LONDON: What is going on with the aluminum spreads on the London Metal Exchange (LME)?
The benchmark cash-to-three-months period was valued Thursday at $19 per ton contango. As recently as May it was trading at $40 contango.
The tightest part of the period is the September-October spread, which was valued at $4.5 backwardation.
Aluminum is the LME's most liquid contract, which means that when spreads move like this they are doing so on big volumes.
Signs are that something big is afoot; is it a passing aberration or, as bulls would love to believe, a signal that the aluminum market is being primed for a major upside move?
BATTLE LINES
The LME's futures banding report shows how the battle-lines are drawn on the September date, which seems to be the epicenter of this spread contraction.
There are two entities in the long camp, each sitting on a position equivalent to somewhere between 5 and 10 percent of open interest. They are matched by two similar-sized positions in the short camp.
Open interest on the September prime date, actually Sept. 19, stands at 74,532 lots, or 1.86 million tons.
That means that all four positions are somewhere between 93,000 and 186,000 tons in size.
Quite evidently, those shorts are struggling to roll their positions, which is why the September-October spread is now trading in backwardation.
There are two schools of thought on the LME “Street” as to what is going on.
The benign view is that the longs are simply capitalizing on a roll-over of short positions and that once the process has been completed, the spreads will revert to “normal” contango.
The less-benign view is that the market is gearing up for one of its sporadic cash-date squeezes, often characterized in the past by huge transfers of metal between bigger players.
The last time this happened, in December 2011, the end-result was the mass cancellation of metal at LME warehouses in Vlissingen, much of it still sitting in the load-out queue.
TIGHTNESS?
Certainly, if this front-spread tightness persists, it will change the profit profile of the stocks-financing trade, which is predicated on financeable forward contango.
Previous spread squeezes have seen large amounts of aluminum delivered into the LME system as stocks-finance trades became unprofitable.
On occasions, such as December last year, the inflow has been followed by mass-tonnage cancellations as the “winner” of the spreads battle took up the metal delivered by the “loser” into the squeeze.
A similar denouement of the current tightness is possible.
But it's worth saying that this is tightness in purely a technical sense of the word, namely the alignment of aluminum longs and shorts on a specific LME prompt date.
Those that argue that high physical premiums are a sign of “real” physical tightness overlook the fact that the physical market only feels “tight” because so much surplus metal has been locked up in stocks-financing deals.
The resulting tug-of-war between industrial and investment buyers for units is the underlying driver of those higher premiums.
The combination of the LME's warehouse load-out rates and the aggressive payment of incentives by some warehouse operators to attract more metal merely exacerbates this conflict.
MORE METAL
But remember that all this is happening because there is so much surplus aluminum sitting around.
Were it not, there would be no financeable contango in the first place.
And all the available evidence suggests that the world is still producing too much aluminum.
The latest figures from the International Aluminium Institute showed global output of the light metal hitting a record annualized run-rate of 45.19 million tons in June.
True, the rate of increase has slowed to 3.6 percent over the first half of 2012 from 7.4 percent last year.
But the world's aluminum smelters are still churning out more metal precisely at a time when demand for all industrial metals is buckling under the combined weight of euro zone weakness, faltering US recovery and Chinese slowdown.
Which is why the outright aluminum price is still trading some way into the global production cost curve.
PRICE SUPPORT
And which is why analysts have been looking for production cuts rather than increases.
Western World production has indeed been declining on a combination of price-induced cutbacks and price-unrelated cutbacks at Rio Tinto Alcan's Alma smelter in Canada (labor unrest) and BHP Billiton's Hillside plant in South Africa (technical problems).
At 24.71 million tons annualized in June production outside of China was down by over a million tons from the end of last year.
A year-on-year comparison shows that output fell in most of the developed world with only the Gulf region bucking the trend thanks to new capacity being started up.
But once again it is China that is declining to read the cut-back script.
The country's aluminum production rose by 11.3 percent in the first half of the year, annualized production rising by almost three million tons to a fresh record high of 20.49 million tons in June.
China has some of the highest-cost smelters in the world but they are being shielded from price weakness by the growing number of regional governments offering power subsidies to keep them afloat.
As always with such non-market intervention, there is the danger of unintended consequences.
In this case, part of the most recent output surge seems to have come from previously idled plants in higher-cost parts of the country being reactivated to capitalize on the new power-rate generosity.
Analysts at consultancy group A-Z China, for example, have identified around 750,000 tons of annual capacity being restarted in China.
Precisely the opposite of what everyone outside of China was expecting.
MISSING TRIGGER
Further production cuts are the missing trigger for the aluminum market.
Distressed shorts being squeezed out rather than rolling forward can generate some upwards price movement.
But without an accompanying shift in fundamental dynamics, any fireworks will be short-lived.
Most of the production cuts already announced have now taken place. If anything, production outside of China could even start rising soon as both Alma and Hillside return to normal operations.
Russian giant UC RUSAL has on several occasions suggested it might cut output in the second half of the year but the move, if it happens, has been so well flagged it could hardly count as “news”.
None of this is going to affect the enigma machine that is the LME aluminum spreads.
That something is up is not in doubt. Whether the September-October tightness persists remains to be seen.
But the upside potential for the outright three-month price is limited as long as the world's smelters keep pumping out more aluminum.
— Andy Home is a Reuters columnist. The opinions expressed are his own.
Aluminum's enigma machine is cranking up again
