COLUMN-More shake, rattle and roll on LME aluminium curve: Andy Home

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

* Repeats with no changes to the text

By Andy Home

LONDON, Nov 4 (Reuters) - Tightness has returned to the London Metal Exchange (LME) aluminium spreads.

The focus point this time around is the December-January spread (CMALZ4-F5), which flared into $25 per tonne backwardation late last week.

That was acute enough to pull the full benchmark cash-to-three-months period into the widest backwardation since December 2012.

That reference point should serve as warning that December-January can often be a "hot" month in the LME's forward delivery calendar due to elevated open interest levels at the end of any year.

But this is the second time in the space of three months that the LME's highly liquid aluminium contract has flipped from contango to backwardation.

The previous incident in August passed quickly enough and with that December-January spread easing again to $5 backwardation this morning, it's possible that this particular episode will also fade.

However, it's also possible that LME spread volatility is becoming embedded in this already dysfunctional market, which has seen pricing splinter between exchange price and physical premium. ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic on LME Aluminium spreads and stocks: http://link.reuters.com/daz33w ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

STOCKS TENSION

Aluminium is leaving the LME warehousing system every day, most, if not all, of it heading for cheaper off-market storage to earn a buck for the stocks financiers.

So normal a daily occurrence is this that's it easy to forget the cumulative significance.

Total registered stocks of 4,421,150 tonnes have now fallen by over a million tonnes since the start of the year.

On-warrant stocks, meaning metal that hasn't been earmarked for physical delivery, have fallen by a harder 1.2 million tonnes to 1,878,675 tonnes.

This is the ultimate liquidity base for LME trading and it's at its lowest level since 2008.

Even that may be deceiving, because not all of that open tonnage is really available to the market. Much of it is locked down in financing deals. Take the 43,500 tonnes of on-warrant aluminium in Hamburg, for example. The last time there was any movement of any kind at this location was in the first quarter of 2009.

Fully liquid stocks equate to "free-float" warrants in the LME system. When warehouse operators such as Metro (Other OTC: MTRAF - news) and Pacorini were still operating the queue-building model, it was in their interest to attract "free-float" metal so it could be cancelled and join the load-out queue.

Both, however, have preemptively changed the model ahead of the LME's load-in-load-out rule, which is coming into effect at the start of February. As a result metal is still leaving like clockwork but less and less is coming in.

Open aluminium tonnage at Metro's Detroit home base has shrunk to just 17,625 tonnes and it's by no means certain that any of this is actually in Metro sheds.

Vlissingen, Pacorini's LME storage hub, still has 496,525 tonnes of non-cancelled aluminium, but that's less than half the amount at the start of 2014.

Tightening stocks liquidity within the LME system may be why someone, presumably under pressure from the spreads squeeze, put 50,000 tonnes back on to LME warrant and delivered a fresh 20,000 tonnes into Vlissingen last week.

That, by the way, was the first significant inflow of aluminium into any LME warehouse since July.

STRUCTURAL TENSION

Although LME open tonnage is steadily contracting, there are still over four million tonnes of aluminium in the warehousing system. And a whole lot more sitting off-market, although how much is anyone's guess.

The financing of all this inventory creates its own structural tensions within the LME forward curve.

Or, to quote Leon Westgate, analyst at Standard Bank London, "the aluminium market is structurally unbalanced, with the sheer tonnage of on- and off-warrant inventory, and the short hedge positions associated with that inventory, meaning that there is a large slug of pretty static borrowing interest in the spreads." ("Commodities Daily", Oct (HKSE: 3366.HK - news) . 30, 2014).

The ratio of LME-registered stocks to market open interest is above 20 percent, eclipsed only by nickel, and that's without including off-market aluminium which is still being financed using the LME forward curve.

All those hedge-shorts require a constant supply of lenders to facilitate any rolling of positions. Any mismatch between the two sides and you get the sort of spreads flare-out that is currently taking place.

SHAKE, RATTLE AND ROLL

Obviously, spread tensions can become more acute if an already rattling system is shaken by any of the market's bigger players.

Right now, for example, the LME's market reports show one entity holding between 30 and 40 percent of open LME aluminium tonnage. That's not enough to trigger the exchange's automatic lending limits but it's certainly enough to exert pressure on shorts looking to roll their positions forward in time.

Moreover, the LME's futures banding report shows plenty of potential targets on both the November and December prime prompt dates (Nov. 19 and Dec. 17 respectively).

November looks particularly congested with three big long positions facing off against four big shorts, two of which are at least 260,000 tonnes in size.

The November-December spread is currently trading in benign contango, but that could change any time.

VOLATILE FUTURE

The combination of underlying positioning imbalance and falling stocks liquidity in the LME aluminium market points to more volatile spreads going forwards.

It's worth bearing in mind that prior to August, there hadn't been any real tightness in the LME alumnium curve for 18 months. Indeed, spreads were almost totally becalmed for much of 2013 and early 2014.

That period of calm may be coming to an end, given there have been two blow-outs in just three months.

Moreover, things may be about to get more complicated, or more interesting, depending on your viewpoint, when the LME launches its aluminium premium contracts.

These will be physically backed by super-liquid warrants available for fast load-out. Warehouse operators opting into the proposed scheme will have to commit to no load-out queues.

The intention is to close the hedging gap created the disconnect between LME price and soaring physical premiums.

It would be ironic if that meant a further diminution of LME stocks liquidity for the majority of exchange players who want to roll rather than take physical delivery. (Editing by Clara Ferreira Marques)