LONDON (Reuters) – How will it all end?
It’s a question the Aluminum market has been asking itself for months now.
Here’s a global industry, already burdened by the weight of massive stocks overhang and still, most analysts agree, generating surplus units month in month out.
Prices are bombed out, but producers are eking out a marginal cash life-line thanks to historically high physical premiums.
The whole precarious structure rests on the continued appetite of investors for buying and holding metal to earn a rate of return that is only attractive in our current looking-glass world of central bank profligacy and negative real interest rates.
But what will happen when, and it is a case of when not if, stocks financing becomes unprofitable or at least less profitable than other investment options?
The range of possible outcomes runs from the good, through the bad, to the outright ugly.
And it looks very much as if we’re going to get something of a preview over the coming weeks.
THE GOOD, THE BAD AND THE UGLY
The benign view of how the market might adjust to the departure of stocks-financiers was recently articulated by Klaus Kleinfeld, head of U.S. producer Alcoa, speaking on the company’s Q4 conference call.
The finance trade is partly predicated on the current ultra-low interest rate environment, meaning both cheap money to fund the metal purchases and a lack of low-risk investment alternatives, such as simply putting money on deposit in a bank.
A normalization of interest rates is widely viewed as the most likely cause of a collective unwind of the financing deals.
“That’s the moment when interest rates would be going up again and that’s the moment when the economy has picked up,” Kleinfeld said.
“The moment that the economy picks up, you have compensation through physical demand and physical demand will be there to pick up the metal”.
In other words, the Aluminum market will smoothly self-balance, rising manufacturing demand taking up the slack from diminishing investor demand.
It’s a nice theory and an attractive one if you’re in the business of producing Aluminum.
Because the alternative could be a disorderly unwind, a mass departure unleashing a flood of metal that overwhelms manufacturers’ capacity to absorb it.
The “ugly scenario”, as it was called by Lloyd O’Carroll, analyst at Davenport and Co, in a paper presented at a conference earlier this year, would likely see both futures price and physical premiums plummet.
In other words, meltdown.
Between the two extremes lies a spectrum of scenarios, all of them involving a degree of badness for the global Aluminum market.
REPEAT REPEAT PERFORMANCE
No-one is expecting central banks to normalize interest rates any time soon but the Aluminum market may not have to wait that long to get a taste of what might be in store when they do.
The other pillar of the stocks-financing trade is the contango on the LME forward curve. It needs to be wide enough to generate a rate of return that is still positive after financing, insurance and storage costs are factored in.
And it’s this particular facet of the trade that looks set to be tested in the coming period.
A squeeze on short position holders, many of them likely to be stocks-financiers, is looming in June.
The June-July spread has been in backwardation for several weeks now. As of yesterday’s close it was valued at $11 per metric ton backwardation.
It’s not the first time this has happened. There have been periodic bouts of tightness in the LME Aluminum market for several years.
More often than not they have been caused by someone trying to wrestle tonnage off someone else. And the pattern has been for the contango to flex back out just as soon as the metal has been transferred from one stocks financier to the next.
This time around, though, there is a kink, or rather two kinks.
Because there are also signs of tightness in the September-October and December 2013-January 2014 spreads, as shown in the graphic below.
This is a new evolving trend. The cash-date squeezes are becoming more frequent.
There were two in 2010, one in May and one in December. Same in 2011, one in May and one in December.
Last year, though, there were squeezes in July, September and December.
The current market structure suggests there are going to be three again this year.
Indeed, cash-date tightness is close to becoming a quarterly event in the LME Aluminum market.
STRUCTURAL SHIFT?
The question is why?
Partly, it seems to reflect a trend towards shorter-dated financing deals.
Where the Aluminum “super-contango” of 2009-2010 allowed for multi-year stocks financing, the market’s forward structure has more recently contracted to the point that anything over a year now looks long-term.
This leads to a concentration of financiers’ short positions on key dates, such as quarter-end, meaning that pressure points in the curve become both more regular and more predictable.
It’s a development that is bound to attract the attention of predators, inevitably exacerbating the quarterly pockets of tightness.
But here’s another curious thing about the June-July tightness.
Past squeezes have often been well flagged in advance in the LME’s market positioning reports, often in the form of one big long facing off against one big short.
No such stand-off is evident on the June date. Today’s banding report shows no major shorts and only one long, equivalent to between 5 and 10 percent of open interest, the lowest of the large-position bands.
The June battlefield looks deserted, even relative to both April and May, neither of which is showing any signs of tightness.
Without obvious protagonists, the inference is that it is the underlying market structure that is changing. That in turn raises the uncomfortable question of whether even the LME’s super-liquid Aluminum contract is struggling to absorb the weight of stocks financing.
It’s an unanswerable question right now.
What is evident, though, is that the greater the number of tight months in the front part of the curve, the less attractive is the yield for would-be financiers.
Right now, for example, the gross yield on an Aluminum finance deal to next January is just 3.75 percent. Making a turn on that is possible, particularly if you’re a large bank with easy access to cheap money and your own warehousing operations, but the margins are shrinking all the time.
Stocks of unsold Aluminum, however, aren’t.
And it’s the tension between these two divergent trends that is causing palpable unease in the market, both futures and physical.
How will it all end?
No-one really knows. But a sneak preview looks increasingly on the cards. And sooner rather than later.
(Editing by Alison Birrane)
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