(The author is a Reuters columnist. The opinions expressed are his own.)
By Andy Home
LONDON, Oct 3 (Reuters) - If you judge the success of an exchange by its trading volumes, the London Metal Exchange (LME) has been doing just fine in this, its 136th year.
Volumes were up eight percent in the first nine months, extending a period of boom that has been running uninterrupted since the fateful year of 2009.
If, however, you judge an exchange by its relationship with its users, the LME is in a lot of trouble. Which means that Hong Kong Exchanges and Clearing (HKEx) (0388.HK), which paid so richly for the LME’s global metals franchise just a year ago, is in trouble, too.
Rarely in the LME’s long, colourful history has it come under such sustained attack by those it is supposed to serve. The focal point for the multiple barbs being aimed at the exchange is its warehouse delivery system.
Consumers are furious with the way things are.
“We believe that the current system is dysfunctional and prone to manipulation,” was the stark message from the Aluminum Users Group, representing the North American beverage can industry. [ID:nL2N0H62DO]
“The current system does not work ...The LME’s current practices must be changed.” The call to arms by Tim Weiner, global risk manager at MillerCoors, has sent regulatory and legal waves crashing out of the U.S. Senate hearing room where he was giving testimony. [ID:nL1N0FS1GL]
Producers are furious about the LME’s proposed solution.
U.S. aluminium giant Alcoa (AA.N) has publicly warned HKEx “not to act carelessly”, lest it send a message to users that “the LME may not be the correct forum for their price discovery process”.
Others have just given up.
The North American Die Casting Association has recommended its members shift their pricing on all new contracts away from the LME’s North American alloy (NASAAC) contract. The NASAAC price, they feel, has just stopped being relevant to their business. [ID:nL5N0HE1OY]
HKEx has, it seems, bought the venerable LME just at the moment it is going through one of its periodic crises of confidence.
There was the Tin Crisis in the 1980s. The Copper Scandal in the 1990s. And now...well, what shall we call it?
The Aluminium Crisis? Maybe The Warehousing Crisis/Scandal?
(Delete according to preference).
The LME’s physical delivery system is certainly the catalyst for the current storm.
But is it the cause or merely the flash point where long-building tensions, both in the aluminium market and the exchange, are now bursting to the surface?
If the LME warehousing system is malfunctioning, it is at least in part because the aluminium market is malfunctioning.
As one industry player put it to me recently: “For the first time in my career and the careers of all of my colleagues (those presently active and retired), we have all been dealing with a business that has become fundamentally dysfunctional.”
Supply chains are cracking, the disconnect between LME and physical prices has become a gaping chasm and the relationship between primary and secondary markets is largely broken.
The root problem is that aluminium is a market that does not obey the law of commodity supply and demand. The law states that when demand contracts, the price should fall to the point that supply adjusts.
In practice, that’s not what happens in this market, as Alcoa itself admitted in its open letter to the LME. When demand collapsed in the Great Financial Crisis of 2008-2009, the supply response was far too little, far too late.
“Due to the prohibitive cost of production curtailments and later re-start costs, hopes for a price recovery, the potentially devastating impact of closures on the communities that aluminum smelters operate in, and the prevalence of sovereign-funded producers, the speed of capacity closure was slower than the demand destruction and aluminum continued to be produced at a rate above that of consumption.”
The result is millions of tonnes of surplus metal gathering dust in warehouses around the world.
How much? Actually, nobody really knows because another problem with this market is the lack of statistical clarity. There is no aluminium equivalent of the government-backed Study Groups whose job it is to throw some numerical light on the workings of the copper, lead, zinc and nickel markets.
The collective best guess is something like 10 million tonnes. Give or take a couple of million.
It is the ebb and flow of this surplus, from LME to non-LME storage, between LME warehouses in the same location and between LME locations, that has clogged up the exchange’s physical delivery system.
Producers are still collectively failing to cut output sufficiently to tackle this legacy mountain. Consumers have collectively failed to manage the pricing consequences.
It’s somehow typical of aluminium that the two sides have offered up diametrically opposed views of what the LME’s problem is and how it should go about fixing it. [ID:nL5N0H81S5]
But on one thing at least they are agreed.
Industrial players, whose pricing is the LME’s life-blood, are being marginalised by financial players.
Or to quote Alcoa again, “the real issue is that the LME price no longer represents the fundamentals of the industry due to increased speculative trading.”
“Speculative trading” has been the main driver of the LME’s splendid growth story to the point, as Alcoa pointed out, that turnover in the LME aluminium contract is now 37 times the size of the physical market, up from 29 times in 2010.
Recent years have brought an influx of managed money in many guises, from hedge funds to black box CTAs to high-frequency traders. It’s not so long ago that a high-frequency trader on the LME was one who couldn’t wait for his broker to have a decent lunch between the morning and afternoon ring sessions. Now, trade signals are measured in milliseconds.
This is the culmination of a long, long process that started in 1991, when Goldman Sachs launched what is now the S&P GSCI commodity index.
In the intervening years industrial metals have been gradually transformed from backwater markets for specialists, who were quite capable of speculating themselves, thank you very much, to part of a new “asset class” to be sold to fund managers as a core component of any investment strategy.
For manufacturers it was bad enough that such investors/speculators (again, delete according to preference) were in “their” marketplace at all.
But things got a lot worse when financial players started wanting to own physical metal as well as paper metal, or, horror of horrors, when they wanted to own their own warehouses to put their physical metal in.
Physically-backed exchange traded funds (ETF) have been a previous flash point for the copper industry. An ongoing rear-guard action against two such proposals in the United States looks as if it’s about to be outflanked by Julius Baer, which has just launched a new suite of such products. [ID:nL5N0H62QG]
These ones are next-generation versions with much lower storage fees, previously the main sticking-point for investors and the main source of relief for industrial players concerned about the implications for their supply chains.
The flash point in aluminium is the cash-and-carry trade, which allows investors to earn a low-risk, fixed return for simply financing (and holding) surplus metal.
It’s not a particularly sexy investment but in the post-2008 world of negative real interest rates, it does at least generate a positive return.
And the return improves if the metal is shifted out of high-cost LME warehouses to something a bit cheaper.
It is the cocktail of too much money and too much metal that has hobbled a physical delivery system that was never designed to handle either, let alone the combination.
So what can the LME do? Or, rather, what can HKEx do? After all, it’s HKEx’s London Metal Exchange now.
Except that it is also the industry’s LME. Without industry’s willingness to use LME pricing in its real-world supply-chain transactions, this market risks losing both body and soul.
Contracts such as aluminium and copper would become no more than metallic versions of the VIX, just another derivative for trading the next macro data event.
How can the LME’s new owners reconcile the needs of the metal men, who guarantee the validity of the exchange’s prices, with the needs of the money men, who have fed the exchange’s recent volume growth?
Better transparency? Just about everyone thinks the LME should disclose more information about who is doing what.
Mind you, it might take something more bespoke than the U.S. Commitment of Traders format, given how adept some of this market’s bigger players have become at disguising their movements.
More contracts? Why not? If the aluminium industry agrees that regional premium contracts, as suggested by Alcoa, or product contracts such as billet and casting alloy, as suggested by United Company RUSAL, are a good thing, the LME should provide them.
A shake-up of the LME’s governance with wider industry participation, as suggested by the Aluminum Users Group? That looks a no-brainer, particularly given the new ownership structure, which risks stretching rather than shortening communication lines.
The solution will have to be multi-dimensional because this is not a one-dimensional problem.
And, of course, it will have to start with LME warehousing itself.
Warehousing, to quote outgoing chief executive Martin Abbott, is “the crunch point, the flash point between every party to this industry”.
It is also the crunch point at which every component of the LME’s deteriorating relationship with its industrial users converges.
Warehousing has, let’s face it, always been the LME’s problem child.
Now, already creaking under the strain of handling millions of tonnes of surplus aluminium, the LME storage system is being gamed by a powerful group of physical market players that control large parts of the exchange delivery mechanism.
Fixing warehousing would be a strong building-block for re-connecting with the exchange’s industrial user base.
But just how can the LME’s long and unhappy relationship with its warehousing operators be reset?
That’s for tomorrow’s column.
(Editing by Jason Neely)
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