Aluminium physical premiums have risen in Q4 due to proposed new LME rules

Aluminium physical premiums have risen in Q4 due to weakness following the announcement of proposed new LME rules in July, said Barclays Capital in a research note.

According to Barclays, they believe downward pressure will be reasserted once the new rules kick in from May 2014, counteracting the current delivery queue extension caused by a rush to off-warrant metal.

After the LME proposed new warehousing rules in July this year, one immediate effect was for European and US Midwest aluminium physical premiums to fall close to 15% by September.

As we highlighted in Base Metals Focus: Aluminium fundamentals turning a corner, the decline in premia helped catalyse a wave of supply rationing with the announcement of 1.4Mty of capacity closures. Providing some confusion for market participants, however, has been the subsequent rebound in premia in Q4: in Europe, duty paid premia have been quoted as high as $270/t, versus a Q3 low of $240/t; while US Midwest premia has risen to a high of $235/t, from $215/t, Barclays added.

This development has raised three questions from market participants:

First, most obviously, why have they risen? Second, does this trend indicate that our interpretation of the new LME rules as bearish for premia was wrong? Third, might the rise in premia alter the outlook for aluminium market fundamentals from the modest deficit Barclays projects for 2014?

To answer the first question, it is important to understand what drives such price dynamics. A physical premium for a base metal reflects the marginal delivery cost (highest cost) on metal units required to solve a regional supply-demand balance. In the US aluminium market for example, domestic primary aluminium demand surpasses domestic primary production by close to 2Mt (in 2013); hence, a combination of imports and stock draws (LME and off-warrant) are also needed to balance the market. In this context, since early 2011, the highest cost aluminium unit to meet US market needs has come from LME stocks, where surging warrant cancellations levels have extended delivery queues (and rental fees) and thus the ‘cost’ of taking delivery on LME metal. In other words, a direct correlation between cancelled warrant level and premia has developed.

With those dynamics in mind, we can understand why aluminium premiums fell in Q3 and then rebounded in Q4. In the aftermath of the LME rule change proposal and associated regulatory attention, the uncertainty created lead to a temporary cessation in physical market transactions. In turn, there was a sharp reduction in global LME warrant cancellations of close to 385Kt (-17%). This fed directly into downward pressure on premia given the shorter delivery queue and rent cost impact, Barclays added.

However, following the finalisation of the warehousing rules by the LME in early November combined with the apparent satisfaction of regulators, normal physical market function effectively returned. At the same time, there was also a hike in warrant cancellation queues at key LME aluminium storage locations.

At Detroit in particular, warrant cancellations rose by close to 20% (+200Kt) in a short space of time, reflecting a move to off-warrant metal for financing given the expectation that LME rents would increase significantly in 2014 (versus cheaper non-LME storage). In the premia pricing framework already considered, the surge in LME cancellation in Q4 has raised the cost of the marginal metal unit and pressured premia higher again.

Does this mean we were wrong about the effect of the LME rules? No. Barclays continues to believe the new LME rules will be bearish for premiums once they are applied. The new load-out rules will not come into effect until 1 May 2014, when the cumulative additional load-out requirements calculated during the preliminary period (1 July 2013-31 March 2014) are then applied. Indeed, if the preliminary calculation period was to end today, the difference of ‘new’ metal loaded in versus loaded out would be 101Kt at Detroit and 84Kt at Vlissingen, which as additional load-out requirements (on top of the 3Ktd basic mandate) during the ensuing application period would shorten queue length and lower LME delivery costs. We note that until LME delivery costs fall below those of the highest cost imported aluminium unit (which are roughly estimated at close to $210/t in the US/EU currently), they will continue to drive the premia dynamics as the marginal unit.

Does the Q4 rise in premia change the outlook for aluminium market fundamentals? Barclays believes ultimately that rather than reverse closure decisions – in our view a somewhat temporary increase in premia is not game changing in terms of long term strategic smelter survival – it will likely limit the pace of further shut-ins announcements until premia pressure returns in the second half of next year.

In that context, we are still confident in our 459Kt global market deficit for 2014, which is based on the current supply profile. In turn, we continue to project a modest upward-sloping price profile for 2014, with an LME cash price average of $1,900/t for Q4 next year, Barclays concluded.