COLUMN-Why the LME is zeroing in on warehouse load-out charges (again): Andy Home

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

By Andy Home

LONDON, April 14 (Reuters) - A huge amount of aluminium is heading for the exit door on the London Metal Exchange (LME).

The amount of metal earmarked for physical load-out from LME warehouses has mushroomed over the last month from 561,450 tonnes on March 14 to a current 1,257,650 tonnes. So-called cancelled tonnage now represents almost half of all the aluminium in the system.

Most of these cancellations have occurred at the Dutch port of Vlissingen, where the amount of metal awaiting load-out has soared to 898,975 tonnes, or 80 percent of the total.

This sudden surge in pending departures, as always with aluminium, is all about storage costs.

Because from May metal trapped in a load-out queue over 30 days will be subject to drastically reduced rent or, if the queue is over 50 days, no rental charges at all.

Pacorini Metals, the logistics arm of Swiss trade house Glencore (Xetra: A1JAGV - news) , had a load-out queue of 84 days at the end of March in Vlissingen. It (Other OTC: ITGL - news) has just got a lot longer over the last few days as traders and financiers lick their lips at the possibility of zero rent.

There will be few tears shed for Pacorini, which has been one of the main beneficiaries of load-out bottlenecks.

But it won't be completely out of pocket because each tonne that is loaded out will earn it another 31.40 euros ($35.40).

And that's the amount that each tonne will gain in value as it moves from a Pacorini shed onto a truck, another part of the disconnect between the LME price of aluminium and the price paid by an actual user.

Which is why the LME's latest discussion paper on tackling excessive storage charges zeroes in on that load-out charge, or as it's known on the exchange, the "free on truck" (FOT) charge.

THIRD TIME AROUND

The LME had flagged well in advance it was about to engage in a consultation on the high headline rental and FOT charges in its warehousing system in light of some sharp increases in both in the current rent-cycle year.

And last week's "Discussion Paper relating to LME Warehousing Costs" included four options aimed at restricting future increases in both.

It was the inclusion of a fifth option, switching all the LME's contracts from the current "in-warehouse" to "free-on-truck" basis that was the surprise.

Particularly since the LME has been here twice before.

The concept was rejected in 1997 and again, after a detailed examination of the issue following a formal complaint from the copper manufacturers association IWCC, in 2007.

So why is the exchange looking at the same issue a third time around?

Because in the looking-glass world of LME warehousing, the "out" charge is far more than just the cost of loading metal onto a truck.

FREE ENTRY, EXPENSIVE EXIT

The costs of LME warehousing are asymmetric in terms of delivering metal into and out of the system.

There is a charge for loading out but not for loading in. Indeed, warehouse operators are locked in endless aggressive competition to attract metal into their sheds.

Free load-in is therefore supplemented by a host of other "incentives" ranging from freight rate offsets to discounted rent.

Such enticements are funded by anticipated rental income and by the FOT charge.

The higher the rental rate and the FOT charge, the more aggressive the incentives that can be offered for deliveries in.

Rental is an infinitely variable component of the warehousing revenue model since it can be and often is heavily discounted to the maximum headline levels published at the start of any year.

Moreover, as Pacorini Vlissingen can attest, it can also be massively impacted by a change of LME rules, such as the Queue-Based-Rent-Cap rule that kicks into effect from the start of next month.

There is less elasticity in the FOT charge. Even (Taiwan OTC: 6436.TWO - news) if the original seller of metal into the LME system reaps some offset in the form of an upfront payment, anyone picking up the same warrants through the day-to-day clearing of contracts will still have to pay the full amount.

It is, according to the LME, "a self-reinforcing system" with the FOT charge "acting to lock in rents".

Moreover, FOT charges have a built-in inflationary driver since any warehouse operator offering relatively cheap load-out would be disadvantaged to those offering a higher load-out charge.

Indeed, the LME notes that "a buyer of the warrants may cancel metal in lower-FOT warehouses in order to move it to higher FOT warehouses and benefit from the resultant incentive."

The asymmetric nature of the warehouse revenue model, or, if you're an LME metal owner, the warehouse cost model, has been hard-wired into the LME storage system for many, many years.

That's why the LME has twice examined the issue in the past.

THE IN-OUT PROBLEM

And why it's mulling the issue a third time.

Changing the core nature of LME contracts' deliverability criteria does have one advantage over the other options it has put out for discussion.

It would "directly reverse the current structural issue of lack of downward pressure on FOT charges" and do so "without resorting to a specific price control regime."

The other options, excepting the unwieldy one of switching to fixed-term contracts with warehouse operators, all involve some sort of "cap" on rental and FOT charges. The process of determining the level of such a cap is itself problematic, while any "price control regime" is going to have to navigate potentially treacherous regulatory waters.

Set against the advantages, however, are two main drawbacks. Implementation, considered in some detail in the original 2007 FOT study by consultancy Europe Economics, would be highly tricky.

Or as the LME puts it in the discussion paper, "if the procedural issues of contract conversion (...) cannot be addressed, then the resultant market disorderliness may be too great to justify implementation."

But a second, more profound problem is one not specifically mentioned in the LME paper but addressed in the 2007 study.

Europe Economics estimated that the FOT charge represented around 20 percent of warehouse operators' profits, albeit with significant variance depending on broader economic cycles.

It went on to warn that, given the loss of such an important income driver, "the capacity of LME warehouses could be expected to be reduced" and that "there would be a tendency for the amount of metal placed on LME warrant to be reduced."

That in turn would lead to "a significant reduction in confidence in the LME system".

Which brings us back to the rush to join the load-out queue at Vlissingen.

Because with so much metal already leaving thanks to the LME's repeated tweaking of its load-out rules, aluminium stocks are already in danger of falling to levels associated with systemic backwardation.

Now (NYSE: DNOW - news) , in other words, might not be the best time to inflict such a hit on warehouse operators' bottom lines, if it acts as a disincentive to drawing more metal into the system.

The LME has made it clear it is going to do something about storage costs but should it use the "bazooka" of rate capping or go nuclear with a change of contract to FOT basis?

If you have an answer to that question, they'd love to hear from you. The deadline for feedback is May 18. (Editing by David Evans)