COLUMN-LME lead flashes warning signs, but are they real?: Home

(Andy Home is a Reuters columnist. The opinions expressed are his own)

By Andy Home

LONDON, Aug 30 (Reuters) - Unglamorous lead has been one of the most resilient performers among London Metal Exchange (LME) base metals this year.

Only zinc has performed better but lead is still commanding a hefty premium to its metallic sister, around $260 per tonne basis 3-month metal as of Thursday's close.

Lead's bull credentials look strong.

The International Lead and Zinc Study Group (ILZSG) estimates the global refined lead market was in a 40,000-tonne deficit in the first half of this year.

Zinc, by contrast, was assessed as still being in surplus to the tune of 44,000 tonnes.

LME registered stocks (MPBSTX-TOTAL (NYSE: TOT - news) ) have fallen by 132,000 tonnes, or almost 42 percent, since the start of January. At 185,675 tonnes, they are at a three-year low.

Visible stocks in China have been falling, too. Registered inventory on the Shanghai Futures Exchange (SHFE) stands at 100,013 tonnes, the lowest level since January.

Adding to the bullish brew has been a return of cash-date tightness on the LME.

The very front part of the curve, cash-to-September , has this morning traded out to $5.8 per tonne backwardation. That has caused the benchmark cash-to-three-months spread to contract into a quoted $4-6 contango. One week ago it was $15 contango.

This is not entirely unexpected. There was a mini squeeze on the LME lead market back in May.

However, now as then, what's happening on the LME market may not be a good prism through which to see the underlying physical market.

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Graphic on LME lead price versus stocks:

http://link.reuters.com/nuf35s

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DEFICIT BREAKDOWN

Take that headline ILZSG deficit figure, for example.

It reflects significant monthly deficits in the February-April period, which corresponds with the protracted harsh winter conditions in much of the Northern Hemisphere.

Lead is used first and foremost in automotive batteries and winter is the "battery kill" season. Extended cold weather tends to force battery-makers to seek extra metal to refill depleted stocks.

The deficit shrank to just 5,400 tonnes over the months of May and June and there's no reason to think that this trend hasn't extended over the Northern Hemisphere summer in what is a highly seasonal market.

Moreover, the first half of this year saw a clear divide between China, which was in 44,000-tonne surplus, and the rest of the world, which registered an 83,000-tonne deficit.

That should raise a question mark against the strong downtrend in Chinese visible stocks, not least because SHFE stocks are a key component of any estimate of "apparent demand" in the country. What should be an indicator of market balance becomes a key input for calculating market balance.

A more pronounced question mark about the state of the Chinese market comes in the form of the country's net trade in refined lead.

China has been a consistent net exporter since the start of the year. The cumulative outbound flow of 10,000 tonnes is hardly huge but remember this metal is leaving the country despite a hefty export duty.

Which suggests that the world's driver of metals demand growth is indeed in surplus when it comes to lead.

STOCKS BREAKDOWN

There are also problems interpreting the LME lead stocks trend as a reliable indicator of market balance outside of China.

The scale of this year's decline in exchange inventory would appear to over-state the ILZSG's calculated market deficit, even the larger one for the world outside of China.

That's in part because while LME stocks have been falling, producer and consumer stocks have been rising, according to ILZSG figures, a contradictory dynamic shown in the graphic below.

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Graphic on lead stocks outside of China:

http://link.reuters.com/qaj72v

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Moreover, the distribution of LME lead stocks suggest that cancellation and drawdown trends may in part be down to the "warehouse wars" and load-out queue dynamics that have infected the exchange's warehousing system over the last couple of years.

Registered inventory has become increasingly concentrated on just a handful of locations.

Between them Antwerp, Vlissingen, Johor and Detroit account for 70 percent of total lead stocks. All four have proved to be "problem" LME storage locations due to the dominance of specific warehousing companies linked to banks or merchants.

There remains the suspicion that at least part of the recent apparently bullish downtrend in LME stocks reflects no more than metal being shuffled around.

It wouldn't be the first time this has happened in the lead market.

There was a steady attrition of LME tonnage over the middle of 2012 before 110,000 tonnes reappeared over the space of a couple of weeks in October the same year.

In other words, even if the underlying physical market has remained tight over the summer months - a questionable proposition given the trend in the ILZSG figures - it has not been nearly as tight as suggested by LME stock trends.

SPREADS BREAKDOWN

None of which offers much comfort to those holding short positions on the LME.

The nature of the LME game is that you only get to play with the chips on the table.

And excluding the 80,725 tonnes sitting in the cancelled category awaiting drawdown, that means the 104,950 open tonnes in the LME's warehouse system.

Open tonnage has rebuilt from the desperately low levels seen in June but it is still a lot less than implied by the headline LME stocks figure.

And it is currently closely held.

The LME's latest warrant holdings report shows a single entity holding somewhere between 30 and 40 percent of that open tonnage.

Throw in long positioning on the cash and "tom-next" dates and the number of dominant longs doubles, with one in the 30-40 percent band and one in the 40-50 percent band.

Look no further to understand why short position holders are paying a price to flee down the curve.

More intriguingly, there's a really big short position sitting on the prime September date (Sept. 18).

The LME's futures banding report reveals the presence of a short accounting for over 40 percent of open interest, a position equivalent to at least 170,000 tonnes. Ranged on the other side are four long position holders.

Unless something changes between now and then, this week's tightening of the spreads may just be a prelude to something much more dramatic.

Just remember, though, that this is LME tightness. The market "out there" is not nearly so tight.

(Editing by Jason Neely)