COLUMN-"Restraint" won't make LME storage competitive: Andy Home

(Andy Home is a Reuters columnist. The opinions expressed are his own)

By Andy Home

LONDON, Jan 31 (Reuters) - Lost in the acrimonious debate and the hail of law suits surrounding the load-out queues in the London Metal Exchange's (LME) warehouse system lies a very simple question.

Where is all that metal, over three million tonnes of it, actually going?

Is the manufacturing world so desperately short of supplies that LME stocks are being systematically drained? The argument might have some validity when it comes to a market like tin, struggling with years of structural supply deficit.

But for other markets such as aluminium, weighed down by many years of structural surplus, it's clearly a nonsense.

The 2.5 million tonnes of aluminium awaiting load-out is mostly owned by stocks financiers, using the market's forward curve structure to make a profit.

And it is leaving the LME system because LME storage is so expensive. Simply put, the cheaper the cost of storing the stuff, the more money there is to be made by playing the cash-and-carry finance trade.

The exchange itself understands full well the problem posed by the yawning gap between the cost of holding metal in an LME warehouse and off market.

"The challenge for the LME will be to work to restore the position of LME warehousing as an attractive storage mechanism for global metal. The key inhibitor to this at present is the level of rent for LME facilities." ("Summary Public Report of the LME Warehousing Consultation", November 2013)

The question is how to reverse years of rampant rental inflation in the LME warehousing system. ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphic on LME warehouse rent since 2000: http://link.reuters.com/gaj56v ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

CONSTRAINTS

As the LME concedes in the same report, "LME warehousing will always be more expensive than off-LME storage, given the greater obligations incurred by a warehouse operator in LME storage."

Warehouse operators are keen to point out that they don't just warehouse any old metal. They warehouse LME-warranted metal.

An LME warrant denotes a unique batch of metal conforming to the LME's purity specifications and originating from a registered producer. It is highly fungible, a metallic financial instrument that can be bought and sold at the stroke of a keyboard and therefore prized as collateral.

The cost of storing warrants is higher because of the long list of LME rules governing where and how they should be warehoused.

That, however, doesn't explain why LME rents have increased so much over the last 20 years or so.

The median rent for a tonne of aluminium has risen from 16 cents per day in 1995 to a current 47 cents, representing average annual inflation of almost six percent.

Economic cycles have come and gone over that period but LME rent has still increased in every single year.

The exchange has been little more than a bystander, its hands tied by European competition law.

It does have the right to query what it feels are excessive rent hikes in any given year, asking a warehouser to justify in writing the reasons for any increase within 10 days of the Dec. 1 notification date.

This has evolved into an annual game of push-and-shove with its warehousers, as nicely depicted in that November report.

"In previous years, it has been the convention that several warehouses would submit extremely high rents, in the expectation that such rates would be queried by the LME per the Warehousing Agreement, after which the warehouse operator would reduce its rents to an amount it thought, in its own discretion, would be more reasonable in the circumstances. This seems to have been particularly true for the smaller warehouses, which do not want to be 'left behind' by the rent increases of the larger players."

The ritual December dance has allowed the LME to act as a brake on rent inflation but, clearly, not to halt it.

RESTRAINT

This year was always going to be different, given the furore over the load-out queues and the regulatory scrutiny of the aluminium market, where physical market prices have diverged from the LME basis price to the point that the "all-in" price is almost unhedgeable for product manufacturers.

In addition there is the impact of the LME's resulting rule change, forcing those operators with queues to link load-out rates to load-in rates.

"It has been clear from the Consultation that the prospect of higher rents represents the market's most widely-feared unintended consequence," the exchange said in its Public Report.

It urged warehousers to show restraint, warning in a Nov. 7 notice that "any attempt by warehouses to increase their fees in the short term is likely to be viewed in an extremely negative light by key market stakeholders."

The not-so-subtle hint was reinforced at a meeting with the warehouse companies just prior to the Dec. 1 deadline for submitting rents for the next financial year starting April 1.

UK regulator the Financial Conduct Authority (FCA) was present, just in case anyone was in any doubt about the views of "key market stakeholders".

"RESTRAINT"

The outcome was only a partial win for the LME, which said rather pointedly in its Dec. 30 notice detailing the new rents that it was "grateful to those warehouse operators that respected the call for restraint".

Most warehouse operators opted to keep rents unchanged. A couple, Worldwide Warehouse Solutions, owned by Noble Group (Frankfurt: N2X.F - news) , and independent operator Kloosterboer, even reduced their rents, an unprecedented development in the last 20 years of LME warehousing.

Crucially, though, three of the biggest players raised rents anyway.

Metro (Toronto: MRU.TO - news) , owned by Goldman Sachs (NYSE: GS-PB - news) , and "owner" of the long load-out queue at Detroit, hiked rents by 3 cents per tonne per day across all locations and all metals.

Pacorini, owned by Glencore, and "owner" of the even longer load-out queue at Vlissingen, went for a smaller 1-cent rise but, unlike Metro, also lifted its load-out (FOT) handling charge.

The reaction is not entirely surprising.

Both are incentivised to maintain the monetary value of the queues even as those queues start to decay under the new load-out rules which kick in next May. Both probably also fear being targeted for specific scrutiny in the LME's pending logistical audit of its warehousing system.

More surprising was the reaction of C. Steinweg, the "grand-daddy" of the LME warehousing business.

It hiked both rents, by 3 cents for aluminium and by 2 cents for other metals, and FOT charges.

Steinweg likes to let it be known it has no queues at its LME warehouses. As such, its decision to increase has overtones of outright defiance.

The "restraint" of these three operators means that while average rent inflation is set to slow significantly in the coming year to around one percent, it will be higher for most of the metal sitting in the LME system.

The LME's own calculations, based on its knowledge of which operator is storing what, are that the stock-weighted average rent will rise three percent and the FOT charge two percent.

COMPETITIVE?

Now, these announced rents are actually the maximum chargeable rent on LME-stored metal.

It's a fair bet that metal that has been cancelled and is awaiting load-out from the system is paying this level.

Much of the on-warrant metal, though, will be stored at negotiated lower prices. Warehousers stress that the market is much more competitive than it appears with operators offering steep discounts to attract metal.

The problem is that such "rebate" deals still use the maximum rental as a starting point and that maximum is still so high relative to any other form of storage. And, in the case of the "big three", poised to go higher still.

The LME is looking again at the potential for "structural limitations" on both rent and FOT charges, which may entail the unusual prospect of an inter-regulator battle as the FCA, with at least implicit support from its U.S. counterpart, the CFTC (Taiwan OTC: 1586.TWO - news) , takes on the European Commission's competition unit.

Capping rents and load-out charges would be a silver bullet in terms of halting LME rent inflation. But it's not as if the exchange hasn't tried this avenue before. Without success.

The new LME rule changes may also help.

It is now widely accepted that the original Metro model, of using queue rental to pay incentives to suck more metal in, has had its day.

But it and the other big players in the LME storage market still have many advantages over would-be rivals, not least the simple fact that the size of the queues at Detroit and Vlissingen means it will take many months for them to decay down to the LME's 50-day target.

And even when they do, the underlying chasm between LME rent and non-LME rent will remain.

Narrowing that gap is the LME's number one task in terms of restoring confidence in its warehousing system. "Restraint" is quite evidently not going to do the trick. (Editing by David Evans)