COLUMN-As LME volumes fall, is base metals pricing fragmenting?: Andy Home

(Repeats Jan. 15 item. The opinions expressed here are those of the author, a columnist for Reuters)

By Andy Home

LONDON, Jan 15 (Reuters) - Trading volumes on the London Metal Exchange (LME) fell by 4.3 percent in 2015.

It (Other OTC: ITGL - news) was the first decline in activity since 2009 and the sharpest drop since 2001.

Those two historical reference points are telling, coinciding as they do with the bursting of the dot-com bubble and the global financial crisis.

The base metal markets are once again in turmoil, with 2015 set to go down in the history books as the year the commodities supercycle finally imploded.

Such broader market turbulence, however, doesn't explain why the CME's copper contract registered year-on-year growth of 16.4 percent against the LME contract's 0.5 percent, nor why base metal volumes on the Shanghai Futures Exchange (ShFE) have been booming.

CME and ShFE rolled out new contracts last year, challenging the LME's dominance of the global market in nonferrous metals trading.

So is the decline in London volumes a sign that dominance is now starting to fracture?

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Graphic on long-term LME volumes: http://tmsnrt.rs/1n4RPCD

Graphic on LME volumes by contract: http://tmsnrt.rs/1n4SpQP

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BENCHMARK PRICING

Excluding some of the LME's more niche products, such as its two aluminium alloy contracts, the two worst-performing contracts last year were aluminium and tin.

Aluminium has been the LME's most liquid contract for many years, so the 9.1 percent decline in trading activity is something of a standout.

Superficially, it looks bad news for the LME's pricing franchise, given CME's launch of four contracts in the aluminium space, three geographic premium contracts and an "all-in" aluminium contract.

Yet there is no clear evidence that the LME is losing any of its benchmark pricing power.

The most successful of the CME's aluminium contracts has been its Midwest U.S (Other OTC: UBGXF - news) . premium contract, launched in 2013. Volumes really took off last year with 936,000 tonnes traded and open interest mushrooming to 22,008 lots at the end of December from just 2,462 lots a year earlier.

CME's European premium contract has also got off to a flying start since its launch in September last year, while the Japanese premium contract registered its first trades early this month.

All three contracts, however, are "premium" contracts, which as the name suggests means they coexist with a basis price. And that basis price is still generated by the LME.

The CME's out-and-out rival contract, its "all-in" aluminium contract, reflecting both basis price and premium, has struggled to build any momentum since its launch in 2014. Last year's volumes of 4,044 lots were less than the 4,651 lots notched up by the European premium contract in just four months of trading.

Similarly, CME's new zinc contract closed the year with just 10 lots of open interest after seven months trading, while its new lead contract hasn't yet seen any action.

The inference is that aluminium traders seem happy to continue using the LME as a benchmark price but prefer hedging their premium exposure on CME. The LME's own aluminium premium contracts, just launched, have so far failed to register a single trade.

Why then has activity in the LME's aluminium contract declined so heavily?

The answer may lie in the LME's own internal reform process rather than competition from CME.

Specifically, the exchange's attack on its aluminium warehouse queues, which have been steadily shortening, has reduced some of the gaming of the aluminium financing trade.

That, insiders suggest, may have reduced the amount of tonnage that is rolled daily on the LME's "tom-next" spread, which has been a big volume generator in years past.

Of course the LME's new fee structure means that trading "tom-next" is no longer the free or heavily discounted trade that it once was, although don't expect any exchange official to dwell on that particular possible linkage.

EASTWARDS HO!

The 30.7 percent decline in LME tin trading may, on the other hand, be a more worrying sign for the LME's global benchmark pricing status.

Pricing of the soldering metal has become multi-dimensional with Indonesia leveraging its status as the world's largest exporter to nurture its own tin contracts, traded on the Indonesian Commodity and Derivatives Exchange (ICDX), and ShFE launching a Chinese tin contract in March 2015.

Neither is an obvious forum for the sort of industrial hedging offered by the LME.

The ICDX contracts are inextricably linked to Indonesia's sporadic attempts to support the price of tin, reducing their international credibility, while the ShFE's tin contract is the laggard of its base metals offering.

But there is a risk to the LME that tin pricing could evolve away from London to an Asian pricing hub, in effect mirroring an eastwards shift in underlying trade patterns away from Europe.

It's still too early to say with any certainty. One year's data does not a trend make and tin is the least liquid of the LME's core base metals contracts at the best of times, meaning external factors such as a falling price can generate an outsized impact.

MEET THE NEW STREET

The real metals trading story of last year was the surge in activity on ShFE, which with the exception of lead and tin saw volumes boom across its base metals contracts.

Copper volumes increased by 25.3 percent, aluminium volumes by 66.4 percent and the new nickel contract traded a staggering 127 million tonnes in its first 10 months of trading, slightly more than the LME's nickel contract.

However, even leaving aside the differing methodologies used in counting volumes by the LME and the ShFE, any direct comparison is problematic.

The two markets still exist in different universes separated by China's capital controls.

Larger Chinese metals companies, particularly the state-owned enterprises, have long been users of the LME for hedging purposes and are likely to increase their activity as more Chinese companies become members of the LME.

The Shanghai market, by contrast, has tended to reflect domestic speculative activity far more than international industrial hedging.

And last year's trading boom seems to have been driven by retail investors in China finding something new to trade, not least because of the government's heavy-handed interventions in the Chinese stock markets.

The difference in trading patterns between the two markets is clear from a comparison of volumes and open interest. LME nickel volumes are a fraction of open interest, while those on the ShFE contract have been as high as six times open interest.

That points to a high degree of day trading by what is a new, or at least new to the world of metals, retail investment crowd.

Such is the weight of money that can be generated by the Chinese "street" that what happens in Shanghai can influence London prices, witness the way in which Chinese funds such as Shanghai Chaos have hit the Western news headlines over the last year.

But there is no sign yet that global industrial players have any desire to shift their pricing to Shanghai, not least because of the Chinese authorities' habit of directly intervening in domestic markets when it suits them.

The LME still sets global metals prices and, with the possible exception of tin, its core industrial franchise still looks strong.

What has really changed, though, is that global base metals pricing is now a multiverse rather than a universe and that particular trend has only just started.

(Editing by Dale Hudson)