COLUMN-An overlooked casualty of LME's warehouse wars: Andy Home

(The author is a Reuters columnist. The opinions expressed are his / her own.)

By Andy Home

LONDON, Sept 18 (Reuters) - As Hong Kong Exchanges and Clearing (HKEx) works to fix the warehousing issues at its expensive purchase, the London Metal Exchange (LME), it can at least take comfort from the continued robust growth in LME trading volumes.

Average daily volume surged by almost 14 percent year-on-year in August, while cumulative volume growth through the first eight months of this year was running at 9.0 percent, matching last year's performance.

Yet not all LME contracts are faring as well as that headline figure might suggest.

The NASAAC (North American Secondary Aluminium Alloy) contract, for example, has seen volumes steadily decline since the fourth quarter of last year. Cumulative volumes of 366,269 lots in the first eight months of 2013 were down by 15.5 percent on last year's equivalent turnover.

******************************************************* Graphic on LME NASAAC volumes: http://link.reuters.com/fer23v *******************************************************

This has nothing to do with the health of the U.S. automotive market, the single biggest buyer of secondary aluminium. It is positively booming with sales rising at their fastest pace in six years in August.

Rather, the NASAAC contract has become a casualty of precisely the same warehousing issues that have generated so many complaints from the primary aluminium industry and which are now exercising the minds of the new owners of the LME.

It's an easily overlooked casualty. NASAAC is one of the LME's more bespoke contracts with a relatively small geographically-defined footprint. LME NASAAC volumes are dwarfed by those of the primary contract.

Yet NASAAC should serve as a timely reminder of why fixing the exchange's warehousing function is so vital.

If the LME's industrial users lose confidence in the exchange as a pricing reference for their physical transactions, they will look elsewhere with inevitable consequences on exchange liquidity.

RE-ENGINEERING (Milan: ENG.MI - news)

This is what has happened with the NASAAC contract.

The North American Die Casting Association (NADCA) has made good on its threat to withdraw support from the LME contract as a reference price. [ID:nL6N0DW3ZR}

NADCA, which represents around 95 percent of North American die casters - manufacturers who produce tailor-made metal products for automotive giants such as Ford (NYSE: F - news) and GM - is now recommending its members remove any LME reference in their contracts.

New contracts are now being referenced against Platts, the leading global energy, metals and petrochemicals information provider, which assesses the price of NASAAC on a delivered consumer works basis.

Now, die casters, often small independently-owned companies, are not the most active hedgers on the LME.

The NASAAC contract's big backers were always the automotive companies and the larger alloy producers.

But as NADCA members collectively shift away from LME benchmark pricing, there is a flow-through impact both up and down the supply chain.

NADCA says that cooperation with its pricing change has been good, even with automotive companies, on new contracts. There is of course natural resistance to altering the terms of existing contracts although several are being modified.

This is how commodity contracts die and it's a direct result of the "warehouse wars" that have raged across the LME delivery network over the last couple of years.

It's just that the impact in the NASAAC sector has been amplified relative to other LME metals.

DISCONNECTS

The core problem for NADCA and its members is the disconnect between LME basis price and delivered price.

Connecting paper and physical metal markets is the physical premium paid over and above the LME price for actual delivery.

And the physical premium for NASAAC has exploded since 2011. Once relatively stable at around 5-6 cents per lb, the premium is currently around 20 cents per lb, equivalent to around 24 percent of the LME NASAAC basis price.

******************************************************* Graphic on LME NASAAC versus Platts Assessment: http://link.reuters.com/ber23v *******************************************************

The same phenomenon in the primary aluminium market has caused major consumers such as U.S. beer companies to lambaste the LME. Yet the level of disconnect in the U.S. alloy contract is far more extreme than anything yet seen in the primary sector.

Its root causes, however, are the same. Namely the financialisaton of the physical metal markets, primarily in the form of stocks-financing, and the competition between LME warehouse operators for units.

The manifestation is the same as well. A concentration of LME stocks into a limited number of good delivery locations and the resulting growth in load-out queues.

This phenomenon has been particularly extreme in the case of NASAAC. The second quarter of this year saw a mass clear-out of registered alloy from every good delivery location other than Detroit.

******************************************************* Graphic on LME NASAAC Stock Movements in Q2: http://link.reuters.com/zes23v *******************************************************

The end-result is that 84 percent of the 110,500 tonnes of stocks in the LME system is located at Detroit.

And no surprise that around half of that, 45,260 tonnes, is sitting in the cancelled tonnage load-out queue.

DELIVERY PROBLEMS

That means that the nominal load-out queue for NASAAC in Detroit is 91 working days.

That assumes a minimum load-out requirement of 500 tonnes per day as stipulated by an April 2013 LME rule-change covering metals trapped behind "dominant" queues, which in the case of Detroit means primary aluminium.

Actually, the last significant deliveries of NASAAC out of Detroit took place last month and the 4,000 tonnes that departed over the course of a couple of weeks suggests the participation of a financial player or trade-house rather than a die caster.

Actually, many die casters appear to have given up on the LME as a source of physical units.

Partly that's due to the queues. Ninety days wait time is ninety days too long for must-have top-up supply.

But partly it's also due to a quirk of secondary aluminium alloy, which does not bear long-term storage as well as primary aluminium.

NADCA members have complained of receiving metal so old that it requires additional working. This was always going to be a problem for the LME NASAAC contract.

But it's been exacerbated by the mass shifting of units between warehouses rather than the replacement of older units destined for manufacturers with newer units.

Taken in isolation, the issue of long-term storage might be readily resolved. Some NADCA members, for example, have suggested the LME might want to consider shrink-wrapping to prevent quality loss.

THREAT OR OPPORTUNITY?

But this is not an isolated problem. Rather, it marks a wholesale loss of confidence in the LME as a benchmark price by a group of companies that forms part of the exchange's core industrial user base.

The same threat is hovering in the background of the wider debate about LME warehousing policy.

To quote from Alcoa (NYSE: AA - news) 's open letter to the LME on its latest proposal to tackle the knotty problem of warehouse queues and disconnected prices:

"While Alcoa recognizes that substantially increased speculative trading is a reality of the current world, it is imperative that those who participate in the physical aluminum market have confidence in the price-setting mechanism of the LME."

But there is an opportunity for the LME here as well.

NADCA met with the LME executive via video conference in May. It felt it got a good hearing and several proposals were forthcoming.

But none of them are going to happen quickly enough to satisfy the association, hence the collective revisiting of existing physical contracts.

NADCA reserves the right to return to the LME as a pricing benchmark. Much will depend on what the exchange does next in terms of breaking the queue syndrome.

But above all, "we continue to monitor the spread between Platts and NASAAC."

In other words, if the LME can close the disconnect, NADCA might well reconnect. (Editing by James Jukwey)