When the chief executive of UC Rusal, Oleg Deripaska, takes to the pages of the FT to air his frustrations about his industry, you’ve got to sit up and listen. Especially when he concludes that output caps are needed to overcome the problems.
Rusal, of course, is one of the world’s top aluminium producers and Deripaska, it turns out, wants output caps because he is worried about the strange anomalies which are gripping his market.
As Deripaska notes, aluminium prices are weak even though physical demand for the “light metal”, especially in North America and Asia, remains strong. He wonders:
What, therefore, is causing this apparent discrepancy between the price and physical demand and how can the industry ensure its future sustainable growth?
As ever, though, you really need to read between the lines. And we’d say it’s the following paragraph which gives us the best clue to what Deripaska is really getting at (our emphasis):
While you would expect the fundamental demand outlined above to keep commodities prices in a state of relative harmony, the last two to three years has witnessed the increasingly influential role that financial institutions are having on the aluminium price.
The average share of aluminium locked in the LME warehouses under financial deals stayed at an average of 65 per cent in the second quarter. Capital inflows driven by index investors and hedge funds in particular have distorted the supply/demand equilibrium, sending a wrong signal for the players in the market.
What we feel Deripaska is outing here is the commodity industry’s (especially metal commodities) growing dependence and reliance on so-called contango financing, which holds back supply from the market via securitisations that allow banks to pocket yield in return for financing inventory.
FT Alphaville has written a lot about this mode of collateralised financing over the last few years, but it’s been hard to get the market to take this phenomenon seriously. Especially with regards to how it may be affecting and skewing prices.
The general idea is simple. There’s a glut of supply, which creates a contango forward structure. Producers, who would otherwise be tempted to cut supply and suffer income loss, are encouraged by banks to keep producing on the basis that they can use their inventory as collateral for secured financing.
The encumbered collateral is kept off market — (much like ECB periphery bonds) — and hedged which derivatives, which due to the contango structure, end up yielding a positive return for banks.
You could call it balance sheet rental to producers and traders for the sake of funding inventory (and/or contango positions in their own right) to take advantage of the mispricing of the curve. After all, the reason banks are able to make these deals profitable is because they bridge the difference between the physical reality and financial investors’ (especially passive ones) overpriced expectations of where commodity prices will be in the future.
The problem is that the off market collateralisation only creates information asymmetry across the market, making it impossible for traders to gauge the true clearing price based on physical supply and demand fundamentals.
In the aluminium market it’s also gone to the other extreme by pushing up premiums for physical spot supply, while adding to volatility more widely — since the trade now responds not only to contango, but to the opposite scenario which is backwardation. Thus when the market backwardates, traders release off-market supply (non-LME) to take advantage of physical premiums. When it goes back to contango, they simply flip back to storage mode. And we are told it only takes as much as a label switch on the inventory within the warehouse to exploit the market changes efficiently.
Deripaska naturally has a bias. According to FT reports, his company is beset by funding troubles associated with the current low clearing price of aluminium. It’s also worth noting that according to the FT, Rusal was involved in a suit filed in London by Victor Vekselberg, over its long-term sales contract to global commodities trader Glencore, which are said to have been granted on a noncompetitive basis, designed to give Rusal a stable cash-flow.
As Bloomberg reported in April:
Rusal will sell about 14.5 million tons to Glencore over the duration of the agreement, which will protect the company against future price declines, the people said. Glencore pays the LME price plus a fixed premium, and can resell the metal or stockpile it in anticipation of higher prices.
Glencore accounted for about 45 per cent of Rusal’s aluminum sales in 2010, adds Bloomberg.
Which is why we find it hard to believe that Deripaska’s plea to cap output is solely about pushing aluminium prices higher.
We think, rather, that he’s subtly urging the industry to own up to its dependence on off-balance sheet securitised funding and to finally wean itself off it — and to do so for the sake of the market. (Not that such a market clearance wouldn’t roil the market, and possibly incur collateral damage.)
In other words… rather than propping itself up with collateralised funding deals, take the cuts that are necessary to restore balance to the market.
For more on how securitised funding deals are skewing the aluminium market, we recommend the following piece from the FT’s Jack Farchy on Thursday.
As he notes:
The banks can lock in a guaranteed return by storing the metal in giant warehouses, allowing them to bid up prices for the metal and remove supplies from the market. The process has pushed premiums for physical aluminium to record highs in excess of $250 a tonne, up by more than half since the start of the year. As a percentage of the aluminium LME price, global premiums are at a record 13 per cent, after averaging 5 per cent between 2007 and 2011.
Banks force aluminium market shake-up – FT
Collateral crunch, commodities financing edition – FT Alphaville
Just like a giant secured loan to commodity producers – FT Alphaville
Goldman on metal pawning – FT