(The opinions expressed here are those of the author, a columnist for Reuters.)
By Andy Home
LONDON, March 19 (Reuters) - CME Group will launch a physically delivered North American aluminium contract this May.
It represents the most credible challenge to the London Metal Exchange’s (LME) pricing franchise in the global aluminium market since ... well, since the CME’s previous aluminium contract.
It’s easy to forget now, but CME has been here before. Twice.
The first foray by CME predecessor COMEX into aluminium trading fizzled out in 1989. It tried again in 1999 with a fully deliverable contract.
At one stage in 2003, COMEX-registered warehouses in Owensboro, Maceo and Clarksville held almost 200,000 tonnes of aluminium. But by then the initial trading impetus had already faded, and the contract lapsed into a long period of dormancy before being finally put out of its misery in 2009.
Will it be third time lucky for CME?
Certainly, the breakdown of the existing aluminium pricing model, starting in the U.S. Midwest, has created a genuine need for a new hedging tool-kit.
The question is whether CME can capitalise on this before the LME itself reacts.
Pricing in the aluminium market has historically been similar to other industrial metals traded on the LME.
The LME generated a global reference price, overlaying which was a physical premium representing the additional cost to be paid by an aluminium user to get the stuff delivered to the door-step.
The relationship between the parts and the whole, the “all-in” price, was generally stable, albeit with regional variability depending on local supply-demand dynamics.
Over the last few years, however, that pricing model has splintered, with the premium accounting for an ever-rising part of the "all-in" price. ******************************************************* Graphic on global aluminium premiums: link.reuters.com/cyr27v Graphic on Japanese quarterly premiums vs "all-in" price: link.reuters.com/der27v *******************************************************
Views in the aluminium industry as to why this has happened are polarized.
Aluminium consumers including drinks companies such as MillerCoors have laid the blame on the LME warehouse system, specifically the long load-out queues to get metal out of locations such as Detroit. Some are even pursuing legal action against the LME and its warehouse operators.
Producers and parts of the analyst community are not so sure, arguing that the queues themselves are symptoms of deeper problems, particularly the combination of huge legacy stocks and investors’ appetite for financing those stocks in a negative real interest rate environment.
The only thing that both sides of this often heated argument agree on is that, as of now, there is a real risk-management problem for the entire aluminium supply chain.
The premium, or as it is now frequently described, the discount to the “all-in” price, cannot be properly hedged.
When it was a relatively stable and small component of the “all-in” price, that was not a problem. When it accounts for 20 percent and more, as it did at the start of this year, it opens up a black hole in risk management programmes.
The CME has already moved into that pricing gap with the launch last April of a cash-settled contract based on Platts’ assessment of the U.S. Midwest premium <0#AUP:>
Its volumes last year were 3,475 tonnes. They have surged to over 16,000 tonnes in the first two months of 2014.
Fanning the jump in activity was the early-year explosion in the Midwest premium to over 20 cents per lb (equivalent to over $440 per tonne).
The move, which caught just about everyone by surprise, appears to have been caused by a distressed short or shorts among the financial players who started to get involved in the premium market last year.
That pinpoints one of the weaknesses of the existing contract, namely its lack of deliverability.
Being short any commodity futures market can prove costly if the price moves higher. Being short a physical premium without having the physical units to deliver or the option of deliverability exponentially compounds the problem.
Which is why CME is now looking at a fully physically delivered offering with warehouses in New Orleans, Baltimore and Ypsilanti, Michigan, which is just outside Detroit, where the LME’s aluminium warehouse woes started.
That there is demand for such a product is not in doubt. Whether CME is the best provider of that contract remains to be seen.
It has two major hurdles to overcome for the new contract to be successful, the same two problems that stymied its previous moves into the aluminium market.
The first is liquidity. A physically deliverable product must be fed with physical metal liquidity.
CME can boast early buy-in from aluminium users such as MillerCoors and sheet manufacturer Tri-Arrows Aluminium, both of which contributed positive quotes to Tuesday’s press announcement.
But physical liquidity requires the buy-in of producers and merchants as well, precisely the players who have been benefiting from the recent surge in premiums thanks to their natural long positioning.
There are only a handful of such big players operating in the North American aluminium market, and most, if not all of them, are already wedded to LME pricing.
Which is the second big hurdle facing CME. How does it take on an existing LME reference point that is deeply and intricately embedded within the industry’s pricing model, even if that model looks increasingly flawed?
That challenge could prove even more daunting if the LME itself decides to go down the regional premium pricing route as it has publicly indicated it might.
Any commodities hedger would naturally prefer to use a single exchange for risk management, simply to avoid duplication of costs and processes. Since most active aluminium hedgers will already be using the LME basis price, an LME regional premium contract has a built-in advantage over a new rival such as that being proposed by CME.
Assuming, of course, that the LME does indeed go ahead with its own premium contracts.
CME has just thrown down the gauntlet. Will the LME pick it up to defend its $54 billion franchise?
If it does, the ensuing battle would mark the opening of a new chapter in the history of base metals pricing. (editing by Jane Baird)