COLUMN-Alloy turbulence may be a sign of what awaits aluminium: Andy Home

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

By Andy Home

LONDON, June 12 (Reuters) - Someone delivered 1,860 tonnes of North American alloy into London Metal Exchange (LME) sheds in Detroit last week.

Hardly earth-shattering stuff, you might be thinking, given the huge stock movements that have come to characterise the LME's primary aluminium contract in recent years.

But the significance of last week's warranting of metal against the North American Special Aluminium Alloy Contract (NASAAC), to use its official name, was not its size but that it happened at all. It was, in fact, the first delivery since August last year.

And it is a sign of the extreme turbulence that has gripped this most specialist and bespoke of the exchange's contracts.

Three-month NASAAC has been on a surge, spurting $450 per tonne higher over the course of May to hit $2,480, the highest level since August 2011. Even with a pull-back to a current $2,370, it is still up by almost 23 percent since the start of the year, a performance bested only by nickel among the major industrial metals.

The front part of the LME curve has been all over the place, the benchmark cash-to-three-months period (CMNA0-3> gyrating from over $30 contango in the middle of April to $3 backwardation last Friday and all the way back into $30 contango again this week.

Such frenetic trading may be partly down to the contract's relative low liquidity but it should also serve as a warning to the primary aluminium market.

Because this, it seems, is what happens when LME and physical markets reconnect.

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic on LME NASAAC, three-month metal and cash-3s spread: http://link.reuters.com/pes99v Graphic on relationship between LME and Platts pricing: http://link.reuters.com/cur99v Graphic on LME stocks of NASAAC: http://link.reuters.com/gyr99v ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

DISCONNECT AND RECONNECT

The aluminium market's pricing problems are by now well known.

The LME price has diverged from the all-in price to an unprecedented degree. The manifestation of this disconnect has been the explosion in physical premiums, now over $400 per tonne, and the result is a breakdown in the industry's ability to manage its pricing risk.

Aluminium manufacturers have blamed the long load-out queues at LME locations such as Detroit, others the stock financiers whose appetite for cheaper storage created the queues in the first place. All the time the market's fundamentals have been steadily tightening, exacerbating competition for metal.

The whole saga has been replayed in miniature in the NASAAC market with the pricing tensions even more extreme than in the primary market.

For much of the first part of last year the LME price was trading at a discount of over 20 cents per lb to the physical market assessment of Platts, the leading global energy, metals and petrochemicals information provider. The historical norm had been around 5-6 cents per lb. At its widest in early May the premium represented almost a quarter of the all-in price of alloy.

The North American Die Casting Association (NADCA), representing the manufacturers of specialist alloy products for automotive giants such as Ford and GM (NYSE: GM - news) , ended up advising its members to switch contractual price references from the LME to Platts.

A policy that remains unchanged.

In the space of just three months, however, the whole NASAAC market dynamic has been turned on its head, the gap between LME price and delivered price collapsing to the point of evaporation.

At the start of March Platts' assessment of A380 alloy, the basis of the LME contract, was 24 cents per lb ($530 per tonne) higher than the LME price.

By the last week of May it had fallen below the super-charged LME price, apparently eliminating completely the premium that should result from the cost of delivering the metal to the customer's doorstep.

Hence last week's deliveries into the LME rather than the physical market.

DWINDLING STOCKS

So what has happened to propel the LME NASAAC price up and through the physically delivered price?

As with primary aluminium, it's all about stocks.

LME inventories of both surged during the Global Financial Crisis of 2008 as producers dumped unwanted units into the market of last resort. At one stage, in early 2009, there were almost a quarter of a million tonnes of NASAAC sitting in LME sheds across the U.S.

That mountain was gradually whittled down over the ensuing years until NASAAC users, like their primary counterparts, found themselves caught up in load-out queues, particularly the primary aluminium queue at Detroit.

As more accessible stocks everywhere else were cleared out, NASAAC stocks have become increasingly concentrated on Detroit, which as of today holds 62,020 tonnes of the total 63,680-tonne LME inventory. And most of that, 40,800 tonnes, is cancelled metal.

Metro (Toronto: MRU.TO - news) , the dominant warehousing operator in Detroit, is now moving out metal faster than ever as its owner Goldman Sachs (NYSE: GS-PB - news) goes out of its way to show it is complying with the LME's proposed changes to load-out rates, even though they are still in legal limbo in the UK courts.

The load-out queue for metals other than primary aluminium at Detroit fell sharply from 186 to 154 calendar days over the course of May, according to the LME's latest report.

DWINDLING LIQUIDITY

This accelerating outflow of NASAAC and the resulting dwindling physical liquidity pool underpinning the contract have roiled the LME market.

The spike in outright price and the ferocious contraction in the nearby curve speak of a vicious short squeeze, the worst of which appears to have passed.

For now at least.

The calm might quickly be shattered again, judging by the proliferation of large positions on next week's third-Wednesday prompt. The LME's futures banding report shows four major long position holders facing off against an equal number of shorts.

The positioning landscape looks equally cluttered on both July and August.

Lurking in the background is the suspicion that the collective retreat from the metals trading arena by some of the bigger investment banks has reduced further the already small number of active LME NASAAC traders.

Dwindling stocks liquidity, in other words, is being matched by dwindling risk-taking liquidity.

A SIGN OF THINGS TO COME?

It's still highly uncertain how all this is going to play out but more volatility, in both LME and physical market pricing, looks like the only safe bet.

After lamenting the previous disconnect between LME and "all-in" price, the NASAAC market seems to have been caught collectively off-guard by the sheer speed and scale of the reconnect.

Is there a warning here for how things might play out in the primary aluminium market?

It might seem far-fetched with the pricing divergence in this particular market still widening and visible stocks still so high.

But those stocks are now also leaving at an accelerating rate, particularly in Detroit, where Metro is promising to deliver out around 600,000 tonnes this year.

Moreover, the pool of non-cancelled stocks is only around half the headline total and the subset of free-floating warrants smaller still.

Meanwhile, as with NASAAC, the market's collective risk appetite has been diminished by the withdrawal of previous dominant investment banks.

Pricing tensions are already in evidence; witness the tightening in the front part of the LME curve in April and again at the start of this month.

A crisis doesn't look imminent but then the message from primary aluminium's little sister is that it never does until it actually arrives. (Editing by Susan Thomas)