COLUMN-LME prepares to enter the heart of warehousing darkness: Andy Home

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

By Andy Home

LONDON, March 1 (Reuters) - Stocks of aluminium sitting in London Metal Exchange warehouses fell by a net 5,225 tonnes on Monday.

This is hardly news.

They fall just about every day and have been doing so for several years. Last month they hit a seven-year low of 2,746,275 tonnes.

As of today's report, they are a little bit higher at 2,755,600 tonnes. But they will continue falling. We know that because there are still 617,600 tonnes waiting to be loaded out of LME warehouses.

Such a steady attrition of exchange inventory would in theory suggest a market struggling with supply shortfall. So too would the persistent tightness at the front end of the forward curve. The benchmark cash-to-three-months LME spread closed Monday valued at $23.25-per tonne backwardation.

Yet, as we all know by now, neither phenomenon has anything to do with underlying market reality. The outright price is currently trading around $1,585 per tonne, just $150 or so above levels last seen during the Global Financial Crisis of 2008-2009. That tells you that all is not well with aluminium.

Rather, falling LME stocks and the resulting front-date tightness are all about the costs of LME storage.

It (Other OTC: ITGL - news) 's an area the exchange has historically shied away from tackling but no more.

A discussion paper is on its way "outlining its options in respect of the implementation of powers to cap rent" and load-out charges.

QUEUES AND COSTS

Those daily aluminium stock falls reflect first and foremost the LME's drive to reduce waiting times to get metal out of the system. That's why 3,000 tonnes were drawn down at the Dutch port of Vlissingen on Monday, the same amount that has left every day this year.

Pacorini, the warehouse operator holding just about all the metal at Vlissingen, is complying with the LME's load-out rules.

The outflow of metal will accelerate this month and again in May due to new rules penalising any warehouse operator with a queue over 30 days. The queue for aluminium at Pacorini's sheds in Vlissingen was 228 days at the end of January.

The LME's increasingly complex web of warehousing regulations explain the amount of metal leaving Vlissingen but not the reason.

That's down to the true problem with LME storage, namely the high cost relative to off-market storage.

All that aluminium flowing out of Vlissingen and Detroit, the other queue-affected LME storage point, is not going to manufacturers to be made into something useful. It's going to other warehouses, ones where storage is a lot cheaper.

The LME has historically had no power to determine how much storage costs in its own approved warehouses.

It has been a hapless by-stander as warehouse operators have aggressively raised both their storage and load-out rates every year for many, many years.

The average cost of storing aluminium in an LME-approved warehouse has increased by a staggering 198 percent over the last 20 years.

It will jump again in the coming rent cycle year beginning April to an average 52 cents per tonne per day. Off-market storage can be had for as little as 10 cents, even lower in some locations.

And although two operators, Metro (Other OTC: MTRAF - news) and ISTIM, have just reversed particularly egregious rent hikes, the trend of rising costs is still going to accelerate.

FALLING BACK IN LINE

Metro, once infamously owned by Goldman Sachs (NYSE: GS-PB - news) and now owned by metals and property magnates the Reuben Brothers, has cut its aluminium rental fee from 77 cents per tonne to 60 cents in the United States and lower at other locations.

ISTIM, which is the creation of Bill Whelan, the original owner of Metro, has also cut its U.S (Other OTC: UBGXF - news) . aluminium fee from 60 cents to 56 cents.

Both have also reduced storage fees for other metals and load-out charges.

They still sit at the top end of the LME storage cost spectrum but have fallen back in line with the rest of the warehousing pack.

It's the first time the LME has allowed warehouse operators to adjust their proposed fees and that in itself says something about how flawed the whole process is.

Mindful of the dangers of competition law, each warehouse operator has to second-guess what others will do each rental year.

The LME has the right to query particularly steep price hikes but it can't reveal what others have submitted prior to publishing all the figures at the start of the year.

This year it seems that both Metro and ISTIM guessed badly, leaving their proposals significantly out of line with the average and drawing heated criticism from other operators.

Which is why the LME decided to re-open a window for downwards adjustments on a "one-off exceptional basis".

But even after these two fee reductions, the stock-weighted average storage fee will rise by seven percent and the load-out charge by nine percent from April.

That will only widen further the yawning gap between LME and off-exchange storage.

So now the exchange is going to start what promises to be a long consultation process about giving itself the right to cap, maybe even reduce, warehousing costs.

WHO'S AFRAID OF BRUSSELS?

It may seem surprising to an outsider that the LME cannot determine the costs of metal stored in its system.

The reason is competition law, first and foremost European competition law.

LME storage is itself a market with prices in theory set by free competition between multiple players, although the end result has ironically been highly uncompetitive prices relative to off-exchange warehouses.

But seen through the eyes of a regulator, the spectrum of storage costs resulting from the existing process, however flawed, is a good thing, a sign the "market" is working.

A flat rate applying to all warehouses could, by contrast, easily be interpreted as a sign of anti-competitive behaviour.

Of course the LME storage market is not quite as straightforward as that.

After all, these published rents merely denote the maximum potential fee that can be charged in any one year.

Most of the metal being stored in LME warehouses is paying lower fees, negotiated privately between the owner and the warehouse operators.

The maximum fees will tend to apply only to metal that has been cancelled prior to physical load-out, although quite evidently this would cover a lot of aluminium in Vlissingen.

Critically, however, the maximum fees determine the level of incentives warehouse operators can offer. The more money you can charge, the higher the theoretical incentive that can be paid to attract more metal.

It's going to be a tricky task for the LME to persuade the competition authorities that the apparent "market" in LME storage is not the same as the real "market".

It will have to tread carefully and you can bet it will try and bring on board as many players, both market users and warehouse operators, as it can in the consultation process.

But the very nature of competition law means it only needs one nay-sayer to trigger an investigation.

This is why the LME has previously shied away from capping rents, even though the cost of storage has been a problem for as long as anyone can remember.

A TALE OF TWO MARKETS

But it has to do something.

The "market" for LME storage is not working and it hasn't worked efficiently for many years.

The point of the exchange is to offer an arena for the setting of metals prices.

That settlement process is being distorted by the "market" for LME storage.

That's why so much aluminium is still moving into the shadows of off-exchange storage, increasing the opacity of an already opaque market.

And it's not just aluminium.

Remember all the zinc bulls who rushed into that market in the early part of last year? They were chasing the promise of a deficit market with LME stocks falling by over 200,000 tonnes in the first half of 2015.

That metal, though, had just disappeared into off-market storage and when it reappeared in August and September, the zinc price collapsed.

This is not how a commodities exchange is supposed to work and the reason the LME is not an efficient, transparent transmitter of supply-demand drivers is because the metals market has been hijacked by the storage market.

Now (NYSE: DNOW - news) , how to persuade Brussels of that problematic reality? (Editing by David Evans)