day for those holding over 900,000 tonnes. Which basically means Pacorini, the warehousing arm of Glencore (Xetra: A1JAGV - news) , in Vlissingen.

The second would be capping rent for metal sitting in a load-out queue. A complete ban on charging rent for metal stuck in a queue for more than 50 days would in essence eliminate the financial incentive for a warehouse operator to maintain a queue.

The rent-capping idea found a good deal of favour in the LME's original consultation exercise and the exchange's decision to go with LILO instead lay at the heart of Rusal's legal challenge.

But the LME warns that litigation risks "may be higher than for other options (...) given the amounts which certain warehouses have invested with the expectation of a return based at least in part on a queue."

Moreover, a legal challenge "could engender a long period (possibly several years) of market uncertainty."

And litigation risk is the main concern about imposing an outright cap on both storage and load-out costs.

The idea would be to appoint an external consultant to determine maximum costs at each delivery location and set rates accordingly, factoring in a return on capital of 2x, the latter representing "the highest return observed from a set of public peers operating in the logistics sector."

"The LME's current assessment is that the likelihood of others seeking to challenge [rent capping and charge capping] through litigation in the courts (or via complaints to competition authorities), regardless of the merits of any such challenge, is high."

THE BALANCE OF RISKS

Yet, it is hard to see how restraining warehouse operator behaviour without doing so is going to work.

LME warehouses have responded to previous attempts to curtail some of their excesses by aggressively increasing both rent and load-out charges.

And, as the LME itself notes, most of its new proposals, which range from limiting cancellations of metal through stipulating even higher discharge rates to setting a straight 50-day load-out deadline, are likely to be greeted the same way.

Moreover, there seems to be a realisation among stakeholders, one in particular, that high LME storage costs are inextricably linked both with the current queues and the future health of the exchange's entire good delivery function.

But is the collateral damage risk to the LME and the market in general worth it?

As well as the litigation risk, there is the unknowable impact on aluminium prices.

Just as queues have played a role, to what extent is still hotly disputed, in splintering the aluminium price between LME basis price and physical premium, so a drastic rule-change such as capping rent could cause a potentially violent re-connect.

In the end this is going to be a risk-assessment exercise, both for the LME, which has the FCA breathing down its neck, and the market.

Time then for the market to have its say.

The full "Discussion paper relating to possible reforms of warehousing policy and physical delivery network" is on the notices section of the LME's website.

Read it and let them know which "bazooka" you think they should use.

(Editing by William Hardy)