(Andy Home is a Reuters columnist. The opinions expressed are his own)
By Andy Home
LONDON, Feb 16 (Reuters) - What to make of last week's mass cancellations of zinc at London Metal Exchange (LME) warehouses in New Orleans?
Wednesday's LME stocks report showed 91,400 tonnes of metal moving to the physical departure lounge at the U.S. port.
A similar round of heavy cancellations in late December created a "flash" load-out queue for zinc at New Orleans. Even after 53,375 tonnes of draws over the course of January, the queue still stretched to 48 days at the end of the month.
It has just got a whole lot longer.
Zinc bulls would love to believe that this huge tonnage of metal is going to fill a hole in the physical market, a sign of supply deficit and a herald of higher prices.
Just about everyone else is a little sceptical. New Orleans has a recent history of this sort of headline-grabbing change in stocks, only for material to flow back onto LME warrant a couple of months later.
The fact that Pacorini, the warehousing arm of physical trading giant Glencore (Xetra: A1JAGV - news) , dominates LME warehousing in New Orleans, only serves to feed the suspicion that things may not be quite what they seem.
We'd all like to know a bit more, but once metal leaves the LME system, it disappears into the statistical night, where only the owner of the metal and the warehouse operator know what's really going on.
The LME itself would like to know more too. And if it gets its way, it soon will.
Because the most controversial part of the exchange's proposed overhaul of its warehousing system is an extension of its regulatory reach into the twilight zone between financial and physical markets.
The LME's consultation period on its proposed reforms has just closed. There will almost certainly have been push-back from warehouse operators.
The LME's proposed reform package comes in two overlapping parts, a logistical review based on a report by management consultancy Oliver Wyman and a legal review of the agreement between the exchange and its warehousing operators.
There is a deluge of resulting detail, much of it representing no more than a clarification of previously hazy concepts, such as what really constitutes an area of net consumption, one of the criteria used to approve a new good delivery point.
Most warehouse operators will have little issue with most of it, although the LME's proposal that they conduct a full annual stock count is a cause of common complaint.
Historically the LME conducted its own stock count and charged the warehousers for doing so in the form of an annual levy equivalent to 1.1 percent of the rental on LME-warranted metal.
The LME is now shifting the burden and costs onto the LME warehouse operators themselves. Without, it has been collectively noted, getting rid of the annual levy. There are muttered threats about withholding the levy, although whether anyone will be bold enough to do so remains to be seen.
Some operators will take issue with the LME's proposed redefinition of what constitutes a load-out.
If metal is destined for relocation to another shed in the same location owned by the same warehouse operator, it won't be deemed a load-out.
Some operators contend it amounts to a restraint on their ability to compete to store metal that was warranted in their sheds once the owner decides to shift it to off-market storage.
But in truth, the only ones really affected by this are those with existing queues who have to comply with the LME's linked load-in-load-out formula.
Which means Metro in Detroit and Pacorini in the Dutch port of Vlissingen. And now Pacorini in New Orleans.
Where things get a lot more controversial is the LME's proposed extension to its warehouse network of its current regulatory powers to prevent market abuse.
All references in the existing warehouse contract to "applicable law" will be changed to "relevant law and regulation".
Note the last two words.
The change, the LME notes, "would clarify both the compliance obligations of warehouses and how the LME may take action when required to do so by law and regulation, including where a warehouse may have breached the (UK regulator) FCA's market abuse regime."
LME warehouse operators "must not prevent the orderly functioning of the LME market". If they do, the LME has an obligation to report them to the Financial Conduct Authority and may impose disciplinary action.
The LME is proposing new information-gathering powers, particularly a requirement that all warehouse operators submit on a quarterly basis details of any inducements offered to metal owners.
Inducements have long been a bug-bear of LME users but have come into ever sharper relief thanks to the aluminium load-out queues.
A long queue means more rental for the warehouse operator, which can then use that revenue stream to pay for more metal, sucking supply out of the physical market into the LME storage market.
Metro in Detroit was again the pioneer of this virtuous/vicious circle (delete according to warehousing/manufacturing preference) and the impact, still hotly disputed, on the fracturing of the aluminium price between LME basis and physical premium.
There will be many who think this extension of LME regulatory reach is long overdue.
Warehouse companies may beg to differ. Inducements and rental deals lie at the heart of their LME business and there is a natural reluctance to open up their books, even if on a strictly confidential basis.
But the more profound problem derives from the way LME warehouses link financial and physical markets.
As the LME seeks more information about what is going on in its warehousing system, it will inevitably find out more about what is happening in the physical market. Reform can't happen without regulatory creep.
There are two sides to both inducements and load-out queues.
If the warehouse operator reveals information about what it is paying to attract metal and what it is offering to keep that metal in warehouse, it is necessarily revealing information the owner of the metal would probably regard as confidential.
A load-out queue may benefit the warehouse operator by assuring locked-in rental revenue, but it can only be formed when the owner or owners cancel sufficient tonnages to create a queue.
To understand the causes of a "flash" queue such as that for zinc at New Orleans, the LME will have to probe who has cancelled the metal and why, even if the metal is actually set to leave the financial arena and what were the historical limits of regulatory vision.
"The LME is granting itself broader powers to intervene in the physical market" and simultaneously reducing the threshold for potential disciplinary action.
Alcoa specifically takes issue with the writing-out of the word "intent" as a pre-requisite for imposing disciplinary action in the event of a market abusive queue.
From the LME's perspective, "the requirement to prove intent sets a relatively high threshold for the LME in taking disciplinary action."
It proposes instead the catch-all definition of taking disciplinary action for behaviour "the Exchange considers may have, or has had, the effect of creating or maintaining a Queue and/or which has led to market manipulation or distortion; or otherwise created or maintained a disorderly market".
From Alcoa's perspective, "anyone that calls (cancels) a warrant is technically at risk of disciplinary action."
The LME, it claims, "proposes to effectively become a regulator, a prosecutor and an enforcer".
PUSH AND PULL
Which may be a little harsh. The LME under new owner Hong Kong Exchanges and Clearing is naturally incentivised to address the sorts of bad warehousing behaviour that a previously lax rule-book facilitated.
But it's also pretty clear that the exchange itself is responding to more powerful regulatory push.
After all, the aluminium queues generated enough heat to show up on the radars of regulators in London, Brussels and Washington.
LME warehousing may be no more than the thin end of a regulatory wedge into the physical commodity markets.
The key question is how warehouse operators, their owners and big physical players respond, particularly when, as with Pacorini and Glencore, they are one and the same thing.
Which brings us back to those mega cancellations at New (KOSDAQ: 160550.KQ - news) Orleans. Once the 172,550 tonnes of cancelled zinc leaves Pacorini sheds, will it come back again, as has been the past pattern?
Or will it disappear into a much darker storage place where not even the LME with its proposed new regulatory powers can reach.
(Editing by David Evans)