Aluminum premiums: A squeeze at the margin

LONDON: You know you’re in trouble as a buyer of any commodity when one of your main suppliers declines to offer you a starter price for negotiations on the next contract.
Such was the ominous backdrop for Japanese aluminum buyers ahead of talks on the premium over London Metal Exchange (LME) cash prices to be applied to fourth-quarter shipments.
Rio Tinto Alcan, one of the major suppliers of the light metal to Japan’s manufacturing sector, did just that, telling its customers it would negotiate with them on an individual basis.
The obvious inference is that the premium, which rocketed from $ 121-122 per ton to $ 200-210 per ton for third-quarter shipments, is going to go higher still.
Indeed, the whispers coming out of the talks between Japanese buyers and aluminum producers suggest another lurch higher to around $ 2 50 per ton, quite possibly more.
After all, spot deals in the Asian region are already going for significantly higher numbers than those Q3 terms, witness the latest South Korean tender, which was awarded at $ 230 per ton.
If the rumors about the Q4 premium turn out to be correct, it will have doubled in the space of just a few months.
Over the period shown the LME price has boomed and bust, ranging from a 2008 high of $ 3,380 per ton to a 2009 low of $ 1,280 and just about everywhere in between.
Yet the Japanese premium as a percentage of the aluminum price never represented much more than 6 percent.
Last quarter it reached 10.7 percent. It seems almost inevitable that the ratio is going to be stretched again in the coming quarter.
Nor is this just an issue for Japanese buyers.
Sure, they are particularly vulnerable to spot market dynamics because of a lack of offsetting domestic production capacity.
And sure, they are particularly vulnerable to regional supply issues, such as Norsk Hydro’s closure of its Kurri Kurri smelter in Australia and the recent partial force majeure on shipments from Rio’s Oman smelter.
But the very concept of a regional premium, calibrated to reflect localized supply-demand balances, is rapidly disappearing.
Two things spring out.
The first is the rapid rise in all three premiums since the start of last year. The second is the increasing convergence of all three premiums toward what might be termed a global premium.
This is because physical buyers in all three regions are facing the same “fundamental” problem, namely the competition for metal units with investors wishing to earn a low-risk, high-margin return on financing stock.
The scale of this new source of demand for aluminum is simply massive.
Japan buys something like two million tons of aluminum a year, making the country one of the single biggest influences on the physical flow and pricing of the metal. This is why the Japanese quarterly premium has over time become a benchmark for physical premiums everywhere else in Asia.
Yet in one location alone, Vlissingen in the Netherlands, the flow of metal into and out of LME sheds has already totalled 1.14 million tons this year. Another 809,000 tons are earmarked for physical draw and only Glencore, which owns the dominant warehousing company in the port, knows how much more will be delivered in.
It’s probably fair to say that not one ton of this metal’s flow is going to a manufacturer.
Rather, the bank that is buying it up is moving it to Rotterdam to capitalize on a cheaper warehouse rent deal, which is the key cost variable in the stocks-financing game.
Actually, that should probably read “moving it back to Rotterdam,” since this is where a lot of the Vlissingen aluminum was moved from in the first place.
And this is just the Dutch version of the aluminum round-about.
Similarly huge tonnages are going through the LME warehouse revolving door in Detroit and in Johor in Malaysia.
The result is the evolution of two parallel aluminum markets, the financialized LME futures market and the industrial physical premium market.
The rapid rise in physical premiums the world over is a symptom of the growing divergence between the two.
But what is the specific cause for premiums going stratospheric over the last few months?
After all, the stocks financing trade has been in vogue ever since 2009 thanks to the combination of surplus metal and cheap money.
There are two possible explanations, both of which might well be in the mix together to squeeze the marginal amount of metal available to buyers such as the Japanese.
The first is that investment demand for aluminum is simply growing ever larger, reducing availability for actual consumers.
This, sadly, is no more than a “known unknown” since only those involved in the business have any true idea of its size and evolution. The second is that investment demand is running at steady levels but supply-demand dynamics in the physical world of aluminum have tightened.
That is starting to look more demonstrably plausible given the accumulation of production cutbacks over the course of the last year.
Production outside of China has fallen by around 1.2 million tons annualized since the fourth quarter 2011, when the LME price first encroached into the top end of the cost curve. Some of this is structural, such as the closure of the Kurri Kurri smelter. Some is transient, such as Rio’s issues at its Oman smelter and BHP Billiton’s technical problems at its Hillside smelter in South Africa earlier this year.
However, the structural component is gaining momentum.
The last couple of days have brought further cutback announcements by Ormet in the US and by RUSAL in Russia.
More will certainly follow as long as the basis LME price stays at these bombed-out levels below $ 2,000 per ton.
It’s worth noting that a growing number of analysts are cutting their estimated surpluses for this year in response to this slow but accumulating supply-side response everywhere outside of China, which largely exists as a third parallel market.
What could end the divergence between financial and physical markets? There is no easy answer because we’ve never been here before.
Arguably, the current physical premiums, representing as they do 10 percent of the LME basis price, are already at a level that should challenge the investment returns earned from the stocks financing trade.
The problem is that most of those likely to be attracted to the stocks financing business are institutional investors with no interest in, let alone knowledge of, what is happening in the parallel manufacturing universe.
And those few that do are unlikely to force out a deluge of metal which would destroy the booming premium market.
Equally, there will be many producers who hope they don’t. The premium has become a vital financial lifeline for those experiencing negative margins on the LME price alone.
But there is a linkage between the two markets in the form of the LME contango, which underpins the profitability of the whole stocks financing business.
And the contango is right now changing.
Around a month ago there was a minor squeeze on the September-October spread.
It appeared to dissipate naturally as short position holders rolled out.
But that tightness is back again. The spread was last night valued at $ 1 per ton backwardation, causing the whole benchmark cash-to-three-months spread to contract to $ 22.75 contango. It was as wide as $ 41 just a couple of weeks ago.
The LME’s futures banding report shows a build-up of large positions on both the short and the long side, suggesting plenty of potential for the current tightness to become more acute.
The LME aluminum market has seen this before. It is often no more than a mammoth tussle for metal between those wanting more to finance. But with the physical market diverging ever further from the LME market, the potential impact of an LME cash-date squeeze on the parallel aluminum market becomes less predictable.
The concept of parallel universes was once purely fictional. But in recent years it has edged into mainstream cosmological thinking. And according to its proponents, what happens when two parallel universes collide is a very, very big bang.
— Andy Home is a Reuters columnist. The opinions expressed are his own.