COLUMN-LME vs Rusal (Part 2) will be legal not market drama: Andy Home

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

By Andy Home

LONDON, July 17 (Reuters) - The legal battle between the London Metal Exchange (LME) and Russian aluminium giant Rusal will resume on July 29.

The LME is appealing a previous British High Court ruling that it failed properly to consult on a proposal for cutting load-out queues at some of its registered warehouse. The rule change, linking load-in and load-out rates, was originally due to come into force in May but has been put on ice after Justice Phillips' call that the consultation was "legally unfair".

This legal tussle cuts to the heart of the aluminium market.

There are currently 2,915,100 tonnes of the stuff waiting for a physical delivery slot in the LME warehouse system, most of it at just two locations; Vlissingen in the Netherlands and Detroit in the United States.

Aluminium consumers have blamed the queues for soaring physical premiums, which have caused an unprecedented divergence between the price of aluminium on the LME and the "all-in" price payable by manufacturers.

Producers, not least Rusal, fear what might happen if all that backlogged metal were to hit the market-place.

The stakes appear high. Higher, indeed, than when Justice Phillips passed down his judgement on March 27. Over the intervening period the LME three-month aluminium price has rallied from $1,730 per tonne to just shy of the $2,000 mark. Premiums, meanwhile, remain super-strong, trading just under 20 cents per lb ($440 per tonne) on the CME .

But, in truth, this latest round of legal fisticuffs might be less significant than it seems. It is certainly important for the two protagonists, given the potential loss of face for whoever loses. And it will be keenly watched by lawyers, given the precedence set for all sorts of consultations, both in the public and private sectors.

On current trends, though, it might not be the make-and-break for the aluminium price that many expect.

LEGAL DETAIL

This is in part due to the nature of that original High Court ruling, which concerned legal due process not potential outcome.

In fact, Justice Phillips rejected Rusal's contention that the proposal would materially affect its business, arguing that "it would be improper for the LME to take into account which category of its users would win and which would lose" from any market impact.

Nor did he judge against the proposal per se. Rather, his core criticism was that the LME should have explained more explicitly why it had rejected an alternative proposal to cap rents for metal sitting in the queues.

Never mind that the LME had taken legal advice in 2000, 2005, 2007 and 2012 about doing so or that it had sought the views of the European Commission in 2000 and 2007. It hadn't, Phillips said, explained fully enough in its consultation document the legal difficulties of rewriting its warehouse contract and overriding existing commercial contracts between holders of the metal and warehouse companies.

The LME has revisited the whole issue yet again but the outcome of the most recent legal review of its warehousing contract is still under wraps. It seems, unlikely, though, that the law has dramatically changed since 2012. Capping rent is still likely to be a legal non-starter.

So what does this all mean were the LME actually to lose its appeal?

Not much. It could simply launch a new consultation, laying out in excruciating legal detail why capping rents, appealing though it would be to many, including the LME, is simply not workable and why therefore the load-in load-out formula is the best way of cutting queues.

All that changes is the timing not the substance of the proposed rule change.

CHANGED BEHAVIOUR

And time is not as important as it seems either.

It is clear that the most aggressive queue-building warehouse operators have changed their operational behaviour anyway, acting as if the rule change had already happened.

The number of locations affected by queues has shrunk from five to two and the number of operators from three to two.

The LME's most recent "queue" report, itself a product of the consultation, shows that as of the end of June there were only queues at Metro (Other OTC: MTRAF - news) sheds in Detroit and at Pacorini sheds in Vlissingen.

Moreover, the "secondary" queues for other metals trapped behind the aluminium log-jams shrank significantly over the course of June to 45 days at Detroit and to just nine days at the Dutch port.

True, both locations actually saw an increase in aluminium queues, that at Motown rising to 681 days from 675 days in May and that at Vlissingen to 774 days from 716 days.

But this was due to more cancellations of LME warrants for physical drawdown, particularly at Vlissingen, which saw almost 175,000 tonnes of metal join the load-out queue.

Critically from the LME's perspective, though, inflow has dropped dramatically to the point of zero at Detroit, where the last heavy-volume arrivals came in February. Pacorini Vlissingen received 31,000 tonnes of aluminium last month, less than half of the tonnage loaded out. This is exactly what the load-in load-out formula was meant to achieve, choking off the supply of fresh fuel for firing up the queues.

Might behaviour change in the event of an adverse legal judgement against the LME?

It seems highly unlikely when it comes to Metro. Owner Goldman Sachs (NYSE: GS-PB - news) has taken a public relations hammering over its metal warehousing business and has no appetite, it seems, for more of the same. It confirmed in a letter to the LME that it was already and would continue complying with the rule change as if it had come into effect.

Glencore (Xetra: A1JAGV - news) , which owns Pacorini, is a different animal and one with almost unlimited amounts of physical aluminium at its disposal, given its multiple off-take agreements with smelters around the world. But even this most aggressive of houses might baulk at being seen to be the only company visibly not working with the grain of the LME's proposal.

NOW YOU SEE IT

But perhaps the most interesting development, and one that argues against a court-room effect on the aluminium price, is what's been happening to premiums themselves.

They remain close to the elevated heights reached in the short-covering panic of early January. And this despite the fact that aluminium is flowing out of the LME system at an average daily rate of around 8,150 tonnes.

Since the start of the year a total 1.18 million tonnes have left LME sheds and total registered inventory has just fallen below the 5-million tonne level for the first time since September 2012.

So why has physical availability not improved? It seems self-evident that barely any of that metal has touched the physical market but has rather gone into off-market storage, which is cheaper than LME storage and therefore much more attractive for those locking metal up in finance deals.

Cash-and-carry financing, using the LME forward curve to generate a low-risk return on capital, remains in robust good health. The era of low interest rates, which underpin the trade, may be approaching an end but right now money is still cheap and the financing game is still attractive.

From a manufacturer's perspective, aluminium sitting in a financing deal off market is as inaccessible as aluminium sitting in an LME queue. Which is why premiums remain untouched by the steady flow of departures from the LME system.

This is the core driver of the aluminium market's distortions and those high stocks, whether visible or invisible, remain the Damocles Sword hanging over the entire industry.

That won't change whatever the outcome of the next bout of legal sparring between the LME and the world's largest aluminium producer. (Editing by William Hardy)