COLUMN-A brief history of aluminium premiums (Part 1?): Andy Home

(Repeat of June 2 column with no changes. The opinions expressed here are those of the author, a columnist for Reuters)

By Andy Home

LONDON, June 2 (Reuters) - Aluminium premiums have gone into meltdown.

This is no normal market correction. Rather, the collective panic to offload metal feels more like the bursting of a speculative bubble.

In Europe, the premium for duty unpaid aluminium has collapsed from more than $400 per tonne over London Metal Exchange (LME) cash at the start of January to less than $100 per tonne last month.

In Japan, the opening premium offers for third-quarter shipments are coming in at $130-160 per tonne, compared with $425 in the first three months of the year.

In the United States, the Midwest delivery premium as assessed by Platts, the global energy, metals and petrochemicals information provider, has fallen below 10 cents per lb for the first time since 2013.

What is going on? And what will happen next?

To attempt an answer to either question requires an understanding of what drove premiums higher in the first place and which of those drivers might offer support going forward.

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Graphic on global aluminium premiums:

http://link.reuters.com/muh84w

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SUPER CONTANGO

Stocks financing lies at the heart of the aluminium premium phenomenon.

And stocks financing depends on contango, the difference between cash and forward prices on the LME.

Contango became super contango in the wake of the Global (Shenzhen: 300465.SZ - news) Financial Crisis, the forward curve flexing out to the extreme levels required to incentivise the financing and storage of millions of tonnes of unwanted aluminium.

As recently as 2013 the LME curve structure could generate a gross rate of return of up to 12 percent for holding aluminium for 15 months.

That sort of return, even allowing for the cost of storage, is eye-wateringly attractive in a world of zero interest rates. Making it even more attractive, of course, is the fact that the money to buy and hold all that aluminium can be borrowed at those same zero interest rates.

Super contango did not directly cause higher premiums but it was the foundation stone on which they grew.

As banks and trading houses rushed to capitalise on the stocks financing trade, they reduced the amount of freely available units, both in the physical market and, more importantly, within the LME warehouse system.

SUPER SMART WAREHOUSERS

Which is where the second, most controversial chapter of the premium history began.

With a large proportion of LME stocks locked down in financing deals, those seeking to buy LME metal to join the financing game increasingly found themselves taking delivery of warrants for metal in Detroit.

And specifically warrants for metal in the sheds of Metro (Other OTC: MTRAF - news) , the LME warehousing company which dominated exchange storage in Motown at the time.

This concentration of "free-float" warrants placed Metro in a unique position which it wasted no time in capitalising on.

Thus began a convoluted dance between a humble warehousing company and some of the world's largest banks, who wanted to maximise their stocks financing return by moving metal out of the expensive LME system to cheaper off-market storage.

The resulting bottle-neck at Detroit generated what was initially a small organic load-out queue. It became what the LME now terms an embedded queue when Deutsche Bank (Xetra: 514000 - news) cancelled 100,000 tonnes of aluminium one day in September 2010.

It was an unprecedentedly big cancellation of LME metal, testimony to the fact that financiers not manufacturers were in the driving seat of the aluminium market.

At the time the LME's stipulated minimum load-out rate was just 1,500 tonnes. In the eyes of a warehouse operator that meant it was the "de facto" maximum load-out rate. And in the eyes of a warehouse operator the resulting much longer load-out queue was gold dust.

From that moment in September 2010, Metro and its owner Goldman Sachs (NYSE: GS-PB - news) industrialised the queue model, using revenue from the rent paid by all the metal in the queue to incentivise more metal into its sheds and devising ever more ingenious ways of making the merry-go-round ever more effective.

Queues and premiums increased in lock-step.

Goldman has remained adamant that the correlation between the two did not amount to causation, although the simple fact is that anyone bidding for metal in the North American market had to factor in the arbitrage between Metro's queue revenue and the physical market premium.

Indeed, so obvious a money-spinner was the queue model that Pacorini, owned by Glencore (Xetra: A1JAGV - news) , created its own, even longer queue at Vlissingen.

The furore over the LME queues continues to reverberate but in the first days of January 2014 a third entirely different chapter opened in the premium story.

SUPER SQUEEZE

The Midwest premium exploded from 12 cents per lb ($264.50 per tonne) to 20 cents ($441.00) over the first three weeks of 2014.

In doing so it broke any linkage, to use a relatively neutral term, with load-out queues in the LME system.

What caused premiums to go super nova at the start of 2014?

The previous steady rise in premiums had opened an ever-widening gap between LME basis price and "all-in" price. A gap that industrial players were desperate to hedge.

U.S. banks were at the forefront of making an over-the-counter market in aluminium premiums to service manufacturers' needs. One at least found out the perils of being short a physical delivery obligation without owning the physical metal to deliver.

The resulting squeeze drove premiums exponentially higher from what was already an unprecedentedly high base.

The premium momentum then just carried on feeding off itself to the point that expectations of rising premiums became embedded in stocks financing deals, in essence offering capital appreciation as well as the fixed rate of return offered by the forward curve.

The market's animal spirits transformed a previously risk-free trade into a gamble that premiums would just carry on rising.

With so many doing the same, very few seem to have realised what would be the likely unhappy consequences of premiums stalling and falling.

DISORDERLY UNWIND

Which is precisely what happened, first in Europe in December 2014 and then in January this year in the U.S.

What caused the seemingly unstoppable premium machine to go into reverse?

Much has been made of rising Chinese exports of semi-fabricated product, some of which challenge the definition of product relative to unwrought metal. Certainly, the flood of metal out of China has altered physical market dynamics, particularly in the Asian region.

But more pertinently two of the core drivers of the premium machine have dissolved at the same time.

Firstly, the LME's increasingly aggressive campaign against warehouse operators running the queue model has both forced the queues down and, in the case of Metro, caused it to abandon completely the queue generation game.

Moreover, the LME is still mulling even more draconian steps such as capping rent in queue-affected locations, which would likely accelerate queue decay.

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Graphic on LME aluminium financing metrics:

http://link.reuters.com/juh84w

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Secondly, the LME contango, the foundation stone of the whole financing game, has become ever more tenuous since the fourth quarter of last year thanks to repeated bouts of front-month tightness.

Financing contracts started not being rolled over, releasing metal to the physical market and pressuring premiums lower. The early trickle turned into an avalanche as falling premiums themselves forced ever more metal out into the physical market.

The result has been the disorderly unwind of the past few weeks with metal flooding out of finance deals and premiums in free fall.

Indeed, such has been the scramble for the exit door that premiums have now arguably undershot on the downside.

They are, for example, now well below the "value" of the two load-out queues at Detroit and Vlissingen, which stood at $259 and $270 respectively at the end of April.

Whether either Metro or Pacorini chooses to capitalise on that fact is a moot point, given the likely regulatory scrutiny from the LME and regulators. But in principle the arbitrage between premium and queue is on again.

Even more significantly, the LME contango has flexed out again to the point that a plain vanilla financing trade is back in the money.

The stabilisation of the European duty unpaid premium, which has risen back above the $100-per tonne level in the last few weeks, may be a sign of renewed appetite for stocks financing, albeit one without any embedded premium component.

The bubble may have burst, in other words, but that doesn't necessarily mark the end of this premium story.

Part II may just be beginning.

(Editing by David Evans)