(The opinions expressed here are those of the author, a columnist for Reuters.)
* LME Aluminium stocks and spreads: tmsnrt.rs/31QegmK
LONDON, July 6 (Reuters) - The London aluminium market was rocked by a short but severe squeeze last week.
Short-position holders had to cough up as much as $20 per tonne to roll their positions a day.
This may seem strange given the world is apparently once again awash in aluminium.
London Metal Exchange stocks (LME) have surged by 68% from a mid-March low of 967,325 tonnes to 1,624,775.
The increase in visible stocks in the market of last-resort delivery is likely being matched by a bigger build in the statistical shadows.
But the aluminium market has learnt before that appearances of surplus can be deceptive when it comes to LME spreads.
As shorts just found out to their cost. The flash squeeze has passed but it’s a sign that the stocks financing business is on the rise again.
It also places the spotlight back on the LME itself, given it has just spent a decade reforming its delivery network after the last wave of surplus aluminium in the wake of the financial crisis.
SHORT BUT BRUTAL
The full force of last week’s squeeze hit short position-holders trying to roll daily positions across the LME’s “tom-next” spread.
“Tom-next”, the shortest-datest of all timespreads in the exchange’s labyrinthine forward trading structure, usually defaults to a small contango.
There was a brief bout of turbulence at the end of June but nothing to compare with the second half of last week when “tom-next” traded out to $20 backwardation on Friday morning, the widest it’s been since 2012.
That wasn’t a rogue print either. A total 140 lots (3,500 tonnes) traded at that level with another 497 lots transacted at a backwardation of $19.
Shorts appear to have misjudged how much liquidity was available with one dominant long position holder accounting for 30-40% of available LME stocks. Additional cash positioning lifted that ratio to 40-50%, not enough to trigger the exchange’s mandated lending caps but still a big position, equivalent to up to 730,000 tonnes.
Cash-date pressure tightened up the whole aluminium forward curve. The benchmark cash-to-three-months time-spread was last week trading at less then $20 contango, compared with double that as recently as May.
The squeeze has now passed. “Tom-next” has reverted to small contango and the cash-threes contango has collapsed back out to $31.25 as of Friday’s close.
This flash squeeze is a timely reminder, however, that rising LME stocks do not automatically mean there’s lots of free metal around.
Particularly when the stocks financiers are back in town.
Actually, they never left the aluminium market, which has been defined by the need to store and finance millions of tonnes of metal ever since the global crisis of 2008-2009.
However, a lot more metal now may be on its way to LME warehouses after the economic hit from the fatal coronavirus.
The collapse in manufacturing activity, particularly in aluminium-intensive sectors such as automotive and aerospace, will push the world outside of China into a massive 3.2 million tonne surplus, according to Paul Williams, head of aluminium analysis at CRU research house.
Quite evidently, that implies a bigger build in inventory than is being captured by LME stocks. It’s quite likely that more is either accumulating in the physical supply chain or in LME “shadow” storage, benefiting from discounted rental relative to being on warrant but available for warranting if required.
All of it is being financed using the LME’s forward curve. The fat contango of April and May would have allowed financiers to lock in a guaranteed return simply by buying cash metal and selling it forward.
Low interest rates fuel the trade both because they make borrowing money cheaper but also because they increase appetite for a fixed-return investment in this sort of metallic bond.
“With low premium, steep contango, attractive rental and low financing cost, we think warehousing deals have become attractive again and speculative buying has started to show up, which has been quite typical in the past decades, especially in 2008 and 2009,” note analysts at Goldman Sachs. (“Turning more constructive on aluminium”, June 9, 2020)
Unlike physical buyers, financial users’ appetite for metal is limited only by the size of their balance sheet or that of their banking partners.
The tussle for aluminium, both within the LME warrant pool and the larger shadow pool, has caused plenty of spread turbulence in the past.
And last week’s mini squeeze suggests the conditions are falling into place for more of the same going forwards.
Goldman Sachs thinks the current finance dynamics will lead to a repeat of the LME’s queue problems with unwanted metal being sucked into the system and then getting log-jammed on the way out as buyers seek out cheaper non-market rental deals.
This, the bank believes, is a positive for the aluminium market since “the surplus is going to be ‘locked in’ or ‘held off’ by warehouse” load-out queues.
This is, of course, what happened 10 years ago and the LME has spent much of the intervening period reforming its warehouse network.
However, this year it has been gradually easing the rental caps on metal stuck in load-out queues, a move intended to allow warehouse companies more financial leeway to attract metal in.
It remains to be seen how this will play out in a world of falling physical premiums. Japanese buyers have just negotiated a premium of $79 per tonne over LME cash for their third-quarter deliveries, the lowest level since the end of 2016.
That lowers the bar for a warehouse company to compete for physical metal, particularly if it is reaping income from a load-out queue.
The LME contends that its load-out rules now prevent the occurrence of what it calls “structural” queues. But there are plenty of “flash” queues, particularly in Malaysia’s Port Klang, which has emerged as a new warehouse-merchant battleground for the storage of aluminium.
One operator in the port, ISTIM, has had “flash” queues at the end of every month since January last year, not always but mostly for loading out aluminium.
Flash queues and flash squeeze. With more surplus aluminium likely to wash into the LME marketplace over the coming months, the LME’s reformed warehouse system looks like its going to get a stress test.
Editing by David Evans
Our Standards: The Thomson Reuters Trust Principles.