As I expected, the LME's global warehouse network was a key talking point at last week's LME Asia events. I was very pleased by the strong market response to our approval of Kaohsiung as the LME's ninth Asian good delivery location. Together with the revised LME Asian Benchmark Price, I'm sure that this will make the LME even more relevant for Asian users, while preserving the global focus which has underpinned the market since its foundation.
You may have heard some criticism of the LME's warehouse network, in particular the warehouse queues. This has been the subject of an ongoing market debate for quite a while. Today, after much deliberation, I’m pleased to report that the LME Board has announced a market consultation to address this important issue for our market.
Our stakeholders in the LME community are much more familiar with this issue and have a much deeper understanding of it. While people may strongly disagree with one another or with the premise and key components of the consultation, the issues and proposed solutions are well understood and the feedback will ultimately help the LME find the best outcome for the industry.
For our new stakeholders in Asia, the warehouse debate is new and the issues are not often easy to understand. Although not all of our Asian stakeholders are deeply affected, they do care about how it affects HKEx’s reputation as the new owner of the LME. As readers have different levels of understanding of this issue, I’ve decided to present this as a series of questions and answers. Let’s begin.
What is a warehouse queue?
Because of the LME’s prominent role in the metals industry, many owners of metal like to hold their metal in an LME-licensed warehouse. They receive a warrant to certify their holding of a particular lot of metal in a given warehouse. If the owner wants to withdraw the metal, he or she needs to ask the warehouse operator to load it out and cancel the warrant. The LME requires its licensed warehouses to load-out a certain amount of metal – at least 3,000 tonnes per day at the largest locations. But, in some warehouses, a lot of metal has historically been loaded-in – as explained below – so when a lot of users want to cancel warrants, a queue will form. These queues have grown longer at some locations – to hundreds of days in a few cases – as the stock of cancelled warrants waiting for delivery out of the warehouse has grown.
We should note that much of the metal sitting in queues isn't being withdrawn by industrial users, but by financing players who are moving it from one warehouse to another to take advantage of lower rents. To be clear, the vast majority of LME Warehouses do not have queues – only five LME good delivery locations have any warehouses with queues. But the queues at these locations have drawn some attention from metals users and the media.
What macro-economic factors lead to warehouse queues?
In an economic recession, such as the world experienced in 2008, market demand for metal declines. To accommodate reduced demand, producers can cut production. But another solution, particularly for an aluminium smelter which is difficult to shut down, is to carry on producing for inventory. Normally, demand recovers after a while, and the market absorbs the excess inventory. But the slowdown of recent years has been unusually prolonged, while interest rates have been so low so that producers could afford to carry inventory for longer. The contango in aluminium, where the futures price exceeds the current cash price, makes it profitable for financial players to invest in metal to capture an arbitrage profit. All these factors have led to unusually large inventories of metal, particularly aluminium, building up. And the best place to hold inventory of metal is on warrant in an LME-licensed warehouse, where it is available for participation in the world’s key market for metal price formation.
Are the queues bad, and if so, for whom?
The market has raised three main concerns with regard to the queues. They are:
that queues are resulting in metal not being accessible to industrial users in a timely manner and hence negatively affecting thereal economy;
that queues are pushing the overall cost of metal, particularly aluminium, too high; and
that the premium charged for delivery at a particular warehouse has become too large relative to the underlying cost of the metal.
Let me deal with these questions one by one.
Regarding the first question, it's very important to note that warehouse queues do not stop real-world metals users from getting access to metal. In general, businesses needing metals do not take that metal from LME warehouses – instead, they buy their metal directly from producers, and use the LME to hedge the price. In other words, anybody who wants metal can get metal. Metal stocks in LME warehouses are simply "supplies of last resort", allowing consumers to address small shortfalls in their metal requirements, and keeping the LME price "honest". Nobody is seriously telling us that they can't get access to metal – it's readily available from the producers – but, when consumers buy it from those producers, they do have to pay the producer’s premium. I’ll elaborate on this in a minute.
Previously, I was quoted saying I would take a “bazooka” to the warehouse queue issue if getting access to metal were a big problem. But our assessment is that buyers have access, so we are not facing a fundamental problem with our market and a bazooka is unnecessary.
Regarding the second concern, that queues are resulting in the underlying price of metal being pushed too high, this is not a problem either. The price of aluminium is currently about 47 per cent below its historical high, reflecting oversupply by aluminium producers, as I mentioned above. The prices of other metals are also below historical peaks. It is likely true that if it weren’t for producer stockpiling, supported by metals financiers, prices would be even lower. But prices would shoot up again as soon as market conditions changed and the big fluctuation of metals prices would not necessarily be in the long term interests of the market. In any case, the metal price has nothing to do with the queues, since it is the availability of metal on the open market that determines price and there is plenty of metal available there. I had talked last year about a surgical operation if the price of metal was being distorted, but we’ve determined that this is not a problem either.
Now, the third issue. Earlier in this blog I mentioned the producer’s premium. This premium, which is usually a small percentage on the LME price, is charged to those who want immediate access to metal in a particular location. The size of the premium depends on supply and demand in that particular location. Premiums have always been a feature of the market and can fluctuate wildly, but the lengthening of queues in recent years may have increased the size of that premium. To give you an example, to get immediate delivery of aluminium in the mid-west of the United States, you'll currently have to pay a premium of around 12 per cent above the LME aluminium price, which is a much higher level than has historically been the case.
The metal premiums and warehouse queues are closely related because, historically, the LME warehouse network has acted as a limit on metal premiums; if the producer premium became too high, then arbitrageurs would buy metal via LME contracts (at the LME price) and withdraw metal from the LME warehouses on settlement, rather than paying the premium to the producer. This had the effect of raising the LME price and hence "tightening" the premium. However, because of the queues at certain key warehouses, this arbitrage is more difficult, so the premium has become higher. The premium is widely tracked and reported, so the "all-in" cost of metal (the LME price plus premium) is easily calculated, but we fully understand the frustrations of users who want the LME price to be as close to the "all-in" price as possible, especially since the premium cannot easily be hedged.
I view a persistently high premium as an unhealthy physical condition, such as swelling, that is not life threatening but is highly irritating and has the potential to cause long term harm. This can’t be solved with either a bazooka or a surgical operation. Instead, a modest approach, such as “Chinese medicine”, might be the cure. That’s what this consultation is all about.
What has the LME done, to date, to address market concerns?
The consensus at the LME has been that warehouse queues are the result of macro-economic forces and that it is not appropriate for the LME to intervene. Although some market participants have suggested that if the LME had applied stronger measures a few years ago, the size of problem could be reduced. While we acknowledge that possibility with the benefit of hindsight, we strongly believe the LME has applied its rules consistent with its historical practices over many years. The most important thing is to look forward and find ways to resolve the issues we face today as best we can.
While this consultation is about the future, it’s also important to note steps the LME has taken in recent years to respond to concerns over warehouse queues.
In 2010, the LME commissioned Europe Economics to prepare an independent assessment of the LME’s warehouse rules. The report made several proposals of potential remedial action to ease the pressure of queues at warehouses, and also recommended the LME carry out routine reviews of delivery out rates every six months.
The LME has adopted this recommendation and has made changes to LME warehouse rules since it was published. We doubled the minimum load-out rates at the largest locations in April 2012, added minimum delivery out rates for nickel and tin in April this year, and we introduced additional requirements on warehouse companies to address the effect that queues were having on other metals. That also took effect in April this year.
What is the LME proposing to do in its consultation?
We don’t necessarily disagree with the consensus that queues are the result of macro-economic forces. However, as queues continue and even get worse in some cases, we want to take a fresh look at the issue. Therefore the LME Board has put forward a proposal that we believe balances the differing needs of LME members, warehouse operators and the metals industry.
Our goal is to present an alternative to the current arrangement that aims to (i) prevent queues from growing longer through introducing new load-out rates for incremental new load-in; (ii) reduce the length of the existing queues by applying new load-out rates for cancelled warrants “recycled back” to the queue; and importantly; (iii) avoid penalising players who have invested and adopted business practices in reliance on previous LME rules through the grandfather provision. Finally, we want to ensure the system is flexible enough to respond to potential unintended consequences. If you are interested in the details of the proposal, you can read them here.
In crafting the proposal, the LME Board had to bear in mind the logistical constraints. You cannot require warehouses to increase their load out rates by much as metal is heavy and difficult to move; there just aren’t the logistical resources in terms of spare fork-lift trucks, rail capacity and so on to load it out much faster. Nor can the physical layout and distribution of warehouses, which is conditioned by existing LME rules, readily be changed either. Acknowledging these realities, the essence of the proposal is that warehouses with queues of more than 100 days must link their load-in rates to their load-out rates so that the queue problem will not get worse, and over time, actually get better.
I want to reiterate that the Board has not formed a view on whether any changes should be made, only that this proposal is an option we can proceed with should the market indicate a desire for us to do so.
What do we want from the market?
We have undertaken this consultation because it’s important we listen to market participants when concerns arise. As the new owner of the LME, we want to be proactive in responding to concerns and addressing perceived problems.
Consultations are only effective if we take them seriously, and we do. We are looking for thoughtful and substantive feedback from market players. If you oppose our proposed solutions, it’s particularly important for us to hear why we should not proceed and what unintended consequences it may cause. If you are in favour of this solution, we also would like a detailed explanation of why.
All feedback will be kept confidential unless we are otherwise instructed. We have a long history of public consultations in Hong Kong and we use the feedback received to make further improvements to our market. We look forward to strengthening this tradition in London as well.
I don't yet know whether changes will result from the consultation. But I do know that, whatever decision is made, we can move forward with the confidence that the LME's rules deliver the best physical network for the metals community, and support a truly global LME price.
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