Winter Park, Florida 20/11/2014 - Record Midwest aluminium premiums, which are directly correlated with long warehouse queues, have negatively impacted end-users financially over the past four years, Jorge Vazquez, Harbor Aluminum Intelligence Unit founder and managing director, testified on Thursday.
According to a report from the influential US Senate Permanent Subcommittee on Investigations, Goldman Sachs along with other banks and metal traders participated in "merry-go-round" trades that artificially inflated warehouse waits, leading to a disruption of market fundamentals.
Prior to Goldman Sachs buying Metro International Trade Services in 2010, the main financing strategy was for warehouse operators to offer 'freight incentives' to entice aluminium owners to move metal into their sheds.
“Paying warehouse incentives to attract metal is a standard and historical practice in the LME warehousing business,” Vazquez told the Subcommittee in Washington DC.
But once taking control of Metro, Goldman became concerned that owners of aluminium in its warehouses were removing the metal from its warehouses and storing it elsewhere, leading to a loss of revenue. In an effort to curb that loss, Goldman and Metro made a strategic decision to offer incentives to metal owners that already had metal stored in Metro’s warehouses.
“What is certainly not a common practice, however, is when LME warehouse operators offer and pay an incentive to warehouse customers to cancel metal and wait in the queue. That practice poses a serious conflict of interest because incentive the lengthening of load-out queues can materially impact market prices (Midwest premium),”
In these new deals, Metro provided financial incentives to the owner of the aluminium stored in its warehouses to: (1) wait in the queue; (2) upon reaching the head of the queue, load out its metal from a Metro warehouse; (3) deliver the metal to another nearby Metro warehouse; and (4) warrant the metal while in the second Metro warehouse.
On September 15, 2010, there was a short queue in Detroit of about 20 days. One week later, after the first of these deals was transacted with Deutsche Bank and 100,000 tonnes of aluminium warrants were cancelled, the Metro queue grew to nearly 120 days.
“It is my conclusion that cancelled warrants and the lengthening of queues in Detroit are the main drivers behind today's unprecedented Midwest premiums,” Vazquez said.
Through the end of 2010, Midwest premiums traded mainly between 2-7 cent per pound and averaged between 2-8 percent of the all-in price (LME+ Midwest premium). Today, the Midwest premium stands between 23.0-24.0 cent/lb, which represents slightly more than 20 percent of the all-in price of aluminum, he added.
Considering the evolution of the full logistical cost of sourcing metal from Russia and the Middle East to the US Midwest region, Harbor estimates that the effect of lengthening queues in market premiums has cost the US consumer an accumulated sum of at least $3.5 billion since 2011.
This estimate considers primary and scrap aluminum consumption volumes in the US, and assumes scrap prices have 50 percent elasticity to changes in the Midwest premium, Vazquez said.
ALL-IN PRICE THEORY
Vazquez also addressed the so-called "all-in price theory" that is voiced by many producers and traders who are the biggest beneficiaries of queues. This theory suggests that the price of an LME warrant is derived from the all-in physical metal price that is established outside the exchange, such that any artificial rise in market premiums is offset by a discount in the underlying LME price.
For example, Goldman claimed today that queues in LME warehouses have not negatively affected aluminium’s “all-in price”, which has run below its long run average since 2008.
"Any suggestion that end-users are paying more for aluminium because of a higher premium is simply not supported by the fact,” Jacques Gabillon, head of Goldman Sachs’ Global Commodities Principal Investment Group, said in testimony before the hearing.
Vazquez, however, said that he has not seen any serious analyses or empirical evidence that supports this theory.
“In my view, this notion has a logical conceptual explanation, but does not reflect how the physical aluminum market actually works. On the contrary, evidence that I have analysed at Harbor indicates that LME price and market premiums (Midwest premium included) have historically moved together in the same direction most of the time (reflecting demand trends and the economic cycle), not in opposite directions,” Vazquez said.
“LME prices are determined day-to-day by the interplay of financial and physical demand that takes place in the exchange. The physical market first references its base price from the LME price and then adds the physical premium that buyers and sellers negotiate outside the exchange,” he added.