By Lisa Reisman
Our story on the CFTC probe of aluminum warehouse operators prompted several reader inquiries as to how aluminum producers may specifically benefit from the current warehouse scheme resulting in slow load-out rates and much-higher-than-average Midwest premium prices.
Here’s what we found out.
Not All Aluminum Mills Are Created Equal…
Aluminum buying organizations may wish to note the distinction between primary ingot producers (Alcoa, Century, Noranda and Ormet, etc.) and semi-fabricated product producers (Novelis, Sapa Group, and the downstream operations of Alcoa). Semi-fabricated product producers, particularly those that remain non-integrated, purchase ingot from the primary producers and, like their customers, also face long load-out times and higher premiums.
In other words, the semi-fab producers and downstream supply chains all sit in the same boat. However, the semi-fab producers no longer rely upon the LME warehouse system for metal (they purchase much of their requirements under long-term contracts directly with producers and traders).
Here is a breakdown of how the system works:
So the producers that have “gained” from the existing warehouse arrangement include primary producers, for both spot contracts and – as my learned colleague Stuart Burns, co-founder and editor of MetalMiner, believes – likely long-term contracts as well.
“It’s been tough for the downstream mills; most (if not all) of them have suffered a premium over the LME, and have faced significant grumbling from end users, who are paying higher conversion premiums in order for the mill to recoup the higher-than-LME supply side cost,” said Burns. “Alcoa was the first to try and apply a ‘pass-through’ of the ingot premium on sheet products – the most commodity end of the range with the biggest margin squeeze.”
Burns believes this has met with mixed success, and others have tried. (Ed. note: Alcoa (NYSE:AA), a vertically integrated mill, benefits from the scheme on the ingot side, but not on the downstream side.)
How the LME System Used to Work
“The LME is truly the supplier of last resort – companies like Novelis can’t handle the working capital inefficiency of waiting 19 months to take delivery of metal,” said Nick Madden, senior VP and chief supply chain officer at Novelis. “It should be available promptly, but it’s not.”
Madden’s concern, as the largest aluminum buyer in the world, involves the scenario if/when U.S. demand exceeds supply, forcing Novelis to source from the LME warehouse system. But currently the market remains oversupplied.
Madden noted an additional issue involving the premiums that all players within the downstream supply chain pay. The historical Platts MW premium average from 2001 to 2010 of 4.76 cents/lb remains substantially under the current average of 12-13 cents/lb. It’s that inflated premium that each company in the supply chain pays and gets passed through – this includes any metal contract for primary or semi-finished products.
How Does the LME Warehouse Scheme Work?
According to Stuart Burns, the primary producer probably receives close to the physical delivery premium because producer(s) would likely get that for spot sales to either the trading market or to the secondary producer or end user. The warehouse operator likely needs to offer enough of an incentive for producers to bother selling into them.
What About the Traders and Service Centers?
Small- and medium-sized traders probably face the same issues as the downstream producers and downstream end markets – they remain at the mercy of the scheme. The bigger traders such as Glencore and Noble run the system and have active roles in the finance deals; even if they don’t own and operate warehouses, they likely can still exploit opportunities. Service centers purchase directly from the downstream producers (e.g. Novelis) and so act as a pass-through of higher MW premiums.