(The opinions expressed are those of the author, a columnist for Reuters.)
By Andy Home
LONDON Feb 26 The tremors caused by the explosion in U.S. physical aluminium premiums have reached the other side of the world.
Japanese buyers are facing an historically unprecedented jump in premiums for shipments arriving in the second quarter of this year.
The opening producer salvoes in the quarterly negotiations are coming in at $370-375 per tonne over LME cash. That compares with $255-256 for the January-March 2014 period.
There's a certain inevitability in this after U.S. premiums went super nova at the start of the year and European premiums started rising in their wake.
But the real issue is not the headline-grabbing rises in premium levels but the widening rupture in the core pricing mechanism of the 45 million tonne global aluminium market.
The future for the light metal has never looked so bright, as it makes increasing inroads into the automotive sector.
But in terms of price discovery, aluminium risks slipping away from the light of exchange trading into the shadows of the over-the-counter market.
******************************************************* Graphic on global aluminium premiums: link.reuters.com/cyr27v Graphic on Japanese quarterly premiums vs "all-in" price: link.reuters.com/der27v *******************************************************
CATCHING UP WITH THE DISCONNECT
Japanese buyers can be expected to resist the scale of the quarterly hike in premium levels but they will struggle to do much more than take some of the sting out of the move.
The U.S. premium as assessed by Platts, a leading global energy, metals and petrochemicals information provider, has edged down from its January highs but currently still stands at 19.25 cents per lb, equivalent to $424 per tonne over LME cash.
In Europe the premium for duty unpaid metal has risen from $220 to $295 per tonne since the start of the year, according to Platts.
Both leave the Japanese premium, which has held in a $240-255 range since the back end of 2012, looking seriously undervalued.
However, if Q2 premiums are settled anywhere near the opening producer offers, the yawning disconnect between LME price and "all-in" aluminium price, will become a global phenomenon.
At $370-375 per tonne and assuming no major move in the LME aluminium price, the Japanese premium would account for around 18 percent of the all-in price for metal delivered in the second quarter.
By way of comparison the premium represented just 2.4 percent of the all-in price in the first quarter of 2008.
The problem for aluminium manufacturers the world over is not the outright level of the all-in price, which remains low enough to inflict continued margin pain on producers , but the growth in the unhedgeable premium component of that price.
IN THE SHADOWS
Premium trading is still an over-the-counter (OTC) market.
True, the CME's new aluminium premium contract <0#AUP:>, based on Platts' market assessments, has seen a sharp pick-up in turnover since the start of the year.
But cumulative volumes so far of 7,190 tonnes are a fraction of the physical aluminium market.
Moreover, this uptick in activity is very much a lagging indicator of the early-January jump in premiums.
Whatever caused that leap from 15.0 cents to 20.5 cents in the space of a couple of weeks happened in the OTC shadow lands.
The best bet is that one of the banks that last year moved in to trade the premium market found itself short and caught. The resilience of the U.S. premium over the course of this month suggests that whoever it was is still short.
CME's products can't help right now. Volumes are too low and there is no physical delivery option.
If you're short a physical premium without the metal to cover it, you're still beholden to those that do have the physical units.
Unlike the periodic tussles that take place between some of the big aluminium players on the LME, this premium battle is going to be largely fought out in the shadows.
LEAVING THE LIGHT
Compounding the shift from exchange to OTC pricing is the movement of stocks out of the LME warehouse system.
Metal leaves like clockwork every day from Detroit and Vlissingen, the two good-delivery locations that hold the most aluminium in the LME network.
It will start leaving faster when the LME's new load-out rules kick in from May. Less will probably arrive, given the linkage between load-in and load-out rates stipulated by the exchange.
The LME of course is reacting to the vociferous consumer complaints about the impact of load-out queues at both locations on physical premiums.
The recent explosion in premium levels has left that argument looking overly simplistic as other drivers, not least the amount of capacity being idled by producers, take over.
But leaving that acrimonious debate to one side, the simple truth is that metal is still leaving the LME system at a fast clip with the departure rate set to quicken further in a couple of months' time.
All this aluminium is not going to meet manufacturing demand. It is largely moving into cheaper off-exchange storage to be held by stocks financiers, who are using the wide contango on the forward part of the LME curve to generate a low-risk profit.
The logical conclusion of this stocks trend is that the shrinkage in the LME component of the all-in price will be mirrored by the exchange's dwindling share of global inventory.
The rise in physical premiums is a major threat to the LME's franchise. Primary aluminium is the exchange's most liquid contract but one that is fast losing its relevance.
But it is also a threat to the whole aluminium supply chain, reducing stocks and price transparency and opening up an unhedgeable gap in the industry's core pricing mechanism.
It's also a threat to regulators. Aluminium's gradual shift towards off-market inventory and pricing runs counter to all post-crisis regulatory efforts to bring markets out of the OTC shadows into exchange-traded and exchange-cleared light.
What can be done?
Until recently, until the first week of January to be precise, the aluminium market had convinced itself that premiums would start falling in response to the LME's load-out rule changes.
That is still the consensus view, albeit one that is challenged every day premiums stay at their current levels.
And what if premiums don't fall? What if a tightening physical market impacts only premiums and not basis price? These are uncharted waters and there is a real risk that the disconnect might yet grow wider.
The LME itself may offer a solution, if it can engineer physically-deliverable regional premium contracts, something producers such as Alcoa have urged it to do.
Designing such contracts and attracting liquidity will not be easy. Moreover, they risk cementing rather than fixing the current fracture in the all-in price.
But something is going to have to be done, and sooner rather than later, to prevent what is the largest of industrial metal markets sliding further into the shadows. (Editing by David Evans)