COLUMN-Testing the aluminium stock financiers: Andy Home

Tue Aug 19, 2014 10:35am EDT

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

By Andy Home

LONDON Aug 19 (Reuters) - The enigma machine that is the London aluminium market has shifted gears again.

The front part of the London Metal Exchange (LME) curve has been tightening for several weeks now to the point that the shortest-dated spreads are currently in backwardation.

This has major significance for the stocks financing trade, predicated as it is on the ability to generate a return from the shape of the curve.

Metal that was previously queuing to leave the LME warehouse system has been moving back on to LME warrant.

It's a sign that the latest spreads tension is starting to undermine the allure of a trade that has insulated both LME prices and physical premiums from the mountain of legacy stocks overhanging the aluminium market.

So far, at least, there is no evidence of a broader unwind of such financing deals.

After all, the aluminium market has seen these periods of tightness come and go over the last few years and on every occasion the curve has reverted to business-as-usual contango once the squeeze has passed.

Why should things be different this time?

BATTLE ON

The latest tightness in the LME aluminium market bears all the hallmarks of the sort of titanic battle between longs and shorts that has characterised similar periods of spread tension in the past.

The exchange's market positioning reports currently show one entity controlling 30-40 percent of available tonnage in the LME system, a grip that increases to 50-80 percent once cash positions are included. <0#LME-WHL><0#LME-WHC>

The market is currently navigating the August third-Wednesday prime prompt, on which two long position-holders were squaring off against three shorts.

The August battle, in other words, is at its most intense right now and it's plain to see in the shortest-dated spreads. "Tom-next" CMALT-0, which today is the cost of rolling a position from Wednesday to Thursday, has this morning flexed out to $9 backwardation with cash-to-September trading out to $14 backwardation.

The current hostilities have served to tighten the whole forward curve and to reduce the return available to financiers from playing the contango.

As shown in the graphic below the gross rate of return on a one-year carry, excluding any cost of storage or finance, was just 2.1 percent yesterday, compared with 6.1 percent three months ago and 7.1 percent six months ago.

******************************************************* Graphic on rate of return on LME aluminium financing: link.reuters.com/ryt62w *******************************************************

Which may explain why someone has just given up their place in the Vlissingen load-out queue. The Dutch port has seen a total 118,850 tonnes move back on to warrant from the cancelled warrant departure lounge.

BUSINESS AS USUAL?

Still, if past form is anything to go by, it should be business as usual once the August fireworks are over.

This is what has happened in the past, cash tightness evaporating once the long-short battle was won with a transfer of ownership of stocks.

But things have changed since the last such episode in December 2012. In particular LME stocks have been steadily falling and, more importantly for spreads, so too has the amount of open tonnage available for physical settlement.

Despite the fillip provided by those reverse cancellations at Vlissingen, open tonnage is still close to the lowest it's been since 2008, when unwanted aluminium was pouring into the LME system during the Global Financial Crisis.

This in large part is down to the LME's attack on load-out queues at locations such as Vlissingen and Detroit. Even though its proposed rule-change is stuck in legal limbo, warehouse operators have adjusted their behaviour preemptively to comply with the load-in-load-out formula.

So while metal is still departing the LME system at a fast clip there has been little, if any, offsetting inflow. The result is a steady fall in the amount of LME-registered aluminium.

And a steady erosion of the contango, from which stocks financiers can engineer a low-risk fixed rate of return.

******************************************************* Graphic on LME stocks and spreads 2014: link.reuters.com/zyt62w *******************************************************

Even before August hostilities really got underway, analysts at Macquarie Bank were warning about the impact of a flattening curve on the profitability of stocks financing.

"On our calculations, rolling forward at full LME rent has been consistently unprofitable over 2014".

Of course, no-one any more uses LME storage for stocks financing, since it is so expensive relative to off-market storage.

But, according to Macquarie, even this option, with metal being stored essentially at cost, "would now yield a negative return on a cash-to-three-months perspective." ("Macquarie Commodities Comment", Aug. 4, 2014).

Macquarie's conclusion was that "for those with a portfolio of financing deals we would expect pressure to release some of this material back to the market."

DOOMSDAY MACHINE

Which is exactly what seems to have been behind the reverse cancellations at Vlissingen.

So far, though, there is no evidence of a broader move to get out of the stocks financing game.

If there were, the most obvious impact would be on physical premiums and these are still holding at elevated levels. The CME's September contract for the Midwest aluminium premium is currently quoted at 20.5 cents per pound with no signs of weakness in either the European or the Asian markets.

But equally there is no doubt that the return on such trades is shrinking and it will contract further if LME spread tightness evolves into something more structural.

And it might do, if current LME stock trends continue.

Remember that the LME itself, in its public consultation document, conceded that punishing warehouse operators for taking in more metal than they load out might lead to an overall reduction in the amount of metal stored in the LME system.

"It is likely necessary to accept the loss of metal as an unintended (but predictable) consequence of the proposal". (Summary Public Report of the LME Warehousing Consultation, Nov 2013, Pages 56-57)

On the LME, a dwindling physical stocks liquidity base normally correlates with structural spread tightness.

This being the aluminium enigma machine, however, "normally" is a dangerous concept.

But if things do evolve "normally", the enigma machine may yet turn out to be the doomsday machine if it forces the mass release of all that stock currently being quarantined from the physical market.

(Editing by William Hardy)