European banks offer swaps on costly aluminium, maybe too late

Thu Feb 7, 2013 10:11am EST

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By Veronica Brown and Susan Thomas

LONDON, Feb 7 (Reuters) - Banks in Europe have begun trading swaps designed to protect industrial users of aluminium - who already have to pay steep premiums above the London Metal Exchange (LME) cash price to get hold of metal - from yet bigger surcharges.

Banking and industry sources say customer enquiries on using the new derivatives products are gaining traction.

But volumes are limited because many potential clients think it is unjust and could become unnecessary to pay extra for derivatives to hedge against rising premiums at a time when there is a global glut of aluminium.

"It's an active market (in the U.S. and Europe), we have regular trades going through the platform," Robert Abel, director, EMEA metals sales and origination at Deutsche Bank in London, told Reuters.

"It's a small market and slightly illiquid in the sense that people are still joining the market, but it's certainly building up," he added.

JP Morgan and Credit Suisse are also said by traders and industry sources to be providing products to hedge aluminium premiums. Both banks declined to comment on how much business they had been doing in the area.

A chief reason aluminium can be costly for firms needing to make car parts or kitchen utensils is that stockpiles are tied up by banks, who can profit from metal financing deals now that interest rates are low.

So even though there are around 5 million tonnes piled up in the global network of warehouses registered by the LME, the world's biggest marketplace for industrial metals, buyers must bid up premiums to obtain material that is not bound up in deals.

HIGHER AND HIGHER

Premiums for duty-paid aluminium in Rotterdam are currently at record highs of around $300 a tonne over the cash price , which was around $2,065 a tonne this week.

Benchmark U.S. Midwest spot aluminium premiums have also reached a record high.

Premiums have been rising since the financial crisis pushed interest rates to near zero, making it attractive for banks to simultaneously buy aluminium and sell it forward for a profit, using cheap funding to store it inexpensively in the interim.

A steadily improving global economy, which may bring rising interest rates and reduce the appeal of such financing deals, has caused some in the market to question the need and sustainability of products aimed at hedging premiums.

These critics say the new swaps have been launched too late.

"My experience is often the banks become active and promote these tools, at a time when it's probably less likely to be interesting to the clients," said Nick Madden, vice president and chief procurement officer at Novelis, a unit of Hindalco Industries.

"It's like taking out flood insurance after the flood."

While data from most leading economies has been positive, some argue low interest rates, which justify hedging against rising premiums, remain firmly intact.

"There has been some understandable reluctance from aluminium consumers in Europe to fixing forward metal premia in swap form, given that premia are at or near all-time highs," said Kamal Naqvi, Head of EMEA Commodity Sales at Credit Suisse.

"However, the argument for fixing these premia via swaps is that the conditions that produced them appear likely to continue and could push levels higher still, so some level of risk management does make sense, particularly for the largest consumers of the metal."

Many buyers in North America already hedge their costs using over-the-counter (OTC) derivatives based on an average monthly Midwest premium, which is paid on top of the LME's benchmark aluminum price.

The CME Group launched a cleared Midwest aluminum premium swap in April last year. No trades have taken place yet, exchange data shows.

Another factor supporting premiums is the regulations of the LME, which permit companies running the warehouses it registers to release only a fraction of their inventories each day and collect rent on the metal that is waiting to be delivered out.

In theory clients who buy metal via the LME, a futures market recently acquired by the Hong Kong stock exchange , can collect it at the most convenient warehouse location.

In practice they can be kept waiting for months, contributing to tightness of supply of metal and forcing some of them to offer premiums for urgently needed supply.

Even if the swaps prove to offer some relief, metals consumers say the underlying problem remains.

"The whole issue is ultimately should premiums be that high anyway?," an industry source said.

"So many consumers are still going to be asking why the hell are premiums this high when the European Union is in recession. It doesn't make any sense."

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