NEW YORK, July 16 With the latest proposal to remake rules for storing metal at London Metal Exchange warehouses, a four-year "long squeeze" is yielding, for the moment, to a short squeeze.
Aluminum traders scrambled last week to buy prompt metal, shrinking the gap between immediate prices and higher rates for next year to near the narrowest in years, a move traders said was the first sign that an overhaul of the LME's vast warehousing network might have unintended consequences.
The buying was sparked by fears that the new rules, aimed at easing wait times of up to a year in five key locations across the globe, could in fact limit the amount of metal that storage facilities would be willing to accept. The rules were announced on July 1, but might not come into force until next April following several months of consultation.
It was also fueled by the realization that some major warehousing firms, owned by Wall Street banks such as JP Morgan Chase & Co and traders such as Glencore Xstrata Plc , have quietly suspended offering financial incentives to store metal as they calculate the impact of sweeping reforms.
Suddenly, after years in which metal was flowing easily into warehouses, but slowly out of them, the reverse is true. Now, dealers fear they might not be able to get enough metal into the LME network to deliver it against expiring short positions.
Traders raced to buy nearby contracts and simultaneously sold later ones, effectively borrowing the metal for that period of time to cover the risk of short-term delivery.
"Off-exchange metal that was going to be warranted between July 1 and March 31 next year may not be able to be warranted now, so people borrow the spreads and it's definitely happened. The first reaction was to borrow Dec-Dec," said a London-based trader.
Buying December 2013 and selling December 2014 cut the spread nearly in half to $58 per tonne on Monday, the narrowest since it hit a record in February. It stood at nearly $99 a tonne at the end of June.
Some have downplayed the issue, saying traders will always find a home for the metal in the LME's over 700 facilities in 36 locations. But they also acknowledge that delays in getting the metal there might cause temporary backwardation, when nearby prices are at a premium to far forward.
The warehouse reforms are the exchange's boldest approach yet to a problem that plagued outgoing chief executive Martin Abbott for four years and threatened the reputation of the 136-year-old exchange - a logjam of metals attempting to leave warehouse storage.
It is the first effort since the LME was acquired six months ago by the Hong Kong Exchanges and Clearing Ltd(HKEx), which has pledged to answer complaints from industrial clients that they are paying excessive premiums for prompt metal, while waiting as long as a year to take delivery off the LME.
The proposal's most significant element would be to link the minimum rate at which a warehouse with big stockpiles and long wait times - more than 100 days - is required to load out material to the rate at which it brings in new metal.
For instance, until now, warehouses with 900,000 tonnes were required to load out metal at a minimum rate of 3,000 tonnes per day, regardless of how much metal was delivered into the warehouse. Under the new rule, if a warehouse accepts an average of 3,000 tonnes a day, then its minimum load out rate would be that amount plus another 1,500 tonnes, a total 4,500 tonnes.
In outlining its proposal, the LME warned it might have a warping effect on the market at times by incentivizing some warehouse companies to limit the in-flows of new metal, since it would then be required to load out metal more quickly.
"As a default is not an option on the LME, backwardated markets may be artificially exacerbated or created as shorts seek to delay delivery on-exchange," it said. "Therefore, potentially, this policy could itself unintentionally create an artificial supply and demand dynamic in LME markets."
Even so, the abrupt market reaction surprised traders since the proposals are months away from being implemented. The spread action is possibly one of the "most serious and perhaps least recognized implications" of the change, Barclays analysts said.
In the long term, the changes will depress aluminum premiums, the price paid on top of the LME for physical delivery, which are at record highs, even though the market is in chronic surplus. LME stocks are close to records above 7 million tonnes, with as much metal estimated to be stored in financing deals off the exchange. So far, there is no indication of that happening. Premiums are still at over 11 cents a pound , up from less than 3 cents per lb in 2008.
LME spreads are likely to gyrate even more wildly in the coming months as traders work out how best to proceed.
"This isn't something that's going to go away. In the meantime, the warehouses are on the sidelines wondering if or when something will happen," said a second London-based trader.
It also means the likely end of a booming business model for the companies that own warehouses, charging rent for storage while also limiting the amount of metal that can be shipped out.
Traders say the move will most directly affect three warehousing companies. They are Pacorini, owned by Glencore Xstrata; Metro operated by Goldman Sachs Group Inc ; and NEMS run by Trafigura in four locations with queues longer than 100 days - New Orleans and Detroit, Johor in Malaysia, Vlissingen in the Netherlands and Antwerp in Belgium.
The sheds with lengthy queues are holding back from making new offers for storage as the owners assess the "complete reengineering" that might be required, a market source said.
The stand-off is likely to be only temporary and warehouses will tout business again soon, but the outlook will be vastly different. Their appetite for metal will be lower because they will be restricted on the size of the queue they can create to 100 days. That will rein in the size of payments, known as incentives, doled out to attract metal.
The market source calculated incentives might plunge to $50 to $60 per tonne for a 100-day waiting time, about a fifth of the current $250 per tonne paid for aluminum in Detroit, where Metro dominates capacity.
"Everyone in the industry from the truck drivers, port operators to the producers is interested in how this works and the consequences for them," source said.