The London Metals Exchange On The Auction Block: Who Stands To Gain?

Two exchanges are currently bidding for the venerable London Metals Exchange, one of the oldest and most respected commodities markets in the world. The contenders are the Hong Kong Exchanges and Clearing (HKE), which trades stocks, indices, fixed income and gold, and the Intercontinental Exchange (NYSE:ICE), which trades energy, agricultural products, freight, ferrous metals and emission allowances.

However, in this battle lies an interesting and easy investment opportunity for the savvy sovereign investor.

Over the past few years, a wave of consolidation has swept through stock markets and commodity futures exchanges around the world. In recent years, to name but a few, the New York Mercantile Exchange has merged with the Commodities Exchange, the benchmark futures market in the U.S. for contracts in gold, silver and copper. Then NYMEX merged with the Chicago Mercantile Exchange. The CME, in turn, merged with the Chicago Board of Trade. And in 2007 the Intercontinental Exchange took over the New York Board of Trade, which offered futures contracts in soft commodities, such as coffee, sugar, cocoa, cotton and frozen concentrated orange juice.

The Consolidation Wave Has Washed Up at the LME

Now that consolidation wave has washed upon the shores of the venerable London Metals Exchange, which traces its roots back to 1571, the year in which the Royal Exchange was founded as the center of commerce for the famed English capital. It was back in 1571, when England was a self-sufficient nation with ample supplies of tin and copper, that traders in metals and a range of other commodities first began to meet on a regular basis at a specific location to conduct their business.

As a result of its industrial revolution in the 17th and 18th centuries, the country -- by now called Great Britain --- had become the most technologically advanced nation in the world. The new era resulted in the need for imports of base metal ores, which were refined into metals for use in British colonies and for export around the world.

The LME has flourished as a commodities exchange ever since, and has become the futures market for copper, aluminum, nickel, lead, zinc and tin. Meanwhile, its clearing house clears over-the-counter transactions in precious metals, such as gold and silver. Now the LME has become the latest consolidation target. It should come as no surprise that the LME is considering a takeover at this juncture. To compete on a global level, bigger is better in the world of commodity futures exchanges.

A Business Where the Action Shifts

An increasing amount of regulation in the U.S. and Europe is raising the cost of running futures exchanges. More importantly, the action often shifts in the commodities world. Sometimes base metals are hot; sometimes soft commodities, precious metals or energy are hot. A large diversified futures exchange does not have all its eggs in one basket.

And there is also financial motivation for a merger. Once, traders and business-people owned seats or memberships on the exchanges. They were the owners, and now they get big money for selling their interests. The new, larger exchanges are now publicly traded companies.

At the same time, the role of the futures exchange is changing. The recent Dodd-Frank legislation has put new regulations on the futures markets. Clearing of over-the-counter transactions is coming soon. And, the exchanges will be clearing those transactions through their clearing systems. The regulators believe this will bring more transparency to the markets.

What it will certainly do is bring more fees to the exchanges. Exchanges make money on fees, when trading volume goes up the exchanges make more money. Clearing over-the-counter transactions will create another revenue stream for futures exchanges. Those exchanges that create economies of scale and trade a more diversified range of commodity products will flourish.

Battle Lines Have Been Drawn

Between the two contenders for LME, the more diversified and global exchange in the commodities world is ICE. Industry observers have noted that ICE has the edge when it comes to clearing, but HKE has the upper hand in warehousing, which is a big issue for the LME with its network of 600 approved warehouses in 27 locations around the world. Goldman Sachs, JPMorgan, physical commodities trading giant Glencore, and even Coca-Cola own some of those warehouses.

However, LME currently has no warehouses in China -- and China is the demand side of the base-metal equation. For the past few years, the story has been the same for base metals. When China buys, prices go up. When China does not buy, prices go down. Base metals, which are a basic requirement of building infrastructure in China and emerging markets, are one of the best indicators of Chinese growth. However, the China Securities Regulatory Commission has banned foreign exchanges from using mainland Chinese warehouses for futures contract-related deliveries.

HKE has stated publicly that it can help the LME facilitate approval of warehouses for base metals in mainland China -- but that is a red herring. With or without HKE, it is inevitable. Warehouses for base metals in China will only boost liquidity for the Chinese and it is coming, no matter who buys the LME or even if the LME decides to remain independent.

ICE Has the Upper Hand

I believe that ICE has the upper hand in the bidding war for the LME today. The broad reach and superior clearing capabilities of ICE make it the perfect suitor for LME. Culturally, American-owned ICE is also a better fit for the venerable British exchange.

At the same time, a merger with LME will turbo-charge ICE's growth on the international stage. ICE is currently trading around $125 per share. The 52-week range in this stock is $102.57-$142.75. ICE has a price-to-earnings ratio of 17.31 times earnings and a market cap of just over $9 billion. Its chief competitor, the CME, has a lower price-to-earnings ratio (10.73 times earnings) but it's almost twice as big.

A merger with LME (and perhaps other commodity exchanges in the futures) will give it economies of scale and diversification, and it will allow ICE to challenge the CME for the number-one spot in the world of commodity futures exchanges. My advice is to buy ICE at current levels and look to take profits at $150 a share. A quick 20% return could be in the cards.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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