Market organisation: The impact of financial deals and warehousing rules

The physical price can be formed through bilateral contracts, but is more frequently formed through cash forward contracts, traded on LME. The pricing complexity of the cash contract is fairly low and, most of the time, even bilateral transactions rely on the publicly available benchmark price. The futures (forward) market is fairly liquid and active, and accounts for over 15% of the value of global production (Table 18). The standardised product characteristics of metals permit the quick development of trading platforms with futures contracts trading these underlying commodities.

The low degradation of the metal, additionally, makes the ‘cheapest-to-deliver’ model the most successful (Geman, 2005). As a result, LME has built a system of warehouses over the years spread widely across the world (with roughly 740 licensed warehouses), making delivery very cheap. This model of delivery dramatically reduces the impact of freight and transportation costs for those using these contracts in pure physical transactions. However, recent issues linked to delivery of aluminium out of specific warehouses and the sudden growth of stocks have raised questions about the organisational rules set by the exchange and potential conflicts of interest with important financial institutions, which hold majority stakes in two of the largest warehouses in the United States and in Europe. Certainly, the underlying trend to accumulate aluminium comes from the drop in demand (and the negative economic cycle) and the strong net production surplus during the recent financial crisis, due to the inability in the short term to adjust production downwards (see above).

A strong contango (spot prices much lower than forward prices) and the low interest rates, which keep the convenience yield (i.e. the total cost of holding a commodity) at a very low level and offer great opportunities for carry trades,¹¹⁴ lead this underlying trend. Figure 108 shows how the drop in the convenience yield, caused by a sudden halt in global demand and zero interest rates, has pushed the curve into a prolonged and strong contango, which is driving accumulation of inventories and in-store delivery and storage of aluminium. As a result, inventories behind LME aluminium contracts were worth more than 11% of the yearly global production in 2011.

Figure 108. Basis and convenience yield (rhs), Q2 2003-Q1 2012 ($/tonne)

Note: ‘Basis’ calculated as differential between cash forward and the maturities mentioned above.

Source: Author’s calculation from LME and the Fed.

While the absolute number may be still considered in a reasonable range (but not so common for industrial metals), the growth of cancelled warrants, i.e. metal that is requested for delivery, signals real problems in loading out aluminium from warehouses. In fact, the sheer increase in inventories, as showed in Figure 109, and the recent spike in cancelled warrants in at least two locations (Detroit for the US and Vlissingen for the EU) may also tell us an additional story.

When interest rates reached almost zero across the advanced economies in 2007-08, the opportunity for a big carry trade emerged. Historically low aluminium prices, due to the financial crisis, also made it easy to exploit a stable contango in the futures/forward curve. Accumulation has occurred due to inventories being maintained in LME warehouses, financed by financial institutions at very low interest rates, in order to resell when demand picks up again (with the end of the oversupply that increased with the economic crisis). This carry trade has allowed an unprecedented amount of aluminium stocks to flow into LME warehouses, especially in 2009 (Figure 110).

Accumulating aluminium in LME warehouses was a rather smooth process, but the unloading process has caused several issues. Despite the recognised of the LME warrants system (see Box 3), aluminium is currently stuck in long queues at delivery, specifically in the two locations mentioned above. The delivery bottleneck is represented by cancelled warrants,¹¹⁵ which were almost none when

114 Holding and carrying the commodity, benefitting from higher prices in the future.

115 Metal that is requested for delivery. In particular, holder that has metal on warrant decides to ship the metal out and notifies the warehouse holding warrant of the desire to cancel. The warehouse requires payment of out charges for loading before cancelling the warrant. It then gives the holder of cancelled warrant notice of when the shipment can be made. At this point, a book-keeping entry is made in LME stocks moving from ‘on warrant’ to

‘cancelled warrant’ but is still reported in total stocks. Rent continues to accrue on the cancelled warrant until it shipment date arrives. The holder of cancelled warrant must pay all accrued rent before metal is shipped. Once

the accumulation of inventories began in 2008 (Figure 109). Delivery requests in specific consumption areas, such as Detroit in the US and Vlissingen in the Netherlands, have waiting time of respectively 355 and 272 days on average (CRU, 2013) and there is no sign that this trend can be soon reversed, especially if demand will pick up again in the future months.

Figure 109. LME inventories and cancelled warrants (rhs)

Source: Author’s elaboration from Alcoa and LME Sword.

Figure 110. Aluminium flows in LME warehouses

Source: LME Sword.

The reasons of this delivery cut are at least twofold. First, since users pay for the storage even if the metal is put in a queue to be loaded out, warehouses have incentives only to increase metal accumulation (load-in) and so to reduce their load-out rate to the minimum level set by the exchange.

Second, the rules set by LME for sponsored warehouses allowed a very low daily delivery rate. Before April 2012, the delivery rate was based on the size of the warehouses, i.e. 1,500 tonnes for warehouses with space of 7,500 m² or more (roughly all warehouses, Europe Economics 2011), 1,200 tonnes for shipped, total cancelled warrants reported by LME are lowered by the amount shipped and total stock declines accordingly.

5,000 m², and 800 tonnes for 2,500 m². This system created the incentive to accumulate supply in one place, slowing down the delivery of the commodity (due to the low delivery out rate) and increasing the storage time for users. Specific warehouses located close to consumption areas have been stocked with massive quantities of aluminium over time. Detroit and Vlissingen, which also represent the closest points to the two of the biggest car manufacturing areas and general aluminium consumption areas in the world, stored over 1 million tonnes of aluminium each in September 2012, and also had the highest number of cancelled warrants. This problem in the system may have also contributed to keeping aluminium prices above the level that a four-year surplus in net production might have pushed them.

As a result of strong pressures from users and after the conclusions of a study commissioned by the LME itself (Europe Economics, 2011), the LME’s Board decided to increase the minimum delivery out rate. A new system, implemented in April 2012, calculates the minimum loading-out rate on the overall amount of metal stored in the warehouse rather than the size in m² of the warehouse (as for the old system).

Table 49. Minimum delivery out of LME warehouses

Warehouse company’s tonnage stored per location Minimum delivery out

Up to 300,000 tonnes 1,500 tonnes network, which is the core aspect of the LME business model, the system may still give incentives to warehouses to concentrate stocks in one place, because above a certain threshold of tonnage stored (900,000 tonnes) the minimum delivery out rate freezes. A system based on a minimum percentage of the total metal in storage (without thresholds) has been ruled out on the claim that it would increase operational costs for warehouses at an unsustainable level. Europe Economics estimated these costs at a minimum of $255 million for 2010 for a warehouse with 1 million tonnes and a minimum delivery rate of 50,000 tonnes. While it cannot be challenged that these extra operational costs are high, the solution applied by the exchange assumes that warehouses are unable to set their own capacity (in competition) as a function of a minimum delivery rate calculated as a percentage of their total capacity. As rental fees are applied also on metal units waiting to be delivered, this model creates the incentive for the warehouses’ owners not to deliver any more units than the minimum quantity set by LME rules, which indirectly become a maximum delivery rate, in order to extract higher fees from aluminium users. Nonetheless, the rules of the exchange have to balance the right of the users to get delivery as soon as possible, and the incentives for the warehouses to be part of the LME network or otherwise compete freely among each other, which may not ensure the current capillarity of the LME warehousing network.

Additionally, the delivery rules set by the exchange will be now subject to periodic review (every six months) by a Committee that should fall under the UK Financial Conduct Authority’s supervision. However, the process shall be complemented by a conflicts of interest policy in relation to the final decision eventually approved by the Board. In fact, the owners of important warehouses in main consumption areas (such as in Detroit and Vlissingen)¹¹⁶ are mainly important financial institutions and commodities trading houses that also run a legitimate business of financing users to store aluminium in their warehouses, but most importantly had altogether a significant shareholding in LME (but with no official majority within the Board)¹¹⁷ before the recent merger with the Hong Kong Exchange, in which some of them keep an interest but diluted in its quasi-dispersed ownership.

116 In particular, warehouses in Detroit are owned by Metro Group (owned by Goldman Sachs) and Henry Bath (owned by JP Morgan), while those in Vlissingen are owned by Pacorini (owned by Glencore) and Metro Group.

117 58 shareholders, including financial institutions, with single shareholdings below 11%.

Figure 111. Regional premia over LME cash, 2008-2012 ($/tonne)

Source: Alcoa from month-end pricing – Platts Metals Week and Metal Bulletin.

As a consequence of the delivery issue caused by the joint effect of cash-and-carry trades and LME delivery rules, regional premia over the LME aluminium cash price in the physical market, have soared to unprecedented levels, partially compensating the drop in the nominal price due to the period of oversupply (Figure 111). As premia are strongly influenced by the costs of the alternative way to source aluminium (LME cash forward), regional premia have partially followed the increase in cost of storage in main regional locations, which have soared due to the long queues to get metal out.

Regional premia are now more than 15% of the nominal cash price.¹¹⁸

Figure 112. US premium and cancelled warrant in North America, 1999-2012

Source: CRU (2013).

118 The cost of storage for additional 355 days of storage is roughly $160/tonne ($45 cent per day; tariff in Vlissingen and Detroit in March 2013), which corresponds to an additional cost of roughly $160 million only in the US (with 1 million tonnes of cancelled warrant). Cost of storage is roughly 50% of the cost that is indirectly discounted into regional premia, on top of other loading out charges and indirect costs for not being able to get delivery when requested.

On top of the negative effects of a delivery system that does not reflect the characteristics of the underlying physical market, this situation could ultimately end up affecting the price formation of LME aluminium cash contract as a global benchmark price, so restricting users’ access to an important hedging tool and finally increasing the cost of the commodity for final users.¹¹⁹ Moreover, a well functioning delivery system provides an efficient tool to support supply adjustments when disequilibrium in the physical market between demand and supply emerges.

More generally, when a system of physical delivery is put in jeopardy, either by external factors or internal policies, this situation may produce disruptive effects on the price formation of all cash and futures (forward) contracts in relation to their convergence with physical spot prices, even for those contracts that are typically cash-settled. Convergence is the only element of the non-arbitrage condition that has made futures contracts so important for commodities hedging. Therefore, some commodities firms may be unable to hedge on the futures market due to the uncertainty around the final price of the commodity caused by physical delivery problems. Spot prices, therefore, may have only started to price the information of a badly functioning cash and forward market, so increasing volatility and pushing premia away from a pure result of supply and demand interaction. In addition, the overreliance on the price formation of regional premia can deteriorate the value of the benchmark and so its liquidity, which may ultimately replace a transparent setting offered by the liquid cash forward market with a more opaque price formation mechanism based on assessed regional premia.

Table 50. Key market organisation factors

Physical market setting Pricing complexity Liquidity futures market Delivery points

Oligopolistic Low High High

Source: Author.

The overall market organisation is based on an open oligopolistic setting in the physical market for supply with low complexity in the pricing system, which relies heavily on a cash forward market run by LME. Liquidity in futures markets is high and the exchange model allows delivery in several regions across the globe.