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COMMENT: Aluminum’s polar vortex

Jan 21, 2014 | 01:46 PM | Andrea Hotter

Tags  aluminum, Midwest premium, Alcoa, Rio Tinto Alcan, Ormet, UC Rusal, Barclays Capital, London Metal Exchange warehousing


NEW YORK — The physical aluminum market is experiencing its very own polar vortex. Like all storms, it will pass.

The benchmark Midwest premium has almost doubled in the past three weeks—from a range of 11.5 to 12 cents per pound at the start of the year to around 19 to 20 cents currently, with some offers as high as 23 or 24 cents.

If you’re looking for a good conspiracy story to explain the move, forget it. The truth is, there are several reasons for the increase.

Some of them we’ve heard dozens of times before: low interest rates, financing deals and contango, contango, contango. Current financing conditions are so attractive that financiers could practically sleep on the metal for two years without having to worry about whether they were collecting a profit.

Other factors also are helping, such as tight scrap availability and a few smelter closures in North America that have tightened things up.

But there are a couple of other important ingredients to throw into the mix. The first one is on the demand side.

Last year, after months of campaigning, aluminum consumers were finally granted their wish: the London Metal Exchange changed its rules on warehousing. Having clamored for the change, consumers were convinced the new rules—which take effect in April but are having an impact on the flow into and out of warehouses already—would be the nail in the coffin of long queues and high premiums. They, along with other physical buyers, did not lock in physical metal or premiums for this year, instead hedging their bets that their ability to source metal would improve and its cost would fall once the rules kicked in.

They were wrong. Queues have lengthened and premiums have skyrocketed.

On the supply side, meanwhile, another important feature has been at work. A large amount of metal is tied up in the hands of one player whose incentive to sell would have to outweigh the yield it receives from financing the metal in the current contango market conditions. In other words, if you want the metal, and you want it quickly, you’re really going to have to pay up.

It is perfectly legal; some might say opportunistic capitalism is the name of the game.

The metal owner is not a producer, despite the continued misconception that they are benefiting significantly from the high price.

Pittsburgh-based Alcoa Inc. and Montreal-based Rio Tinto Alcan Inc. have been cutting capacity in North America, while Hannibal, Ohio-based Ormet Corp. has shut down completely.

Clearly, the high premiums are not helping them. Ask any producer and they would take an LME aluminum price of $2,500 per tonne and a premium of zero over current prices and premiums any day.

Moscow-based United Co. Rusal (UC Rusal), meanwhile, is committed to selling the majority of its primary production to Baar, Switzerland-based Glencore Xstrata Plc under a seven-year contract agreed to in 2012, although its supplies to Russia are excluded. It sold about 12 percent of its output to North American end-users in 2012. In other words, the world’s largest producer based on current output levels doesn’t have much metal to sell into the North American market, even if it wanted to.

Inevitably, the finger of blame is being turned back on the LME for responding to market requests and changing the warehousing rules.

No one is twisting a trader’s, producer’s or financier’s arm to sell based on the LME price; they can sell on whatever basis they like. But if you accept LME metal, you accept the exchange’s rules and regulations, which have never said metal cannot be delivered in and out. The LME cannot be held responsible for someone buying metal and then deciding not to sell it.

So why, some might ask, did the LME change the rules? Because the market asked it to do something and it took the best bad idea it had. Damned if they do; damned if they don’t.

The vicious circle of cancellations also is having an impact. Every time warrants are canceled, it helps put upward pressure on premiums due to the cost of waiting in the queue to be delivered out. The stronger premium then incentivizes people to take metal off-warrant, taking metal out of the LME system completely.

Stocks are becoming increasingly illiquid, while the move of metal off-warrant is reducing transparency even further.

Will imports start to come into the United States to plug the gap? There is no evidence of that so far, although available data runs only to November.

According to statistics derived from customs data, U.S. and Canadian imports of aluminum ingot, scrap and mill products, excluding cross-border trade, fell 3.8 percent in November compared with a year earlier, while aluminum exports, excluding scrap, fell 14.8 percent in the same comparison. Aluminum imports in the first 11 months of 2013 declined 4.9 percent while exports fell 4.2 percent.

So although imports did not increase, the decline in exports implies some of the slack was being taken up by North American output.

If there is a pull on inventory, the global system ought to resolve it.

According to analysts at London-based Barclays Capital Plc, the global market will move into a net 1.4-million-tonne deficit this year—divided between a small surplus in China and a deficit in the rest of the world.

Drilling into the data further, North American production of 4.55 million tonnes will be outstripped by consumption of nearly 6.17 million tonnes, leaving a deficit of about 1.62 million tonnes. The biggest deficit is in western Europe, where demand will outstrip supply by 2.77 million tonnes, according to Barclays.

That leaves China and the rest of the world—presumably largely the Middle East—to fill the gap.

So the market has two hopes: that new production in regions with a surplus will start to flow into North America, and/or that warrant holders will be incentivized to release financed metal.

That is the challenge.




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