London 14/04/2016 - The current ease with which LME price spreads can be squeezed into backwardations will be exacerbated if the exchange implements its proposed reforms to warehousing rent and FOT charges, sources told FastMarkets.
As part of a bid to clamp down on soaring FOT rates set annually by warehouses to load out LME-warranted metal, the exchange on Wednesday last week proposed a series of reforms aimed at reducing these levels in a discussion document.
All the suggested measures aim to shift warehouse business models away from a "game theory" approach whereby the warehouse charging the highest FOT to those loading out metal gains a competitive advantage by being able to offer metal holders the highest incentive fee to load in, receiving more rent in the process.
But while moves to curb ever-increasing FOT rates for physical users of the exchange would be welcomed by a portion of the market, base metal traders have expressed concerns that lowering FOTs and therefore incentives would lead to large chunks of metal being moved off-warrant.
"There's no secret that LME stocks are falling significantly and we understand that much of that metal is going to off-warrant storage; if people want to use the LME for storage because of the quality of the warrant, that's fine but it is not a management priority," the LME's head of business development, Matt Chamberlain, told reporters during a press conference after the release of the discussion paper.
And this drop in LME inventories will increasingly facilitate market squeezes because there will be less metal physically backing up massively liquid LME metal markets.
"If all the metal leaves the LME, then issues with backwardations become a bigger deal. There is no shortage on the aluminium market but there is a shortage of LME-registered metal in LME sheds. [This is] dangerous," a trading source said.
Aluminium stocks have fallen to 2.7 million tonnes - their lowest since January 2009 - from more than 5.4 million tonnes in 2014. This decrease in LME availability would make a backwardated curve "the new normal", participants said.
"More stocks will move out of LME warehouses and a backwardation would be a permanent feature. That would mean the new 'level' would be a constant backwardation as you would need that to make it worth your while to deliver," a market participant said.
"There was uncounted aluminium in [Vlissingen] because nobody wanted it - what's there now is getting cancelled and pretty quickly moving to zero, which means nobody wants to risk lending those units," a second trading source said.
"You'll have the same number of borrowers you always have so that supply demand of lenders and borrowers that's going to shift against the borrowers - and that's going to hurt the spreads," he added.
The aluminium leaving sheds is simply moving off-warrant and is not being physically used; this growth is 'invisible' stocks adds to the sense of uncertainty, sources said.
Any large backwardations could see huge clips arrive back on-warrant to deliver against the tightness; once it had passed, the metal would simply move back into non-LME sheds.
"A steady back would be hard to maintain; with so much sitting off-warrant they can control it… for aluminium, how could you guarantee that it wouldn't just load in?” an analyst said.
Tough measures by the LME to end long queues to receive material have resulted in large swathes of metal moving off-exchange.
More than 600,000 tonnes has been booked for removal since the start of March ahead of the implementation of the LME's queue-based rent cap (QBRC) rule change that comes into effect on May 1.
As well, aluminium is traditionally used in financing - an abundance of material has meant that historically its forward curve trades in a contango - the future date is more expensive than the spot price.
"There are some warehouses when all the metal is tied up in financing deals so you can't get hold of the metal anyway. So this is also going to exacerbate the back," the first market participant said.
DOMINANT POSITIONS GOING CHEAP
What's more, a metal owner can become a dominant holder accidentally if metal continues to be drawn down from warehouses, which has been the case in aluminium.
Today LME's warrant holdings report shows there is a dominant holder in tin at 40-49 percent, copper at 30-39 percent and nickel at 30-39 percent, with 'Tom'/Next and cash holdings also exhibiting signs of tightening.
Dominant holdings of LME warrants and market spreads increase the likelihood of backwardations and enable those holding large chunks of warrants to squeeze; last year the finger was pointed at US investment bank JP Morgan for a series of squeezes in the aluminium market, while Hong-Kong based trader Noble cornered the LME lead market through a series of massive warrant cancellations.
But this is in part due to lower volumes of metal physically backing up LME contracts, sources said.
"For something like tin, these days all you have to do is take a decent long position and you're the dominant," a warrant trader in London said.
As well, pockets will no longer need to be as deep because it will require less money to tie up material.
"As long as the contract can be settled financially and physically, then you have a contract with an inventory of 2.5 million tonnes that is handling the hedges of 10 million tonnes [and] probably more," one trader said of the aluminium market.
"The funny part is that it doesn't take much money these days to control the longs - you need to tighten up the market," he added.
(Editing by Mark Shaw)