When purchasing the London Metal Exchange (the “LME”) last year, the new owner, Hong Kong Exchanges and Clearing (HKEx), knew it was inheriting a concern that has been developing progressively since 2008: the increasing load-out queues at certain LME-approved warehouses. On 1 July 2013, after a thorough review of the issue, the LME announced its latest proposal to reduce these queues (the “LME Proposal”).
The LME Proposal has been described by one metals analyst as “one of the most significant developments in LME-traded metals markets in a long time”.1 This client alert aims to assess the effectiveness of the LME Proposal in resolving the concerns, considering the various factors that apparently led to the queues in the first place.
Put simply, the concern is “the length of time it takes to deliver the relevant metal out of an LME-approved warehouse, once it has come off warrant”. Currently delays of over 200 days are occurring at some LME warehouses.2 Originally the concern was limited to aluminium load-out queues but has also spread to other metals, such as copper and nickel.
This concern of delay has, of course, to be put into context. The LME has over 700 approved warehouses in 36 locations in 14 different countries. It is not suggested that the delays are occurring in all these locations; only a selected few. In fact, five locations are reported to be the centres of the delay.3 The warehouses in these locations are nevertheless significant because of their size, with Vlissingen and Detroit accounting for 64% of LME aluminium stocks and Johor, New Orleans and Detroit accounting for 89% of total LME copper stocks.4
Since 2008 there has been a significant increase in the amount of metal stored in LME warehouses (from 1.5 million tonnes at the start of 2008 to 7.7 million tonnes at the beginning of July 20135). However, the amount of any metal in LME warehouses is still not significant in the context of the size of the overall market. For example, the amount of aluminium stored in LME-approved warehouses is only approximately 5 million tonnes, compared with the overall size of the aluminium market which stands at 45 million tonnes.6
The limited number of warehouses and metals originally impacted by the load-out queues allowed the prior owners of the LME to argue that the issue is not one of systemic concern.7 It is that argument that had previously led to small tweaks of the LME rules to address the perceived concern. For example, the LME introduced increased minimum load-out requirements, based on the amount of metal being stored in warehouses (in April 2012); introduced separate minimum load-out rates for tin and nickel (in April 2013); and introduced a measure so that prospective LME warehouses which had significant load-out commitments in one metal, would be required to load out minimum amounts of other metals (in April 2013). However these measures have not been particularly effective as queues have continued to increase.
LME Warehouses – Some facts
The LME does not own the warehouses; it merely approves them and requires them to abide by the uniform rules applicable to all its approved warehouses
The LME rules require there to be an information barrier between warehouse companies and metals trading companies in the same group or having a close connection to the warehouse company
The metal goes onto warrant when entering the warehouse and comes off warrant when the warrant cancellation instruction is received by the warehouse
Rent is payable to warehouses for the duration of the metal held under warrant with the maximum tariff capable of being increased only once a year (in April)
The majority (almost 90%) of all metal held in LME warehouses never leaves the warehouse
The LME Proposal
The LME Proposal is, for warehouses with load-out queues of more than 100 calendar days (the “Affected Warehouses”), that there should be an increase in the minimum load-out requirements, based on the amount of new metal being loaded in. This increase is subject to a formula and an adjustment process described below. If implemented, this proposal would work in two phases, with each phase containing (i) “calculation periods” during which the amount of metal being loaded in and loaded out is measured, and (ii) “discharge periods” during which excess metal taken in during the relevant calculation period is discharged from the Affected Warehouse(s).
Phase 1 – Preliminary calculation and preliminary discharge period
The first phase consists of the preliminary calculation period (1 July 2013 – 31 March 2014) and the preliminary discharge period (1 May 2014 – 31 July 2014). By introducing the preliminary calculation period from the date of publication of the LME Proposal, the LME hopes to prevent warehouses evading the proposed rule changes by increasing their intake of a given metal before the LME Proposal is fully implemented.
During this first phase the LME’s Proposal aims only to prevent stocks, and therefore queue lengths, from increasing. It seeks to do this by requiring that, during the preliminary discharge period, Affected Warehouses must discharge not only the existing minimum load-out requirements, but also the amount by which metal loaded in during the preliminary calculation period exceeds the amount of metal loaded out during the preliminary calculation period.8
For example if, during the preliminary calculation period, an Affected Warehouse has a minimum load-out requirement of 3,000 tonnes of copper per day and loads in 3,500 tonnes of copper per day for that calculation period then, during the preliminary discharge period, it will have to discharge its minimum load-out requirement plus an additional surplus 500 tonnes of copper per day. However, the Affected Warehouse would not be under an obligation to load out the surplus copper evenly throughout the discharge period. For example, it could decide to load out only the minimum load-out requirement of 3,000 tonnes per day on some days and 4,000 tonnes per day on other days.
It is important to note that the preliminary calculation period is much longer than the preliminary discharge period. Therefore, under the above example, an Affected Warehouse would have a cumulative minimum load-out requirement of 1,095,000 tonnes, and have loaded in 1,277,500 tonnes during the preliminary calculation period. Therefore, during the preliminary discharge period, it would have to load out an average of 1,984 tonnes per day in addition to the minimum requirement of 3,000 tonnes per day in order to meet its obligations.
Phase 2 – First and subsequent calculation and discharge periods
The second phase consists of a first calculation period (1 April 2014 – 30 June 2014) and a first discharge period (1 August 2014 – 31 October 2014), as well as the subsequent calculation and discharge periods, which will each have a three-month term. In all cases, there will be a month’s gap between the start of the discharge period and the end of the relevant calculation period to which that discharge period relates.
During this second phase, the LME Proposal aims to reduce the length of queues. How quickly this will be achieved will depend on the rate at which warrants are cancelled and “un-cancelled”. However, in the long run it will reduce queues by requiring that, for each day during the calculation period where the load-out queue length is greater than 100 calendar days, Affected Warehouses must discharge during the discharge period:
The minimum daily load-out requirement; plus
Half of the new metal placed on warrant on that day, up to and including the minimum daily load-out requirement; and
The amount of new metal placed on warrant on that day, to the extent that it exceeds the minimum load-out rate
Therefore if, for example, warehouses are loading in 0 tonnes, they will not have any additional discharge requirements above the 3,000 tonne minimum. As demonstrated in the chart below, this scenario would lead to the maximum amount of reduction in warehouse stocks. If warehouses are loading in 3,000 tonnes or more per day, the additional discharge requirements will be 1,500 tonnes more than the amount they are loading in.
The effectiveness of the LME Proposal At the time of acquisition of the LME, Charles Li, the chief executive of HKEx, had talked about taking a “bazooka” to the load-out queue issue; but when discussing the LME Proposal he preferred the analogy of applying “Chinese Medicine” to cure things. The main reason for this change in tone is his conclusion that the impact of the load-out queues is not as harmful as the principal complaints suggest. These complaints mostly originate from the consumer side of the market rather than from the producers, warehouse owners or metals market traders. The complaints are that the queues: (i) are leading to metal being inaccessible in a timely manner, (ii) are pushing the overall cost of metal, especially aluminium, too high and (iii) have led to an increased premium charged for delivery at any given warehouse; too high, relative to the underlying cost of non LME-metal.
HKEx is broadly dismissive of the complaints at (i) and (ii) above, pointing towards the fact that the LME is not the main source of metal in the markets but is a supplier of last resort, and that the current prices of metals are well below their historical highs. It does however recognise the complaint regarding premiums (at (iii) above), as it has the potential to jeopardize the LME’s price-discovery processes. Long queues may prevent the LME price from continuing to act as a cap on the premiums demanded by producers for metals, because the LME will no longer be an effective alternative source of metals for consumers. In the long run, this risks the possibility for price convergence between LME prices and the spot price metals outside the LME. The LME Proposal must therefore be viewed as targeting this main concern. So how effective will the LME Proposal be?
The LME Proposal only targets warehouses where the load-out queue is greater than 100 calendar days. Most warehouses are significantly under that, therefore the LME Proposal is really only targeting the few warehouse locations where the concern has been endemic. The LME Proposal therefore, does not stop load-out queues of just under 100 calendar days from arising, thereby raising the possibility that 100 calendar days becomes the expected queue length rather than a maximum one.
As previously mentioned, Phase 1 of the LME Proposal is about preventing the situation from further accelerating. Only in Phase 2 does the current load-out queue begin to come down through the increase of the load-out rate, by making it greater than the load-in rate.
Given Phase 2 doesn’t begin until 1 August 2014, it may be a fair while before the reduction in load-out queues begins to show. The factors that impact the time over which the reductions will be achieved also include whether the current load-in rates continue or significantly drop off, the rate at which warrants are cancelled and the amount of built-up stock within the Affected Warehouse.
The LME Proposal acknowledges the impact of increasing cancellations of warranted metals that are already in warehouses, which will also contribute to queue lengths. Economic changes (e.g., increase in interest rates and their impacts on costs of carry) are likely to have a significant effect on cancellation rates.
Of course, the LME Proposal doesn’t seek to address all of the underlying causes of the increase in the stocks at LME-approved warehouses. Although the original factor that led to the increase in warehouse stock was a reduction in demand for metals following the global economic slowdown, the reality is that there have been plenty of other reasons driving stocks into LME warehouses. Although a comprehensive discourse on the operations of the market in base metals is outside the scope of this client alert, it is worth touching on some market aspects that have led to the bloating of the warehouses.
Investors (e.g. pension funds and institutional investors) flocking to the metals market via ETFs and other structured products, seeking a greater return on capital, thereby leading to increased issuance of securities backed by metals held on LME warrant
Historically low interest rates, encouraging metals spot and futures market arbitrage opportunities reflected in “cash and carry” trades
The availability of cheap cash through quantitative easing, which is allowing financial institutions to provide off balance sheet solutions to metals market participants taking long positions in the market, and holding the metals in warehouses to provide security for their bank financings
Rental rate variations, offered by warehouses with enough metal to be able to afford enticements, to attract metal into those warehouses over others, leading to concentration of stock in certain locations
The LME Proposal is currently on consultation until 30 September 2013 with a final decision expected from the LME Board during its October 2013 meeting. As mentioned above, if the LME Proposal is approved, the preliminary calculation period will be deemed to have started on 1 July 2013. The success of the LME Proposal in reducing load-out queues is, in the short-term, more likely to depend on extraneous market factors rather than the proposal itself.
In the longer term, the effect of the LME Proposal should, logically, lead to the reduction of queues in the Affected Warehouses. The concern will be that the proposal increases the average load-out times at all other warehouses in the process.
The risk is, of course, that the LME Proposal is arriving too late, because of the greater scrutiny that warehouse owners already now face from regulators, such as the CFTC and the U.S. Department of Justice, and legislators such as the U.S. Senate, which have become concerned about the alleged impact of warehousing queues on commodity prices as flagged by end user industrials. Unfortunately, the rational response to such complaints, as articulated by Charles Li of HKEx, is not reciprocated in the rhetoric or sentiment expressed by regulators that are still trying to understand how the market works, and the legislators that are targeting any potential links between commodity prices and market speculation. Their intervention in this self-regulated market may be a more significant development in the traded metals markets than the current LME Proposal.
1. Jack Farchy, “Metals pricing under threat from warehousing rule change”, Financial Times, 4 July 2013.
2. Andy Home, “Playing the new LME warehousing game”, Reuters, 8 April 2013.
3. These are reported to be Detroit, New Orleans, Antwerp, Vlissingen and Johor, see Maria Kolesnikova and Agnieszka Troszkiewicz, “LME Seeks to shorten 100-day withdrawal times at warehouses”, Resource Investor, 1 July 2013.
4. see Maria Kolesnikova and Agnieszka Troszkiewicz above.
5. see Jack Farchy above.
6. Andy Home, “Think LME metal stocks are high? Look again”, Yahoo Finance, 31 May 2013.
7. This seems to have been supported by the conclusion of the Europe Economics report commissioned by the LME and delivered in 2011.
8. The minimum load-out amount used for the calculations will always be at least the minimum load-out requirement for the relevant warehouse. Therefore warehouses would not for example, be able to load out less than the minimum load-out requirement, in order to decrease their load-out requirements during the preliminary discharge period.