COLUMN-LME picks up the gauntlet on physical premium trading: Andy Home

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

By Andy Home

LONDON, April 8 (Reuters) - Forced by the UK High Court to put the safety-catch back on its "bazooka" solution to long load-out queues, the London Metal Exchange (LME) has just unveiled the other weapons in its arsenal.

The list includes a new physical market committee, populated with the great and the good from the exchange's industrial user base, a new Commitment of Traders type report and detailed information on load-out times at individual warehouse operators.

But the real stand-out is a pledge to launch physical premium contracts, starting with primary aluminium.

This is, of course, a tacit admission that the queues are not going to disappear any time soon, the court ruling pushing back further what was always going to be a slow-fuse solution.

And nor, it seems, is the disconnect between the LME price of aluminium and the "all-in" price, the unhedgeable gap that is driving the aluminium industry towards physical premium contracts.

PHYSICAL (H)EDGE

The idea of the LME offering regional premium contracts to complement its primary aluminium contract came out of the original consultation process on what to do with its dysfunctional warehouse system.

Since then premiums have risen further, prising further apart the price of aluminium as traded on the LME and the "all-in" price payable by an actual user of the metal.

That has created a systemic risk management dilemma for the aluminium supply chain, which has historically hedged only its LME price exposure.

The CME has offered a sticking-plaster solution in the form of a premium contract , linked to Platts' assessment of the Midwest U.S. physical premium.

Launched in August last year, the contract got off to a slow start before being invigorated by the explosion in premiums at the start of this year. However, following a flurry in January and February, activity fell back in March to 3,625 tonnes, bringing the year-to-date total to 19,725 tonnes, a drop in the physical aluminium ocean.

The CME has followed up with a planned physically-delivered "all-in" aluminium price contract due to go live in May.

That gives the U.S. exchange a time edge, since even though the LME said yesterday it plans to announce contract specifications and launch date "as soon as possible", the new contracts will at the very earliest only be ready at the end of this year.

READY-MADE LIQUIDITY?

Where the LME does have an edge over its U.S. rival, however, is in the complementarity of the offering with its own established global basis-price contract and readily available liquidity.

The conceptual design of the three proposed premium contracts, one for each major geographic region, represents a neat dovetailing with the LME's existing physical delivery function.

The idea is for the premium contracts to overlay the current aluminium contract with settlement effected by a "premium warrant", defined as one that gives title to metal in a warehouse unaffected by load-out queues.

At settlement the seller delivers a "premium warrant" in return for a "cheapest to deliver" warrant, most likely one giving title to metal behind a long queue, plus cash to reflect the regional premium.

The buyer thus gets metal in the "right" location and a hedge against both components of the "all-in" price.

Providing the physical delivery liquidity will be what the LME calls "the very substantial tonnages of LME-warranted aluminium in non-queued warehouses, which currently are generally not delivered against the LME contract".

To which might be added the words "at a price".

What premium might be required to unlock this tonnage in the LME system, some of which has been in financing cold storage for years?

And how much will be left by the time the LME's contracts go live?

Take the U.S. for example. Excluding queue-bound Detroit there are currently 173,750 tonnes of open tonnage at LME locations in the country. Some of it, such as the 10,050 tonnes at Toledo, is quite evidently in long-term lock-down; the last activity here was in June 2012.

The most liquid concentration of non-queued aluminium is at Baltimore, which is presumably why it is already in such high demand. Cancelled tonnage at the port was just 900 tonnes at the start of the year. There are now 53,100 tonnes of aluminium awaiting load-out.

The recent history of physical aluminium premiums is already one of unintended consequences. Everyone assumed that premiums would fall after the LME's original announcement of its linked load-in/load-out warehousing formula. Instead, or maybe because, they went supernova at the start of 2014.

It's hard to believe that more surprises will not arise from the race by exchanges into the physical trading arena, however rational the motivation.

PEACE OFFERINGS

The LME's announcement on physical premium contracts was part and parcel of a broader array of measures intended to pacify manufacturers' criticism of its still-disputed role in creating the very problem that is now attempting to fix.

Olive branches have been handed out to some of the exchange's fiercest critics in the form of representation on the newly-created physical market committee.

The 16 members include both Nick Madden, supply chain officer for aluminium fabricator Novelis and long-standing critic of the LME's warehousing function, and Tim Weiner, global risk manager at beer-maker MillerCoors, whose explosive testimony to a U.S. Senate banking committee last July stirred a legal fire storm for the LME.

Representing the aluminium producer camp is Tim Reyes, head of commercial activities at Alcoa (NYSE: AA - news) , which has criticised the LME for reasons diametrically opposed to the consumer camp.

The only thing that everyone agreed on in the LME's consultation process was on the need for greater transparency.

The exchange is therefore offering a Commitments of Traders report consistent with the methodology of the existing format used by U.S. regulator the CFTC (Taiwan OTC: 1586.TWO - news) .

The first report is due in the second quarter of this year, albeit with an LME caveat that the outcome "will inevitably result in the published (...) data reflecting only a subset of the total activity conducted within the LME ecosystem".

Causing the LME headaches are the twin problems of large users falling into multiple categories and the practice of exchange members netting off order flows before channelling business through the exchange.

More useful maybe will be a new monthly report, showing stocks on a per-operator basis, including queue times for affected warehouses. The first is due on the 12th of next month.

STILL QUEUEING

None of which, of course, is going to cut the long, and in the case of the Dutch port of Vlissingen still-growing, queues to load out aluminium from LME warehouses.

At best the LME has stabilised the situation, noting that warehouse operators with queues "are maintaining a broadly neutral balance of load-in and load-out".

The LME has extended beyond the original end-March deadline the first calculation period for its formula linking load-in to load-out rates, while it mulls over how to react to the UK court ruling. Together with new investigation powers into warehouse operators with load-out queues, that should act as a deterrent to renewed queue formation.

Meanwhile, the LME is still working on heavier-calibre solutions in the form of legal and logistics reviews of its warehousing operations.

The latter may yet contain some real surprises for LME warehousers, while the former will tackle the thorniest of issues, namely the level of rents and load-out charges applicable for LME storage.

And, after the High Court ruling, a specific consideration of whether the LME has the power to cap rent for metal in queues.

In other words, the "bazooka" may be on hold but the heavy artillery is still being prepared.

Time, however, is not necessarily on the LME's side either in terms of CME's attempt to capitalise on the LME's current warehousing problems or in terms of the potential for more unwelcome surprises from the aluminium market itself.

(Editing by Keiron Henderson)