INSIGHT-Trade houses trump banks in metals storage play
* Fed might force Goldman, JP Morgan to sell warehouse units
* Glencore expands warehouse units; regulators hold fire
* Backlogs at Glencore's Dutch sheds set to worsen
* LME reviews warehouse policy, no real change expected
By Maytaal Angel and Susan Thomas
VLISSINGEN, Oct 18 (Reuters) - It's not only the mining of aluminium that changes the landscape. Warehousing it, a neat but legal trick commodity traders use to screw more profit from the metal, is also having a very visible impact on the environment.
Over the past year, warehouses in the Dutch port of Vlissingen run by Pacorini Metals, a unit of commodity trader Glencore, have mushroomed from 19 to 36, enough to house nearly 2 million tonnes of metal, about a fifth of total aluminium stocks, in an area the size of 40 football fields.
All that extra space is needed because of "financing deals" whereby traders or banks buy the metal from producers then sell it for future delivery to speculators at a profit, a market spread known as 'contango', when futures prices are higher than spot prices for immediate delivery.
In the meantime, it goes into the warehouses monitored by the London Metal Exchange and largely run by the same banks and commodity traders.
LME regulations allow companies operating warehouses in the global network registered by the exchange to release only a fraction of their inventories each day.
This, along with the financing deals, results in long queues for the metal and an artificial tightness in immediate supply, infuriating customers who pay rent to the warehouses while they wait, sometimes for up to a year, to get their goods out.
It's a trick that looks set to become even more lucrative for the specialist commodities houses, as their main rivals, the banks, are handicapped by tighter regulation.
Long backlogs have developed in LME-listed depots in Detroit, run by investment bank Goldman Sachs's subsidiary Metro, but the threat of new legislation that might force U.S. banks to sell physical assets like warehouses is already crimping investment.
"Today, it has become impossible to run warehouses as a U.S. bank. We can only carry so much physical value on our balance sheets. It's much easier for a non-listed entity like a commodity trader to run physical operations," said a top-level banking source.
Unlike rival Pacorini, Metro has added just five LME-listed sheds in Detroit over the past year, while Henry Bath, the warehouse unit of JP Morgan, has likewise registered just four new LME sheds in its Rotterdam hub.
In the wake of the 2008 financial crisis, too-big-to-fail banks are under pressure to reduce risk on their balance sheets, withdraw from proprietary trading in assets such as commodities, and run hard assets like warehouses at arms length.
No such worries burden commodity traders, especially not those listed in business-friendly Switzerland.
Unsurprisingly, Pacorini managing director Simon Yntema is confident about business prospects.
"We are growing fast. These times of crisis are golden times for us," he said last month in an interview with an online trade publication.
"Despite the decreasing demand for non-ferrous (metals), its production continues. These metals produced have to be stored somewhere. And these stocks find their way to our warehouses, increasing our turnover," he added.
In some cases, the sprawling sheds struggle to keep pace with the flood of metal coming into the port, so rust-proof metals like aluminium are simply stored outside in long, uniform rows.
Industrial users, such as metals manufacturing companies, usually buy direct from producers on fixed long-term contracts, but if they need extra, they have to wait sometimes for over a year in some locations.
They can try their luck on the spot market, but as the warehousing ruse sucks in so much metal, there's little available, and hence comes at a crippling premium to the LME spot prices.
According to Reuters calculations, Pacorini makes $150 million a year in rental charges just from the aluminium backlog in its Vlissingen warehouses.
A CONFLICT OF INTEREST
Commodity trader Trafigura is taking its cue from trade counterpart Glencore. Sheds in Antwerp run by its warehouse subsidiary NEMS have soared in the past year from one to 13 - equivalent to about 16 football fields.
Pacorini is in a fortunate position. Earlier this year, its owner Glencore signed a seven-year term contract with Russia's Rusal to purchase 14.5 million tonnes of aluminium.
The deal is worth about $28 billion at current prices , and sources say they expect a fair chunk of the metal will find its way to Vlissingen, exacerbating the backlog.
As Europe's debt crisis continues to cast a pall on the global economy, there is every reason to believe that not all of the Rusal metal will go to industrial use. In any case, Glencore, unlike banks, has no reason to limit its lucrative warehouse business.
Regulators in Europe are currently distracted by the debt crisis and by post-2008 banking reforms. They therefore have little appetite to look into the seemingly harmless matter of commodity traders owning LME warehouses.
But detractors say they are missing a fundamental conflict of interest, as commodity traders and banks that speculate on price also have insight into one of the key drivers of price, namely LME stock flows.
"For a trader or banker to own a warehouse for logistics purposes is fine, but for them to own an LME approved warehouse is not the same thing. It's an interference in a free market," said Anthony Lipmann, managing director of minor metals trader Lipmann Walton & Co.
"If the LME had ruled that no warehouse could ever be owned by a party that has an interest in price, that would have been that, but because they didn't they are left with the alternative which is 'Chinese Walls' - not a very good second best."
The LME, Goldman Sachs, JP Morgan and Glencore declined to comment.
The LME has said it is satisfied with the Chinese walls that have been put in place between those parts of an entity that speculate on price, and those that operate LME warehouses.
MARKET OF LAST RESORT?
The problem is not lost on Hong Kong Exchanges and Clearing Limited, currently in the final stages of buying the LME.
"Are we really talking about people not being able to have aluminium and having to wait for years in order for their production to continue," HKEx Chief Executive Officer Charles Li said on Monday.
"If people have to wait for a year, that's a very big problem; it is a level-one issue. If somehow the LME system is making clients suffer in that way, that is not acceptable."
The LME is currently conducting a six-month review of warehouse load-out rates, as it struggles to deal with new backlogs popping up across its global warehouse network.
The backlogs are affecting almost all metals, with warehouses offering incentives for producers to deposit their metal in their depots, adding to the queues of aluminium.
Critics say this is undermining the exchange's role as a market of last resort, and bringing it into disrepute.
But no one expects major changes any time soon.
LME chief executive Martin Abbott has long argued that warehouse backlogs exist primarily as a result of stocks financing deals, and not as a result of warehouse ownership, nor of LME regulations stipulating the minimum rate of delivery.
Given finance deals will likely be a feature of the market as long as the conditions that make them profitable remain in place, the LME is essentially arguing that its hands are tied.
So while Goldman Sachs and JP Morgan can at best hope to keep their warehouse units at arms length and then sell them, commodity traders will likely continue to expand their units.
And as long as interest rates remain low and rent remains cheap - pretty much a given for an entity that owns a warehouse company - commodity traders, banks and even investment funds will finance metal, especially aluminium.
"Last time I was visiting an aluminium plant, I was warned to never tell workers whose families are starving what happens to all the metal they produce, that it sits in storage for years, in order to feed the appetite of capitalists," said the top level banking source. "I'm not joking, it would cause social unrest."