FT Alphaville noted a couple of weeks ago how backlogs at London Metal Exchange (LME) warehouses in Detroit were seeing some market participants have to wait up to 10 months to receive their aluminium.
We also noted that an independent study into the LME’s warehousing network had recommended upping load-out rates, to try and deal with some of these issues.
Reuters’ Andy Home has now looked at the issue in more detail.
As he wrote on Wednesday regarding the situation in Detroit:
Detroit aluminium stocks have grown by another quarter of a million tonnes this year. That’s because the dominant warehouse company in the city has been offering incentives for fresh metal, in essence out-bidding the rest of the physical market for available units.
Or as Europe Economics put it: “The queuing problem is most acute when a warehouse develops a level of stocks that, given the existing loading out rate, means that the warehouse’s income reaches a level at which after all costs, capital is fully remunerated and there is still a sufficient surplus to make it possible to buy in metal at a rate equal to or in excess of the loading out rate.” Moreover, “this in turn allows the warehouse to float its warrants on the Exchange.” It is this “free-float” tonnage that determines actual warrant availability on a day-to-day basis at the exchange.
This is one reason why the aluminium curve has at times become slightly backwardated even despite lots of inventory being out there. In a sense there is a type of fake crunch going on in the spot market simply because of the accessibility problem.
Though, as Home also notes, it does beg the question about what’s up with the other three million tonnes of aluminium in the LME system:
Even a cursory glance at LME stocks dynamics this year shows there are 10 locations, holding over 600,000 tonnes between them, that have not seen one tonne drawn down this year. There are another five, holding nearly 350,000 tonnes, which have seen less than 1,000 tonnes of cumulative deliveries. It’s none of the LME’s business what people want to do with their metal and there are some very financially sound reasons for financing it at a time of ultra-low interest rates and aluminium market contango. But it is that non-availability of “free-float” metal that is the root cause of the long queues at Detroit. Simply forming a more orderly queue at the outlet pipe doesn’t really help solve the problem of why all the liquid warrants are being forced down that restricted channel in the first place.
Home points out that it will be important to watch cancelled warrants — an indicator of demand, since it reflects the moment a market participant wants to take delivery of their metal — to see how the situation plays out.
Some 233,600 tonnes of warrants have been cancelled since May, but none of them at Detroit. This is understandable given the queues. The biggest number instead came from Mobile, New Orleans and then Liverpool. And, says Home, it will be interesting to see how these drawdown rates compare with Detroit over the coming days. Though, as he also points out:
When someone cancels 50,550 tonnes in a single day, as happened last week at Mobile, it’s not a fabricator looking for some emergency top-up metal. It’s another financing player, quite possibly one with its own tied warehouse operator, looking to lock up more metal.
Indeed, at this point, watching the scale of un-cancelled warrants (when those who have cancelled warrants change their minds and bring metal that has never left the building back on warrant) will be key.
Un-cancelled warrants
Back in January 2011, Metal Bulletin reported that there was a huge pick-up in un-cancelled warrants at Detroit:
Nearly 35,000 tonnes of aluminium was “un-cancelled” on Friday, with the material made available as open stock in London Metal Exchange warehouses in Detroit. Warrants for the material were previously cancelled, to be delivered out of LME warehouses or stored off-warrant, but those warrants have now been reissued. On Friday, cancelled warrants fell to 41,500 tonnes in Detroit locations, from 75,275 tonnes previously.
It’s a curious situation because why really would there be a reason to un-cancel a warrant? Usually it’s down to logistical reasons, something like a ship not showing up or some other technical detail. But for there to be a sudden bout of uncancelled warrants is, simply put, bizarre.
But as the BBC’s Michael Johnson pointed out in his series Bubble Trouble?, in many cases, there is just as much off-warrant inventory sitting in warehouses as there is on-warrant. That means when LME metal is cancelled, it often doesn’t even get shifted out of the warehouse at all. It just has its label changed.
Uncancelled warrants on the other hand see the labels being changed once again, but this time from off-market to on-market.
The ability to engage in this sort of label shuffle is very useful for physical traders who want to exploit the changing structure of the futures curve. When there is a contango it suits them to take the metal off-market — usually because off-market storage rates are lower. This way they can generate a healthy contango yield from selling the futures forward. It’s basically the financing trade referred to above.
When there’s any prospect of the market going into a weaker contango or even backwardation, they take the metal back on warrant. Not only does it provide them with an effective cash equivalent with which they can purchase what are now cheaper futures, it prevents their contango-trade from losing money.
So when Home says it’s worth watching what happens to the cancelled warrants in Mobile, New Orleans and Liverpool, he means it’s worth watching if they translate into real deliveries or creep back into the warrant market once the contango depletes itself.
As an industry expert pointed out to us, it used to be that the LME only allowed its warehouses to store LME metal and LME metal only. In that environment the off-market contango game would have been much harder to play. More than anything it would have been too costly to shift the metal around.
But given that the industry still reads cancelled warrants as an indicator of physical demand, the new dynamic is very important to factor into that assessment. Many of the “cancelled” warrants are, after all, arguably not transforming into real deliveries, they’re just being stacked elsewhere in the same warehouse. In which case the demand they insinuate is potentially not real at all.
The number of un-cancelled trades is thus, if anything, a possible indicator of how much metal is being used for financing deals.
On that front, the latest LME warrant statistics show a curiously high number of uncancelled warrants in aluminium. Not only in Detroit (where it might by now be expected due to the backlogs) but in other areas too — including Mobile, New Orleans and Liverpool. See the below table from JP Morgan in which uncancelled warrants are marked under ‘can-ch’, with a minus figure indicating uncancelled warrants:
Curious.
Related links:
LME warehouse recommends upping load-out rates – FT Alphaville
Please wait 10 months for your aluminium. Thank you – FT Alphaville
Welcome to ‘synthetic warehousing’ – FT Alphaville
China’s bonded-warehouse copper mystery – FT Alphaville
LME cancelled warrants are rising fast - FT Alphaville