LONDON (Reuters) - There was a time when the global aluminum market could be seen as two parallel universes, to borrow a phrase coined by Klaus Kleinfeld, chairman and chief executive of Alcoa.
There was China. And there was the rest of the world.
The great dividing wall was China’s 15 percent export tax, effectively preventing the flow of primary metal out of what was already the world’s biggest volume producer.
There was always an element of wishful thinking in Kleinfeld’s parallel vision, ignoring as it did the flow of semi-manufactured aluminum products out of China. But in terms of physical and paper trading of commodity-grade aluminum, the analogy just about held, until only a few years ago.
Alcoa has since divided itself into two separately listed companies but the two parts of the global aluminum market have moved ever closer.
The physical export flow of “semis” has steadily increased with over four million tonnes leaving China in both 2015 and 2016.
And, equally significantly, the two main trading venues of London and Shanghai have started to connect, with the eastern universe exerting increasing influence over the western.
Graphic on Shanghai aluminum: price, open interest and volumes: tmsnrt.rs/2lAxPuY
Arbitrage between the London Metal Exchange (LME) and the Shanghai Futures Exchange (ShFE) has been long established in markets such as copper.
But in aluminum it’s a newer phenomenon dating to the end of 2015.
That’s when the Shanghai aluminum contract experienced a step-change in usage with market open interest and volumes exploding.
At the time it looked like one of those crowd trades that have roiled other Chinese commodity exchanges at various times over the last couple of years.
Producers lashed out at “irrational” speculation as prices collapsed under a torrent of short-selling.
And maybe it was.
But Shanghai’s new aluminum friends have stayed with it ever since. Volumes almost doubled last year and market open interest remains a multiple of what it was prior to the fourth quarter of 2015.
That in turn has generated greater connectivity with the London market.
The clearest manifestation is the higher trading volumes during the overlap between the Shanghai and London trading days, according to the LME’s “Insight” team of analysts.
So-called LME “Asian hours” trading jumped from five percent of the daily total in the third quarter of 2015 to nine percent in the fourth quarter of that year. That ratio held pretty steady last year, averaging eight percent.
Moreover, “the LME-ShFE arbitrage has swung more aggressively since Q4 2015 and LME prices have been more volatile in Asian hours,” particularly during times of high Shanghai turnover, according to the LME. (“LME Aluminum: West to East as Asian influence rises”)
The precise origin of this liquidity boost is unclear.
It may well be that the increased flow of semi-manufactured products out of China has generated increased arbitrage between the two markets.
But as the LME’s Insight analysts concede, “a genuine increase in intraday activity suggests the relationship has widened beyond just merchants hedging physical profits.”
“On-screen traders are increasingly trading the aluminum arb or, at least, allowing the direction of one market to influence trading on the other.”
Liquidity, in other words, begets more liquidity. This is true of all exchanges but maybe particularly true of China where speculators hunt in packs.
Graphic on LME aluminum stocks by region:
Working in parallel, as it were, with this increased trading connectivity has been a steady shift in the location of LME stocks away from the United States and Europe towards Asia.
As of the end of January over 60 percent of “live” LME stocks, meaning those not in the form of canceled warrants, were located at Asian locations.
It’s the highest ratio since 2007, although the historical comparison is muddied by the fact that LME stocks were much lower prior to the 2008-2009 global financial crisis.
This in part may also reflect that steady stream of semi-manufactured product leaving China. If it is displacing primary metal in the rest of the world, it is logical that the hardest impact would be in the closest geographical region.
But in part it’s also down to the LME’s own policy of targeting excessive load-out queues at some of its locations in Europe (Vlissingen) and the United States (Detroit).
Recent tightness in the LME contract’s time-spreads have incentivized physical deliveries into the exchange’s warehousing network. With some queue-affected operators elsewhere reluctant to take in more metal, the default delivery location has shifted from west to east.
In terms of physical liquidity of underlying stocks the LME aluminum contract is shifting towards China just as Chinese exchange trading is exerting ever more influence on Western pricing.
In some ways aluminum is still catching up with other base metals.
“Asian hours” trading of LME copper accounted for 16 percent of daily volume last year and nickel an even higher 17 percent, according to the LME.
Copper in particular has been periodically rocked by trading surges on the Shanghai Futures Exchange, forcing LME traders to wake up to the power of Chinese money when it’s on the move.
Aluminum looks set to follow the same path as the two universes collide.
In November last year “Asian hours” trading on the LME aluminum contract surged to over 14 percent in response to heightened activity in Shanghai.
“The average price range for aluminum in the London morning more than doubled” to hit a peak of 1.2 percent, according to the LME’s Insight team.
The problem for the rest of the world, which has grown used to aluminum’s relatively low level of volatility, is that all this is happening just as the Chinese aluminum market becomes more unpredictable.
Now accounting for well over half of the world’s production of the light metal, future Chinese output trends are in danger of becoming increasingly beholden to government policy.
Aluminum smelters were included in a proposal to switch off key industrial sectors over the winter months to alleviate Beijing’s choking smog.
This is still a proposal and it remains to be seen whether it translates into smelter cutbacks.
But if it does, you can be sure there’s going to be a reaction in the Shanghai price.
And increasingly that’s going to generate a reaction in the London price.
(The opinions expressed here are those of the author, a columnist for Reuters.)
Editing by Susan Fenton