Alcoa’s comments in response to LME’s proposed changes to the warehouse rules reflect the Company’s role as the world’s largest miner of bauxite and refiner of alumina as well as a leading global producer of primary aluminum and OEM for consumers in a wide array of end markets. We believe that the proposed changes constitute a major market intervention that will aggravate the lack of transparency that has had a damaging impact on the aluminum industry and will do nothing to help our customers manage their exposure to aluminum pricing.
Instead of HKEx imposing a counter-productive rules change on the industry as its first major initiative as the new LME owner, Alcoa recommends that the HKEx take the following two steps that directly address the business needs of producers and consumers of aluminum:
- Improve transparency to enhance market efficiency and confidence in the LME as the price-setter for aluminum.
- Establish regional premium contracts to enable market participants to manage price risk by hedging of premiums.
By immediately addressing basic transparency requirements fundamental to fair and efficient markets, the HKEx has an opportunity to fix the major issues in the aluminum LME marketplace. By adopting an approach similar to the CFTC’s Commitment of Traders (COT) reports, the LME would help to clarify for market participants the impact and relative influence financial investors have on the price discovery process. Besides benefiting aluminum consumers, producers and traders, greater transparency will enable the HKEx to improve the efficiency of the LME and establish a reputation for enlightened market leadership.
Improving transparency also allows the HKEx to address the business need for users to manage exposure to premiums, while increasing HKEx’s trading volume and revenues. It would provide the essential confidence for the LME to be the price-setter for aluminum and give the HKEx credibility to establish a platform for regional LME premium contracts that would enable users to hedge the full price of aluminum, while maintaining market integrity.
Alcoa is well aware of the pressure to address an issue that has taken on a high public profile. But the warehouse queue issue is a “red herring”. It was driven by claims that it would reduce prices, despite the reality that aluminum prices have declined 40% in the past 5 years, and by claims that it would increase supply, despite a surplus of physical aluminum available to end market consumers. While LME leadership has affirmed those claims are false, it proposes a warehouse remedy that actually complicates and prolongs a cure for the actual problem – the growing spread between the LME and premiums. While satisfying a short term PR need, imposing this rules change will have serious short and long term impacts -- encouraging the movement of LME inventory to invisible, off warrant inventory, increasing the call for regulation of the LME and undermining confidence in the HKEx, its understanding of the aluminum industry and its motivation for purchasing the LME.
In summary, Alcoa strongly disagrees with the proposed warehouse rules change. We propose instead that HKEx immediately mandate practices to ensure LME transparency and establish regional premium contracts that provide a vehicle for market participants to more effectively manage premium price risk and offer a more open premium price discovery process.
The attached analysis [keep reading or download the pdf from the right column] provides context and clarity for Alcoa’s recommendations for fundamental and sustainable solutions that can and should be implemented immediately.
President, Alcoa Materials Management
ANALYSIS AND RECOMMENDATIONS
Given Alcoa’s unique perspective as the leading aluminum producer as well as OEM to end market consumers, we offer the following analysis in support of our opposition to the warehouse rules proposal and recommendations for LME initiatives that are required immediately.
The current level of aluminum inventory in warehouses is a consequence of the global financial crisis, low interest rates, contango, and the high cost of exit in the industry.
The 2008 financial crisis and the resulting global recession led to a significant amount of turmoil in world commodity markets. During this time period, aluminum consumption stalled, and production of aluminum-intensive products, such as automobiles, airplanes and buildings, declined at historical rates as the market for these goods collapsed. In response, the impacted industries, including Alcoa’s down-stream components, ‘right-sized’ to meet the new demand dynamic.
In line with the decline in demand, the aluminum market price declined substantially, at one point hitting just 38% of its pre-recession high. Throughout the recession, the market price was well below the cost of production. However, due to the prohibitive cost of production curtailments and later re-start costs, hopes for a price recovery, the potentially devastating impact of closures on the communities that aluminum smelters operate in, and the prevalence of sovereign-funded producers, the speed of capacity closure was slower than the demand destruction and aluminum continued to be produced at a rate above that of consumption (Figure 1).
As historically intended, the LME’s warehousing system again fulfilled its role and acted as a buffer for such times of potential supply disruptions to overcome the period of supply/demand imbalance. LME warehouses, traditionally located in large and diverse centers of consumption, took delivery of an increasing portion of production. Interestingly, demand for physical metal to be warehoused increased substantially as a new group of low risk financiers emerged. The later phenomenon was driven by historically low interest rates and metal price contango combined with the increased attractiveness of metal and other commodities as an asset class.
As the broader economy has recovered, we have seen an accelerating demand growth for the aluminum industry’s downstream products. Based on Alcoa’s estimates as of July 8, 2013, the global automotive and aerospace markets were showing strength, with year-over-year growth estimated on average at 2% and roughly 10%, respectively. Even the building and construction market is estimated to grow at nearly 5%.
Conversely, aluminum producers have continued to struggle. Despite strong downstream demand and a steady stream of smelter curtailments, the ‘fully-loaded price’ of LME-grade aluminum (i.e. LME market price plus the corresponding regional premium) is currently sitting at a four-year low (Figure 2).Consumers are still able to access primary aluminum at a cost equivalent to that seen in mid-2009, when global markets were just coming out of recession and still fragile.
Regional premiums for physical buyers have always existed to balance the LME pricing with the physical demand realities. In the last years they have increased from historically 4-8 percent to above 10 percent (Figure 3). Some consumers are complaining about the higher premiums and long queues in warehouses.
The current alternatives available to hedge premium exposure are illiquid and only available in the OTC market. Credit exposure to financial premium swap counterparties limits liquidity and there are no visible benchmarks for forward premium prices necessary for valuing forward positions.
The London Metal Exchange (LME) has been bought by the HKEx in 2012
The HKEx bought the LME for more than $2 billion. It paid this price for an exchange that reported profits of less than $15 million in 2011. The HKEx has described their value creation strategy by moving beyond the current controversy and proceeding with growth that will improve profitability. Volume growth will be driven by opening the exchange to the Chinese market and by increasingly attracting volume from purely financial investors through a friendlier trading platform that caters better to electronic trading.
Proposed warehouse rule changes are based on false claim of high prices and lack of accessibility to aluminum.
Primary aluminum is readily available to the market. Aluminum inventory tied up in the much-publicized “queues” in Detroit and Vlissingen, by far the largest stores on the Exchange, represents just 20% of global aluminum inventory. Even if we consider the full LME inventory levels of Detroit and Vlissingen, the total represents 35% of global aluminum inventory in our estimation. In fact, total LME inventory represents only 50% of global stocks. Nor are aluminum prices artificially high -- the fully-loaded price of aluminum has fallen approximately 40% since its peak in 2008. The current fully-loaded price of aluminum is the lowest since mid-2009.
The real issue is that the LME price no longer represents the fundamentals of the industry due to increased speculative trading with no interest ever in physical metal delivery but rather driven by short-term macro events. Activity from this sector has driven overall trading volume in the aluminum contract to 37 times the physical market (Figure 4). Today’s antiquated reporting structure of the LME is not providing the pricing transparency by differentiating between fast money investors and those that are interested in physical metal supply raising questions about the validity of the price determination.
While Alcoa recognizes that substantially increased speculative trading is a reality of the current world, it is imperative that those who participate in the physical aluminum market have confidence in the price-setting mechanism of the LME.
The basic problem is that hedging premiums in the current marketplace is difficult. With premiums increasing to more than 10% of the overall aluminum price, this creates legitimate business issues for participants in the physical metal market. The price discovery process in the current OTC market is not transparent. The visibility and liquidity of forward premiums is poor, making it both difficult for those with exposure to hedge effectively and to value forward exposure. Credit worthiness limits the number of counterparties to trade within the OTC market. And lastly, it is time to move beyond the survey/index system for a market of this size.
The LME warehouse system is not designed to serve metal consumers; end users have not traditionally used the LME as a sourcing tool. LME contracts have a global structure and delivery is based upon the seller’s option. The LME’s global warehouse network of 54 companies with 719 sheds provides sellers with many options. On the other hand, the buyer of an LME warrant does not know which location he will get in advance.
A contract that is not structured in a way that provides the buyer with the option to choose his location prevents consumers from using the LME as a source of supply. Furthermore, most end users demand payment terms and prefer to source from the most accommodative supplier. The current LME cash-in-advance structure does not coincide with consumers’ financing demands and the reality of extended payment terms. If the proposed rule changes are enacted, consumers will still be unable to hedge regional premiums and unlikely to use the LME as a source of metal.
Warehouse inventory is being supported by financial risk averse buyers who have a real interest in owning the metal; much different from fast speculative money purely driving trading up with no interest however of ever owning metal. The profits of these financial risk adverse buyers are driven by locking in the LME contango, the enormously low interest rates and low costs of warehouse storage. As the global economy recovers and interest rates rise decreasing the attractiveness of this investments structure, therefore warehouse stocks will unwind naturally as we are seeing happen today.
The negative implications of the proposed warehouse rule changes have serious consequences for aluminum producers, consumers and HKEx.
The proposed rule changes do not clarify the role LME warehouses play in the market.
If the LME wishes to make its warehouse and delivery system one in which it is useful for consumers to take physical delivery of metal, the proposed rules do not help to achieve that goal. Consumers in general have not used the LME warehouse network as a source of primary aluminum for many reasons which pre-date the presence of “queues.” For example, the LME’s global warehouse network operates such that the buyer of LME warrants will receive delivery in the location of seller’s choice. Thus, a consumer that needs aluminum in Indiana may be directed by the seller to a warehouse in Asia – the buyer must pay for the aluminum before the buyer knows the designated delivery point. Also, the majority of consumers in the world minimize the use of their balance sheet to finance inventory, and therefore the prepaid nature of taking LME delivery is unfriendly to consumers. In regard to the proposed rule change, a consumer who already has a disincentive to use the LME warehouse network as a source of metal would not be more likely to use the LME as a source of metal when queues move from current lengths to 100 days. In this regard, it would benefit the marketplace for the LME to clearly define the role that LME warehouses play in the market and explicitly factor this in to the consideration of any rule changes.
The proposed rule changes will likely result in less transparency in the market as owners of inventory will have a greater incentive to store metal off warrant, outside of LME warehouses.
The LME points out in the proposed rule change that warehouses may respond by increasing rents and handling fees. Alcoa agrees. Therefore, inventory owners of LME-warranted metal will subsequently prefer to hold metal in lower cost, off warrant warehouse locations. In this case, a larger amount of inventory will no longer be tracked and reported to the market, and will be out of regulators’ purview. This will decrease visibility and transparency.
Another possible result is that as metal is forced out of LME warehouses with queues extending beyond 100 days, it could also go back into other LME warehouses that do not have 100-day queues. The metal could remain there, off warrant, piling up for some time until the point at which the decision is made to place a large amount of metal on warrant in a short time. Since that warehouse does not have a 100-day queue at the time, it will be unaffected by the new rules until the time when a 100-day queue could form. This possibility also decreases visibility and transparency as the market will be unaware of the buildup of large stock piles in certain locations until they are placed on warrant. There also exists the potential for the market to see metal flow back and forth between a limited number of warehouses in this fashion, creating a prolonged time of uncertainty and lack of transparency regarding market stocks.
Additionally, logistically constrained warehouses could be forced to refuse delivery of metal, which could create an artificial tightness creating backwardations even in times of actual market surplus. These artificial supply/demand economics would create further volatility and distort the market, causing participants to lose confidence in LME prices.
The proposed warehouse rule changes will likely disrupt the HKEx growth strategy for the LME.
A quick and narrowly focused market intervention like the warehouse rules changes will undermine confidence that the new LME owners have broad understanding of market drivers at the very time HKEx plans to make the LME more friendly for electronic trading and build it out as a gateway for China’s commodity trading with the West. Instead of taking such a questionable action that massively interferes with supply and demand market dynamics, to maintain the credibility necessary to achieve those growth goals the LME needs to address pricing transparency immediately. Given that the Chinese market represents roughly 50% of global primary aluminum demand and that both physical and financial participants are active in the Chinese market, there is increased scrutiny on how LME actions taken by the HKEx will affect price determination. Putting in place greater transparency now will convince new market participants that the LME under new HKEx ownership is the best market in the world to trade aluminum and other base metals. On the other hand, if the proposed warehouse rule changes are implemented, it will say to existing and potential users of the exchange that the HKEx is willing to act carelessly and that the LME may not be the correct forum for their price discovery process.
It is good that the HKEx put up for commentary the proposed rules changes.
Having the opportunity to review the proposed rules changes before implementing avoids potential criticism of the HKEx as interventionists and enables the HKEx to bring the real facts to light. Alcoa believes that this clarity of discussion demonstrates that the rules changes would be wrong and there are better ways to leave free market dynamics in place and deal with some of the serious inefficiencies and lack of transparency in the LME.
In that spirit, Alcoa proposes two essential solutions that should be addressed immediately.
Improve transparency to enhance market efficiency and confidence in the LME as the price-setter for aluminum.
Improved transparency into the sources of trading on the LME would give all parties concerned the benefit of information that is commonly accessible to market participants in other commodities. It is an essential first step toward improving marketplace confidence that the LME remains the best source of price discovery for aluminum.
To this end, it is Alcoa’s view that the LME should establish reporting similar to the CFTC’s Commitment of Traders (COT) reports. These reports would help to clarify for market participants the impact and relative influence financial investors have on the price discovery process. Enhancing the availability and quality of information for all physical commodities that underlie a financial market contract would improve the reliability of price discovery in financial markets. Global regulators have also called for greater transparency: the G20 has called for more robust reporting on commodities derivatives markets, and the EU is currently developing new reporting requirements as part of its financial services regulatory review.
Alcoa requests that immediate action be taken to improve transparency by publishing segment positioning. The LME should not wait for pending regulation to force the Exchange to improve transparency.
Establish regional premium contracts to enable market participants to manage price risk by hedging of premiums.
Today’s method for setting regional prices, by publication surveys, also does not allow risk holders to effectively hedge their positions. An exchange-traded premium contract will address the call for more transparency in how premiums are set. And a clearing system would enhance liquidity in the marketplace by allowing a greater portion of the market to participate.
To manage exposure to premiums, Alcoa recommends creating four new regional contracts – Midwest, Rotterdam Duty Paid, Rotterdam Duty Unpaid, and CIF Japan. LME premium contracts would improve transparency around premium price-setting and would allow the ability to hedge the full price of aluminum, while maintaining market integrity.
Introducing regional contracts will benefit all participants and also increase broader market confidence. Offering these contracts will enable users to hedge closer to 100% of their price risk and improve price discovery, especially around the setting of regional premiums. The over-the-counter market is currently the only venue to hedge premium risk; however, this market is not transparent and does not offer a published forward curve to be used as a daily benchmark. The LME already has the forum, platform, and technology in place to offer a transparent marketplace for these products to trade in the open market. Through premium contracts, users will have the ability to trade a transparent, clearinghouse-backed product and value their forward positions on a daily basis.