This has meant the total delivered aluminium price has been a stronger, despite very weak LME prices.
However, high premiums as a proportion of total prices creates risks for all market participants as this cannot be hedged and is likely to be affected by non-market forces.
Aluminium prices have moved in a saw-tooth pattern since late 2013 and are currently back in the bottom end of the range. The contango from cash to 3-month prices has remained fairly consistent through this period, at ~2.5-2.7%.
While cash prices have been choppy in a ~$50/t range, premiums for delivery have skyrocketed. Reported premiums by the likes of Metal Bulletin and Platts have surged at the turn of the year, rising by ~$80/t, on average, in January.
Ultimately stronger premiums are supporting producers, of which ~50% of the cost curve wouldn't make a return at the LME price alone. Its also a windfall for traders who can access spot tonnes and move physical metal.
That said, the risks too producer profits in particular are much higher when the the premium is such a large component of the delivered price, because premiums cannot be hedged. There is one financial contract for US midwest premiums traded on the CME, but volumes are very very small.
Furthermore, the premiums could shift dramatically on events that have very little to do with market mechanisms. In particular, the change LME load-out rules should have a significant impact of large LME listed warehouses holding metal in financing deals, of which the warehouses tend to cover the premium risk.
In the last month or so, both Detroit and Vlissingen have accumulated more metal. Vlissingen has seen sizeable net inflows despite maintaining the 3,000tpd load out as stipulated for a warehouse holding large amounts of metal. Cancelled warrants are a little lower over the last few days, but remain close to all time highs.
The situation at Detroit is much more severe, with cancelled warrants vastly higher than mid-2013 levels. Load-out rate have also been quite a bit below the 3,000tpd rate they are supposed to be, which is curious given the apparent squeeze for physical metal.
At the current run rates, these warehouses will have to see net withdrawals as we enter the preliminary period in 1 May for additional load-out requirements. These will become more stringent after three months after the first calculation period is over (see this post).
If anything, the current increase in queues and premiums seem like a final rush into financing deals in LME warehouses before the rules become more binding. But once the rules do become more restrictive, it seems likely that premiums will fall sharply as those warehouses will large queues will not have the same ability to cover high premiums for delivery for financing deals as they do now.
This is important even if the contango in the aluminium market remains very steep. While there is still a huge incentive for fully-hedged financing deals, these will only be interesting to current players if the premium risk is also hedged. If not, returns could be completely wiped-out by a drop in the premium, which defeats the purpose of engaging in a hedged-carry trade strategy in the first place.
Metal coming out of Detroit and Vlissingen could end up in other LME or non-LME locations. But these warehouses won't have the same ability to cover premiums for carry trades as Vlissingen or Detroit given they are not collecting rent on queued metal.
The diagram above maps what impact the change in load-out requirements should have in theory on prices. The delivered aluminium price is the LME price and the premium and is a function of supply and demand. Demand is in turn a function of end use markets and demand for carry trades.
Critically, carry trades are only a function of the risk-free contango and not premiums. So the change in load-out rules shouldn't have an effect on carry trade demand.
But it does reduce warehouse queues, which does impact the ability for warehouses to cover premiums as revenue is reduced.
This diagram also assumes that increased availability from affected warehouses doesn't constitute additional supply. This may not make immediate sense, as rules aimed at reducing queues could be seen as increasing available metal.
But an alternative way to think of it as rather than increasing supply, you are affecting the purchasing power of warehouses to cover premiums. This is a subtle difference, but is important when thinking about the impact on LME prices.
If hoarding of metal via carry trades is merely shifted into warehouses with lower ability to cover premiums, then it doesn't really impact the demand and supply balance. Subsequently, the LME price should really go up to cover the fall in premiums.
This is of course assumes everything else is equal, which is rarely the case. But it does provide a framework for how flat prices should rise once the LME rules become binding.
However, high premiums as a proportion of total prices creates risks for all market participants as this cannot be hedged and is likely to be affected by non-market forces.
Aluminium prices have moved in a saw-tooth pattern since late 2013 and are currently back in the bottom end of the range. The contango from cash to 3-month prices has remained fairly consistent through this period, at ~2.5-2.7%.
Ultimately stronger premiums are supporting producers, of which ~50% of the cost curve wouldn't make a return at the LME price alone. Its also a windfall for traders who can access spot tonnes and move physical metal.
That said, the risks too producer profits in particular are much higher when the the premium is such a large component of the delivered price, because premiums cannot be hedged. There is one financial contract for US midwest premiums traded on the CME, but volumes are very very small.
Furthermore, the premiums could shift dramatically on events that have very little to do with market mechanisms. In particular, the change LME load-out rules should have a significant impact of large LME listed warehouses holding metal in financing deals, of which the warehouses tend to cover the premium risk.
At the current run rates, these warehouses will have to see net withdrawals as we enter the preliminary period in 1 May for additional load-out requirements. These will become more stringent after three months after the first calculation period is over (see this post).
If anything, the current increase in queues and premiums seem like a final rush into financing deals in LME warehouses before the rules become more binding. But once the rules do become more restrictive, it seems likely that premiums will fall sharply as those warehouses will large queues will not have the same ability to cover high premiums for delivery for financing deals as they do now.
This is important even if the contango in the aluminium market remains very steep. While there is still a huge incentive for fully-hedged financing deals, these will only be interesting to current players if the premium risk is also hedged. If not, returns could be completely wiped-out by a drop in the premium, which defeats the purpose of engaging in a hedged-carry trade strategy in the first place.
Metal coming out of Detroit and Vlissingen could end up in other LME or non-LME locations. But these warehouses won't have the same ability to cover premiums for carry trades as Vlissingen or Detroit given they are not collecting rent on queued metal.
The diagram above maps what impact the change in load-out requirements should have in theory on prices. The delivered aluminium price is the LME price and the premium and is a function of supply and demand. Demand is in turn a function of end use markets and demand for carry trades.
Critically, carry trades are only a function of the risk-free contango and not premiums. So the change in load-out rules shouldn't have an effect on carry trade demand.
But it does reduce warehouse queues, which does impact the ability for warehouses to cover premiums as revenue is reduced.
This diagram also assumes that increased availability from affected warehouses doesn't constitute additional supply. This may not make immediate sense, as rules aimed at reducing queues could be seen as increasing available metal.
But an alternative way to think of it as rather than increasing supply, you are affecting the purchasing power of warehouses to cover premiums. This is a subtle difference, but is important when thinking about the impact on LME prices.
If hoarding of metal via carry trades is merely shifted into warehouses with lower ability to cover premiums, then it doesn't really impact the demand and supply balance. Subsequently, the LME price should really go up to cover the fall in premiums.
This is of course assumes everything else is equal, which is rarely the case. But it does provide a framework for how flat prices should rise once the LME rules become binding.
