Column: LME warehousing, more than a simple bazooka: Andy Home

Yu Tak International Holdings

08/11/2013 14:45

(The author is a Reuters columnist.  The opinions expressed are his own.) By Andy Home LONDON, Nov 8 (Reuters) - Caught in the middle of a polarised and increasingly acrimonious debate between its diverse user constituencies, the London Metal Exchange (LME) has done the obvious thing.  It has split the difference.  The threshold for reducing metal load-out queues in parts of its warehousing system has been cut from the original 100 calendar days to 50 days.  It's a solution that will please no-one.  Producers such as Alcoa  AA.N  and UC Rusal  0486.HK , who argued that no change to the load-out rules was necessary, aren't happy.  Indeed, Alcoa's official response to the LME announcement neatly side-stepped the specifics of the proposal. ID:nBw3kG3QZa  It "commends" the LME for taking steps towards greater transparency and "supports" the exchange's promise to look at regional premium contracts.  But as for the actual new rule?  It "cautions against direct market intervention". For which read, it hasn't changed its view that "it is fundamentally wrong for an exchange to alter the rules of the market with the express aim of moving prices (in this case regional premia)". ("Analysis of the proposed amendment to the LME warehouse rules", Oct 18, 2013)   Fabricators such as the Aluminum Users Group, comprising companies such as Novelis  NVLX.UL  and MillerCoors, aren't happy either.  They wanted the LME to eliminate completely the queues to get metal out of the LME warehouse system.    The proposal is "a move in the right direction" but "we believe further reforms could be immediately implemented to return the LME to a proper, free-market function of global aluminum price discovery."  ID:nL2N0IS28N  But while all the headlines have focused on the queue length, the LME's full report on its consultation points to a much broader package of measures aimed at tackling some of the thorny issues hard-wired into its problematic warehouse system.  If implemented, they would amount to the most far-reaching overhaul of the exchange's physical delivery function since the late 1990s.  Not just the single "bazooka" once threatened by Charles Li, chief executive of the LME's new owner, Hong Kong Exchanges and Clearing (HKEx) 8048.HK , more of a full artillery barrage.  CUT THE QUEUE... At one level, the LME's rule change will do what it says on the tin.  It will reduce queue lengths to 50 calendar days.  Over time.  The LME's load-in/load-out formula, in essence forcing warehouse operators with long queues to deliver out more metal than they take in, will only kick in next April and will take many months to achieve its intended result at locations such as Detroit and Vlissingen, where the queues extend to hundreds of days.  Obviously, much depends on warehouse operator behaviour. "Queues may diminish more quickly if warehouses choose not to optimise their load-in/load-out model". But on the other hand,  "queue development will be dependent on warrant-holder cancellation behaviour." Operators may try and game the system, such as using a "rotating queue" model, leveraging a "flash" queue in one location, created by the sudden mass cancellation of warrants, to finance the creation of a second queue in a different one.  The LME "recognises the potential for warehouse models which are consistent with the letter of the Rule, but inconsistent with the spirit thereof." It will insert a clause into its existing warehouse agreement, giving itself powers to seek more information "without limit" on the formation of new queues.  It will also reserve the right to adjust load-out rates by operator if necessary.  Equally, it may exempt warehouse operators from load-out requirements if the operator is itself being gamed by another party or if the market shows signs of distress.  Critically, every part of the formula from queue length threshold to queue "decay" can be tweaked in response to market developments.  ...CUT THE PREMIUM? But will cutting the length of load-out queue reduce the physical premiums that have grown with the queues? This, after all, is the stated aim of the policy, to realign the LME basis price with the "all-in" aluminium price.  The LME draws a clear picture of how queue length and the associated ability of warehouse companies to pay incentives to get more metal interacts with the physical premium.  "Merchants bidding on metal will often contact warehouses prior to submitting the bid, requesting indicative premiums which could be paid in the event that the merchant was successful in obtaining the metal." "In particular, this illustrates why warehouse incentives are a good proxy for physical metal premiums, as the warehouse effectively competes for metal with physical users, and so the premium which each pays over the LME price would logically be equal." But the document is also careful to note that "this does not imply that warehouse incentives cause premiums - rather, the warehouses are part of a competitive metal ecosystem, and the warehouse needs to set its premiums at a level where it can compete for metal against other users." In other words, cutting the queues should in theory reduce the discount of the LME basis price to the "all-in" (LME plus premium) price.  But in practice this still amounts to an unprecedented experiment in commodity market economics. The results, as with all experiments, are unknowable in advance. MORE BAZOOKAS But the LME, and its owner HKEx are actually proposing far more than simply cutting queue length.  Two of the much-discussed consequences of the rule change could be the mass movement of metal from exchange warehouses to cheaper off-market storage and a sharp hike in storage and load-out costs by LME warehouses.  The two are of course interrelated.  "The challenge for the LME will be to work to restore the position of LME warehousing as an attractive storage mechanism for global metal...it is hoped that an eventual outcome of the Proposal will be the restoration of rent competition to the market, which would represent a key step to catalysing LME storage." The exchange notes that "legal analysis of this topic is already underway" and here the devil is in the fine print, quite literally since the scope of the analysis comes in footnote 66 in the document.  "For completeness, the analysis will consider (i) the regulation of rents and FoTs (free on truck load-out charges) by setting a maximum for each, (ii) limiting inducements, (iii) restricting ownership of warehouses, and (iv) capping capacity by operator." This legal bazooka is aimed at the very heart of the LME warehousing problem. Those first three have been the source of user wailing and gnashing of teeth since the dawn of LME warehousing time.  Now, it's not the first time the LME has sought legal advice on its asymmetric relationship with "its" warehousers, whereby it cannot control the most important levers of its own storage and delivery function.  But it is the first time that HKEx has done so with the added 1.388 billion pound ($2.2 billion) incentive of making sure its purchase of the LME's global franchise doesn't dissipate in the sheds of Detroit and Vlissingen.  And symptomatic of that willingness to look again at the fundamentals of the LME's warehouse system is the proposal to engage a third party to conduct a root-and-branch investigation of the delivery network.  "In the final analysis, the issue remains...that the LME has never undertaken an ab initio assessment of warehouses' logistical capacity, and all of the load-out requirements are arbitrary figures. As such, it is difficult for the LME to enter into meaningful discussion as to load-out rates." It's an extraordinary admission given the unique importance of the warehousing system to the LME's efficient functioning. Oh well. Better late than never! FIRST STEP There is more, much more, in the full 76-page document, which is to be found on the LME's website.  Better representation for the market's physical users, particularly the industrial base on which the exchange's reputation for price discovery ultimately depends.  More transparency, not just a commitment of traders type report suggested by both sides of the aluminium industry, but detailed information on stocks breakdown by operator (albeit delayed).  Legal consultation on banning rent on metal caught up in queues.  A full analysis of premium discovery and hedging solutions with the potential for regional premium contracts. The list goes on.  It is clear that the exchange's new owners have realised that dealing with warehousing is going to require a fully holistic set of changes.  As such, maybe the best description of the load-in/load-out rule change came from the UK regulator, the Financial Conduct Authority.  "We see these measures as a first step towards strengthening LME's warehousing arrangements and increasing the transparency of its market." It's going to be a long march. This is just the first step. ($1 = 0.6232 British pounds) (Editing by Anthony Barker) ((andy.home@thomsonreuters.com)(Tel: 44-207-542-4412)) Keywords: COLUMN HOME/LME WAREHOUSING