COLUMN-LME proposal: Aluminium industry agrees to disagree: Home

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

By Andy Home

LONDON, Sept 12 (Reuters) - The North American aluminium industry has this week collectively responded to the London Metal Exchange's (LME) proposed changes to its warehousing rules.

The Aluminum Users Group (AUG), backed by the Beer Institute and the American Beverage Association, has spoken for consumers, U.S. aluminium giant Alcoa (NYSE: AA - news) for producers.

And on one thing they are agreed.

The LME's latest idea for tackling the long load-out queues in good-delivery locations such as Detroit and Vlissingen won't work.

"AUG applauds the LME for trying to address the lengthy queues with the proposed linked load-in, load-out mechanism, but the proposal falls short in terms of providing an efficient function for physical delivery settlement."

And from Alcoa.

"We believe that the proposed changes constitute a major market intervention that will aggravate the lack of transparency that has had a damaging impact on the aluminum industry and will do nothing to help our customers manage their exposure to aluminum pricing."

Both sides of the supply chain also agree that the proposal risks incentivising the storage of aluminium in non-LME warehouses.

According to the AUG: "This would not facilitate more efficient physical delivery settlement, and would decrease rather than increase transparency in warehouse operations."

And according to Alcoa: "In this case, a larger amount of inventory will no longer be tracked and reported to the market, and will be out of regulators' purview. This will decrease visibility and transparency."

Beyond this meeting of minds, however, there is complete disagreement on how to fix the problem. Actually, there's complete disagreement on what the problem is.

THE CONSUMER VIEW

For the AUG the problem is the load-out queue. Its solution is therefore to kill the queue, not cap it at 100 days as proposed by the exchange.

Firstly, the LME should allow warehouse operators three months, starting October 1 of this year, to "eliminate current queues".

This, it suggests "is an ample period to load-out or re-warrant metal."

You can almost hear the sharp intakes of breath at the offices of Metro (Other OTC: MTRAF - news) , which dominates the LME warehousing business in Detroit, and Pacorini, which effectively owns LME storage in Vlissingen.

Based on the current amount of cancelled tonnage, the implied daily load-out rate would have to be 13,700 tonnes and 16,100 tonnes respectively. Operators might even have to break with LME warehousing tradition and work over weekends to meet that sort of target.

It would also mean Christmas coming early for the trucking companies, with around 700 pick-ups a day at Detroit.

Once the queues have been eliminated, the AUG suggests a maximum five-day wait for load-out from the moment an LME warrant is presented for withdrawal of metal.

If the warehouse operator doesn't comply, it would be required to explain in writing to the LME why. The LME would then have the option of prohibiting it from taking in any more metal for warranting.

Moreover, if a warehouse operator has been given shipping instructions by the 20th of any month, the metal must be released by the close of business of the last day of that month. Otherwise, the operator is not allowed to charge any more rental on that metal.

Underpinning the AUG's solution is a view that LME load-out rates should not be applied by location, as is currently the case, but by individual shed.

And echoing user complaints since the beginning of warehousing time, the AUG also thinks the LME should stop warehouse operators offering "exceptional inducements or incentives for delivery of metal" into warehouse and from "imposing unreasonable charges" on storing the stuff or loading it out.

Problem solved!

THE PRODUCER VIEW

Except, that, if you listen to Alcoa, the queue problem is a "red herring".

Or as Klaus Kleinfeld, company chairman and chief executive, put it, "the proposed changes to the LME warehousing rules are trying to solve a non-existent metal availability problem."

The whole proposed rule change may, according to the company's open letter to the LME, satisfy "a short term PR need", but it "actually complicates and prolongs a cure for the actual problem."

The real problem, according to Alcoa, is not the queues per se but "the growing spread between the LME and premiums."

Alcoa's solution is for the LME to establish new contracts to allow users to hedge regional physical premiums.

This, after all, is what is really riling users such as the AUG.

Metal is there and available. How could it not be, given the five million tonnes sitting in the LME warehouse system and what Alcoa suggests is the equivalent amount of metal sitting in dark inventory off the exchange?

The price is low. What Alcoa calls the "fully-loaded" price of aluminium, meaning the LME basis price plus the physical premium, is currently at a four-year low and some 40 percent lower than it was in 2008.

But the split between basis price and physical price has steadily widened.

Semi-manufacturers sitting in the middle of the supply chain are locked into long-term contracts, including a physical component which they have no means to hedge.

Give them the means to hedge and problem solved!

COMPROMISE?

You can start to understand why the LME has struggled to come up with a coherent answer to its warehousing issues.

Here are two diametrically opposed solutions to the same problem from two parts of an industry that is a core user of the exchange.

Are the load-out queues the cause of the disconnect between LME reference price and physical premiums, as consumers claim?

Or are the queues merely the symptom of the new aluminium market, where demand for physical units is dominated by "a new group of low risk financiers", as Alcoa claims?

Actually, maybe the answer to both questions is yes and it takes two different perspectives to pinpoint the dual nature of this knotty problem.

That stocks financing is a reality is not in doubt. That it was a core driver of that original queue in Detroit should also not be in doubt.

But in a world where the only constant is change, things have, well, changed since Goldman Sachs (NYSE: GS-PB - news) bought Metro in 2010.

A new breed of warehouse operator, the merchant-warehouser, has changed the queue game from revenue maximisation to premium maximisation. What was once collateral damage has become the target.

In other words, both the AUG and Alcoa are right in their solutions. The queues should be forcibly reduced. But unless premiums fall to zero for ever, which is only going to happen in consumers' dreams, there should be a viable, exchange-traded way of hedging them.

There already is but it's on the CME. It would be better sitting alongside the global reference price on the LME.

AGREED

Actually, there is one thing on which both the AUG and Alcoa are also agreed. That other giant of the aluminium sector, UC Rusal, agrees. Even Goldman Sachs, owner of Metro, agrees.

The LME needs greater transparency.

The current LME is financialised to an extent never seen before in its 136-year history.

The market needs more information on how that financialisation is interacting with price.

The quick-and-easy solution would be to duplicate the Commitment of Traders reports published by the Commodity Futures Trading Commission on U.S. markets.

A more bespoke add-on suggested by Goldman would be enhanced disclosure "with respect to who owns the warrants for metals and to designate by broad market participant who is in the queue".

A warehouse-specific add-on suggested by the AUG would be enhanced disclosure of LME audits on its warehousing operators.

All of which is eminently sensible and arguably overdue.

Indeed, the LME might want to consider a banding report on how much metal in its system is actually available, based on length of time since a warrant last went through the clearing.

But more transparency won't in itself fix the aluminium market's problem.

That's going to be up to the LME at its October board meeting. The only problem it faces is that the solution depends on which problem we're talking about.

(Editing by William Hardy)