COLUMN-LME warehouse queues no longer the only metric: Andy Home

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

By Andy Home

LONDON, Sept 15 (Reuters) - It is ironic that the London Metal Exchange (LME), which has taken so much flak over long waiting times to get metal out of some of its warehouses, is itself now forced to wait before it can start fixing the problems.

A raft of reviews and potential changes to its physical delivery function is on hold as the exchange waits to hear the outcome of its legal tussle in the UK High Court.

Since the court case, brought against the LME by Russian aluminium producer Rusal, centres on how the LME conducted its consultation on introducing a formula to cut the load-out queues, everything else that might necessitate a consultation is stuck on legal hold.

Still, at least the queues are starting to show signs of contracting. Aluminium has been and still is the metal most affected by the LME's malfunctioning warehouse system but around 9,000 tonnes of the lightweight metal are now leaving LME sheds every day with the cumulative year-to-date departure rate just shy of 1.5 million tonnes.

That this has happened without any impact whatsoever on physical market premiums, undermining Rusal's original basis for seeking a High Court review in the first place.

It also shows that for both the LME and the global aluminium market, LME warehouse queues are no longer the only metric.

WORK IN PROGRESS

The LME on Friday issued an update on where it is with its package of warehouse reforms.

Much of the easy stuff has already been done.

The exchange has ticked the transparency box with two new reports, one covering queue length and per-operator stocks storage and another Commitments of Traders Report showing market positioning.

A physical market committee, intended to reconnect the exchange with its industrial users, is up and running and has met twice.

The LME has also given itself extra regulatory muscle to prevent new queues forming and is in the process of beefing up its rules on "Chinese Walls" at warehouse operators owned by banks or trading companies.

The big stuff is still to come though.

The original proposal linking load-in and load-out rates at queue-bound locations is of course what landed the LME in the UK High Court. Rusal's contention is that the LME didn't conduct a fair consultation and presiding judge Justice Stephen Phillips agreed. The exchange is now appealing against that decision.

Key to Rusal's argument was that the LME failed to explain properly why it had rejected an alternative proposal to reduce queue length by capping or banning the rent paid by those sitting in the queues.

The LME's problem is that it is constrained by competition law from interfering in the economics of its own warehousing network. That curious anomaly has been revisited as part of a legal review of its relationship with its storage operators.

"Certain changes" will be proposed, it said on Friday, but we're going to have to wait for the slow wheels of British justice to turn until we find out more.

The same goes for the logistics review of the LME warehousing system, which will require unspecified "amendments" to exchange policy on authorising new warehouses and new good-delivery locations.

Which is all very frustrating for both the LME and its many manufacturing critics.

QUEUES FALL...SLOWLY

It would be a whole lot more frustrating, however, if the queues were not falling.

There were originally five locations experiencing load-out times in excess of 50 days, the cut-off point used by the LME in formulating its load-in-load-out proposal.

There are now only two. Both Vlissingen and Detroit still have long queues for the drawdown of aluminium. LME storage in the Dutch port is dominated by Pacorini, owned by Glencore , while Detroit and Metro (Other OTC: MTRAF - news) , owned by Goldman Sachs (NYSE: GS-PB - news) , is where the infamous queues first started.

And it's clear that both Pacorini and Metro, for now at least, are operating as if the load-in-load-out rule was actually in force rather than lost in legal limbo.

Crucially, load-in rates have been negligible at both locations in recent months. This hasn't stopped the secondary queue for other metals stuck behind all that aluminium in Detroit from growing. But it has only done so because more has been cancelled and joined the load-out queue.

Last month saw the cancellation of almost 10,000 tonnes of aluminium alloy and 4,000 tonnes of zinc at Detroit, which served to increase the load-out time to 74 days from 64 days at the end of July.

But the primary aluminium queue at Detroit fell to 620 days from 650, matching the rate of decline seen in July. With only 137,000 tonnes of "live" aluminium warrants left in Detroit, there's little scope for fresh cancellations to reverse the trend.

At Vlissingen the aluminium queue shrank from 743 days at the end of July to 599 days at the end of August.

That shrinkage reflected both a steady stream of daily departures and the mass movement of 234,000 tonnes of metal from the loading bay back onto LME warrant during the mini squeeze last month.

It's going to be a long, long process but everything right now points to a continuing steady attrition of the two remaining load-out queues in the LME system.

This diminishes the significance of the UK High Court deliberations, since Metro and Pacorini are already in compliance with the load-in-load-out rule.

Even (Taiwan OTC: 6436.TWO - news) if the LME loses its appeal, all that really changes is the time-line since it will have to go through a new consultation period, but the stated aim of forcing warehouses to load out more than they load in has already been achieved.

BEYOND THE QUEUES

Falling load-out queues for aluminium at Detroit and Vlissingen, meanwhile, have also broken the link between waiting times and physical market premiums.

Remember that it was the explosion in physical premiums relative to the underlying LME price that generated all the original furore among some of the exchange's manufacturing users.

At one stage the linkage between the queue length and the premium was direct, since Metro could use the revenue from its load-out queue to pay incentives to attract more metal into its sheds. The longer the queue, the more it could pay and everyone else had to chase the physical premium higher in response.

That operating model no longer works, however, even if Metro (SES: E1:M01.SI - news) and Goldman Sachs had the stomach to revive it.

The "cost" of the queue in Detroit, meaning the rent and the load-out charge, was $356 per tonne at the end of August. But the Midwest U.S. premium is currently trading on CME at 21-22 cents per lb, equivalent to $463-$485 per tonne.

The queues may have fallen but physical premiums have still risen, confounding the fears of producers such as Rusal. Its legal challenge to the LME was predicated on an expectation that the rule change would send prices tumbling as a deluge of metal left the LME warehouse system to flood the physical market.

Not so apparently.

It's quite clear that the nearly 1.5 million tonnes of aluminium that have left LME storage so far this year have largely bypassed the physical market.

Rather than meeting buoyant demand in the U.S. Midwest manufacturing hub, most of the metal appears merely to have gone to cheaper off-market storage to gather dust under long-term stocks financing deals. It is no more accessible than when it was sitting in the queue at Metro.

The notional cost of the Detroit queue may still define the floor for physical premiums but the aluminium market, arguably as dysfunctional as the LME warehouse system, appears to have evolved to a new "post-queue" phase.

Quite what happens in the next stage of the Great Aluminium Pricing Experiment is highly uncertain but it does appear as if the LME's proposed new premium contracts may find fertile ground as aluminium consumers look for ways to hedge the physical component of their "all-in" price.

Those premium contracts are now pushed back to a tentative second-quarter-2015 start. That's because they will need a change in exchange rules which can only follow...you guessed it, a consultation period.

All eyes are on the UK High Court. Don't you just hate it when people keep you waiting? (Editing by Keiron Henderson)