Warehouse upheaval to pile pressure on aluminium smelters
Proposed rule changes for industrial metals warehouses and increased scrutiny by regulators are likely to unleash stored aluminium, adding to the global surplus and forcing more smelters to shut. The new rules will slash the profitability of financing deals that have locked up metal in London Metal Exchange (LME)-registered warehouses and kept millions of tonnes of aluminium off the market, which has supported prices.
"The conclusion we've drawn from the warehousing financing issues is that it is pretty much coming towards the end game," consultant Marco Georgiou of CRU in London said.
But the shift out of these deals will take years, and the resulting cuts in production capacity may take even longer.
Benchmark aluminium prices will need to slide below recent four-year lows to force producers, many of which are already suffering heavy losses, to cut output.
LME-registered warehouses hold 5.5 million tonnes of metal. Much of it is tied up in financing deals, in which investors take advantage of low borrowing costs to sell aluminium forward and store it cheaply in the interim.
Backlogs in deliveries from the LME warehousing network have created long queues and inflated the premiums to obtain physical metal, sparking complaints from consumers.
Those complaints have led to a string of U.S. lawsuits and an LME proposal to overhaul its delivery system from next April.
PREMIUMS AND PRESSURE
As the new rules force warehouses to release more stocks, LME prices and premiums are expected to decline.
"Premiums have started to fall already, and we'd expect if the LME implements the proposals, then we'll see a reduction in warehouse queues from next year ... that would push premiums down further," Georgiou said.
The increased stocks on the market will add pressure on aluminium smelters to curtail capacity. Smelters in Europe and North America are likely to feel the greatest impact. U.S. producer Alcoa Inc and Russia's Rusal have recently announced cutbacks. China, the world's biggest producer, is not directly affected by the premiums, and its smelters may keep churning out metal.
CRU estimates it will take until 2017 for the knock-on effects of the new rules to force the shutdown of 700,000 to 1 million tonnes of annual production capacity outside China. The scope of the predicted shutdowns compares with a surplus on the global aluminium market that is forecast to increase from 825,385 tonnes this year to 1 million tonnes in 2014, according to a Reuters poll of analysts.
Analysts differ on how the new LME rules will affect two elements of the total aluminium price - the LME price and the premium for delivery of metal. The LME proposal has already started to have an impact on premiums since it was announced last month. Duty-paid premiums in Europe are down by as much as $35 a tonne to $260-$285 a tonne.
Record premiums have been a lifeline for aluminium smelters, adding to the price they can charge to metals consumers at a time that the underlying LME price has fallen by nearly a third from a peak of $2,803 a tonne in May 2011. Nomura estimates profitability of warehousing would fall by $127 per tonne in Europe and $82 a tonne in the United States and that premiums would probably fall by about a similar amount.
"It is fair to conclude that there will be downward pressure on physical premiums ... but we are in uncharted waters. You'll only get more cutbacks if the LME price does not rise to compensate," analyst Stephen Briggs at BNP Paribas said.
Some investors in Europe and the United States are seeking to hedge exposure on premiums, said Kamal Naqvi, head of EMEA commodities sales at Credit Suisse, which trades premium swaps.
"We've seen interest pick up in aluminium premia swaps in the last few weeks," he said. "There is two-way interest, because there is so much uncertainty regarding timing and scale of any possible decline in aluminium premia." Last week, CME Group announced the trade of its first aluminium Midwest premium futures contract. Nomura analyst Neil Sampat estimates that, as more metal is released on to the market, LME prices could slide to $1,500 a tonne, down a fifth from current levels.
For the moment, the appetite for finance deals has diminished slightly but not disappeared. "It had been a pretty steadily growing business, but I wouldn't say it's growing at the moment," said one physical trader in London. Higher forward prices for aluminium are still in play - a market structure known as contango - making financing deals profitable. "I think that now it is front page news in broadsheet newspapers, we will see companies starting to reduce positions (because of the risk to reputation)," a trader based in New York said.