Is Wall Street warehousing the price of aluminum?
Wall Street behemoths have been blamed for a host of misdeeds: gouging credit card users, deceiving mortgage applicants, rigging electricity markets and manipulating interest rates.
Add artificially inflating aluminum prices to the list.
Complaints from aluminum users about higher prices and lengthy delays in getting the metal from warehouses owned by Goldman Sachs and other bank holding companies have sparked lawsuits as well as a proposed solution from the London Metal Exchange, which regulates the warehouses.
Brewing giant MillerCoors, which uses the equivalent of 4,000 jumbo jets worth of aluminum each year to make beer cans, says the warehouses have caused aluminum prices to defy the law of supply and demand. Testifying before the U.S. Senate Banking Committee in July, MillerCoors executive Tim Weiner said aluminum prices remain inflated despite "massive oversupply and record production."
"What's supposed to happen under these economic conditions? When supplies rise while demand is flat to down, prices should fall," he testified.
Industry officials dispute that claim, calling complaints about delivery delays a red herring. On its website, Alcoa says aluminum prices have fallen 40 percent over the last five years and there is plenty available at mid-2009 prices.
The London Metal Exchange is "trying to solve a nonexistent metal availability problem," says Klaus Kleinfeld, chairman and CEO of Alcoa, one of the world's largest aluminum producers.
One longtime metals industry analyst disagrees.
"I believe the complaints of the beverage brewing customers are completely valid," said John Tumazos, a Holmdel, N.J., metals analyst.
Warehouses "bring it in, but they don't bring it out," he added.
Contracts to purchase aluminum held in warehouses at a specified price at some point in the future are traded on the LME. Aluminum buyers use those futures prices to hedge their risk against sharp movements in prices. Hedge funds and other investors trade the futures contracts, complicating efforts to determine what demand for the metal actually is.
When demand for aluminum tumbled during the Great Recession, the LME warehouses became the buyer of last resort. Those purchases have caused aluminum prices to remain higher than they would have been if there were fewer buyers. They have also caused large increases in the amount of aluminum the warehouses are holding.
Those weren't the only changes ushered in by the recession. Financial firms and commodities traders began buying warehouses. And record low interest rates provided an opportunity for what analysts say is a risk-free investment being made by investors -- including warehouse operators -- who have no intention of converting the aluminum they own into beverage cans or parts for cars and jet planes.
Whether buying from a producer or a warehouse, companies that make things from aluminum pay prices determined on the LME. Users claim those prices have been inflated by what has been happening at the warehouses, including the lengthy delays in getting aluminum out of them and into factories.
The price of the aluminum itself has come down, but that is not the only cost aluminum buyers pay. They also pay costs associated with storing the aluminum in the warehouses and delivering it to customers. Those costs have nearly doubled over the last three years for aluminum held in Midwest warehouses, according to Lloyd O'Carroll, a metals analyst with Davenport & Co. in Richmond, Va.
Several customers have sued Goldman, accusing the company of hoarding aluminum in its Detroit warehouses in an effort to restrict supply and raise prices. A lawsuit against Goldman and the London Metal Exchange filed in federal court in Detroit in August said the practice generates "hundreds of millions" in storage fees for the Wall Street firm.
Critics point out that warehouses move aluminum into their warehouses faster than they move it out. The lawsuit noted that in the first half of 2011, Goldman's Detroit warehouses took in 364,175 tons of aluminum but only shipped out 171,350 tons.
In a statement on its website, Goldman said it does not own the aluminum in its warehouses and that how fast it gets to customers is determined by the people who do. When a lot of owners want to move aluminum out of warehouses at the same time, deliveries are delayed, the firm said.
Many of those aluminum owners are not actual aluminum users. They are financial buyers or arbitragers seeking to profit from the difference between current aluminum prices and what prices are expected to be in the future.
Here's how the arbitrage works, according to Mr. O'Carroll.
Financial buyers borrow money to purchase aluminum at the current price and simultaneously sell a contract to someone who agrees to pay a higher price for it in the future. Since the recession, futures prices have consistently been higher than current market prices. This summer there was a $190 difference between current prices per metric ton and the price of a 15-month futures contract, Mr. O'Carroll said.
Arbitragers' borrowing costs are small because of record low interest rates. So are costs for storing the aluminum, since warehouse owners have been discounting storage costs to attract aluminum. Some arbitragers do so much business that they purchase their own warehouses, further reducing storage costs because they are essentially paying rent to themselves, Mr. O'Carroll said.
The result is nearly a 9 percent risk-free return, he wrote in a note to clients this summer.
"It would not be shocking that a market that can be manipulated would be manipulated," he said.
John Mothersole, an analyst with IHS Global Insight, an economics consulting firm, said the spread between current and futures prices and low interest rates are "a license to print money" for arbitragers.
He said the involvement of banks in the commodities business has kept aluminum prices from falling as much as they would have if the warehouse system did not exist. When demand picks up, prices will not increase as fast as they would have if a ready supply of aluminum were not available in the warehouses, Mr. Mothersole said.
That is little comfort to aluminum buyers complaining about the lengthy waits and inflated prices.
To address their concerns, the LME is considering a proposal that would require warehouses to move more aluminum out faster. The exchange is expected to act on the measure this month. If approved, it would be implemented in April.
But there are doubts about whether the idea will work.
Mr. Mothersole said a similar measure enacted last year failed to loosen the flow of metal to customers. Warehouse owners compensated by raising rents and there's nothing to prevent them from doing that again, he said.
In its comments to the LME, Alcoa said "fast money investors" who will not actually use the metal are distorting aluminum prices. Alcoa is asking the exchange to increase the transparency of the market by providing more information about the involvement of financial investors in LME futures.
Some analysts believe the LME proposal could end up lowering aluminum prices, putting further pressure on producers such as Alcoa, whose stock is down about 9 percent over the past 12 months.
Mr. Mothersole said the real culprit is low interest rates. As long as they make the risk-free investment possible, arbitragers will keep buying aluminum and restricting the supply.
"What makes this profitable is that you can finance the transaction at low interest rates," he said. "Once that changes, this whole thing goes away."
Source: Post Gazette