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LME rules changes may fuel ‘invisible’ stocks

Keywords: Tags  London Metal Exchange, LME, inventories, rule changes, price discovery, aluminum, nonferrous metals, Lloyd O'Carroll O'Carroll Aluminum Bulletin

FORT LAUDERDALE, Fla. — Changes to London Metal Exchange warehouse rules may have the unintended consequence of driving millions of tonnes of aluminum out of exchange-listed sheds and into "invisible" stocks, according to industry observers.

Such a trend means more transparency is needed in the aluminum market, some said, with one analyst calling for reporting requirements in commodities similar to those already in place for equities under U.S. Securities and Exchange Commission (SEC) rules.

"Transparency is critical to price discovery," said Lloyd O’Carroll, principal of the O’Carroll Aluminum Bulletin. "Wouldn’t it be nice if we actually knew who the warrant holders were?"

O’Carroll made the comments Jan. 13 during a panel discussion at the Platts Aluminum Symposium in Fort Lauderdale, Fla.

Other information that should be disclosed includes the identity of those canceling warrants as well as the destination of metal being loaded out of LME-listed warehouses, O’Carroll said. The SEC requires investors over a certain size to report their holdings every quarter, something commodities exchanges should consider, he said.

Canceled warrants, for example, were historically a good indicator of physical demand but have lost that status in a "warehouse-financing world," O’Carroll said. Canceling a warrant is now "strictly a way to cut your cost of storage by moving into your own warehouse or moving off warrant sometimes in the same physical warehouse," he said, noting that "only a very small portion" of canceled warrants represent metal earmarked for actual consumers.

Almost all warrant holders are financiers, O’Carroll said. "Once they’ve sold it forward and financed it, the only way to improve their return is to cut rental costs—so they will continually seek lower rents through whatever means necessary, especially if they expect the (LME) warehouses to raise rents," he said.

Historically, LME rule changes have led to higher rental rates, O’Carroll said. And off-warrant rates are already only a fraction of LME rental rates, he added. "This suggests a major outflow of inventory from the LME system over time."

In the future the only people left in the LME-listed sheds might be either players without strong balance sheets who need warrants as collateral or those who own their own warehouses, O’Carroll said, pegging off-warrant inventories at 4.5 million tonnes—a number that could climb to 6 million to 7 million tonnes in the next year to two. "But whether the material is on warrant or off warrant, it’s not physically available," he said.

Another analyst pegged off-warrant inventories at even higher levels.

LME inventories are approximately 5.5 million tonnes, but off-exchange stocks could be as high as 10 million tonnes, said Joel Spier, principal of J Spier Consulting LLC. "Most of us can only guess how much inventory is not being reported," he said.

An unintended impact of the new LME warehouse rules likely will be to push even more metal into non-LME-listed sheds, Spier agreed. "The metal is going to go off warrant."

Matt Chamberlain, head of business development for the LME, defended the exchange’s policies

"Whatever is happening out there in the market is going to be reflected on the LME," Chamberlain said, also touting new load-out rules. "It stands to reason that if a substantial amount of metal flows into a warehouse, then it must eventually leave."

But Chamberlain also cautioned against changing exchange rules too much, such as forcing sheds to be able to load out their inventories "overnight." The LME, he noted, served as "a market of last resort" during the 2008 financial crisis and would not be able to do that again under such conditions. "We would be in danger of reforming the LME in a way that meant in the next financial swing—which will surely happen at some point—we would not have a network that is able to perform that function."

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