LONDON (Reuters) - The London Metal Exchange (LME) copper market has experienced several “stocks bombshells” this year with huge amounts of metal seemingly arriving out of nowhere in a single day.
Almost 80,000 tonnes of copper was put onto warrant over just two days in the middle of March causing LME stocks to jump by 71%. There have been six subsequent days of copper warrantings exceeding 30,000 tonnes.
Such “arrival events”, extremely rare until a couple of years ago, are now becoming commonplace.
LME exchange stocks have in the past been seen as a reflector of shifts in fundamental dynamics. A 70% overnight jump in copper stocks, however, defies such interpretation.
The world’s metallic economy may be weak but it is not in meltdown as such heavy-volume inflows would suggest.
The increasing frequency of such “bombshells” is down to the growth of a shadow LME warehousing system, metal that is sitting in the statistical darkness but which can at any given moment flood into the exchange’s stocks reports, disrupting market expectations and pricing.
The LME would like more of this shadow stock to be warranted and on Thursday published a consultation paper covering a series of measures intended to incentivise players to do so.
However, unlike the exchange’s previous warehousing problem of long load-out queues, there is no “bazooka” solution, to coin a phrase used by Charles Li, head of the LME’s owner Hong Kong Exchanges and Clearing.
The LME shadow storage system is not going to disappear any time soon, which is why the LME is also proposing to extend its current stocks reporting to include off-market storage.
LME registered stocks of all metals have fallen from 6.5 million tonnes in June 2014 to 1.66 million tonnes at the end of last month.
This is in large part down to the “bazooka” solution of clearing multi-year load-out queues at several LME warehouse locations.
The last of those structural queues, that at the Dutch port of Vlissingen, disappeared around the middle of 2017 thanks to faster load-out rules and rent capping for those holding metal stuck in queues.
Most, if not all, of that metal, has migrated to cheaper off-market storage, even though it is still sitting in an LME-registered warehouse ready to be warranted at the stroke of a keyboard key.
That’s why so much copper or aluminium can “arrive” in a single day apparently defying normal logistical constraints.
The challenge for the LME is to try and entice some of that metal back to prevent on-warrant stocks running at permanently depleted levels, generating repeat contractions in time-spreads.
The easiest “bazooka” solution would be to drive down LME storage costs to compete with off-market rates.
However, so large is the gap that this is not really feasible. On warrant storage can be as high as 56 cents per tonne per day for aluminium. Shadow storage can be as low as 10 cents.
The LME has already capped annual rents and will continue to cap them for another five years but any inflationary push on storage costs will take still take years to bring the two warehousing markets into closer alignment.
The exchange is therefore proposing several smaller tweaks to try and shift the current on-off market storage ratio.
One idea is to relax the current rent penalties for warehousers with a load-out queue. At the moment rent is cut by half if metal has been in a queue for more than 30 days and not payable at all after 50 days.
That grace period will be extended in quarterly increments to 80 days, after which no rent will be payable.
The hope is that this will allow warehouse operators more scope in offering incentives to attract fresh metal, albeit with an implicit threat that the process will be halted if anyone starts to play the queue game again.
Evergreen rent deals, a particularly controversial form of warehouse incentive which grant a future share of rental revenue to someone delivering metal into the LME system, are widely blamed for incentivising subsequent buyers of that metal to remove it from the LME system just as soon as they can.
Such deals will continue to be permitted but only for the original warranting party not subsequent buyers of that metal in the hope, and it is no more than that, that the market itself will adapt in a way that keeps more metal in the system.
This will also be work in progress, with the LME keeping the option of taking a more draconian approach to evergreens.
Mindful that the strong economic rationale for holding metal stocks in the shadow system rather than on LME warrant is not going to disappear any time soon, the exchange is looking to at least shine a bit of light into those shadows.
The proposal is to extend the current daily exchange stocks report to include shadow stocks in what would be a significant extension of regulatory reach.
This, however, is not metal sitting in a Siberian field or outside a consumer’s works. Such privately held stocks have always existed and always will.
Rather, it is metal that is being stored under financial terms explicitly stating that it must either be in an LME-registered shed or at the very least available for speedy warranting.
If those are the terms of finance, then the metal should be reported because it might, as copper traders have found out, suddenly “appear” overnight in the on-warrant system, the LME argues.
The exchange is also hoping that metal market players might embrace a voluntary reporting system for potentially warrantable metal as the broader regulatory environmental stimulates more proactive compliance.
The shadow stocks report will initially not be published as the LME itself digests whether the data is meaningful.
Also on the agenda is a breakdown of the “cancelled” warrant category in the LME reports to differentiate between metal that is genuinely on its way to load-out and metal that is merely resting in off-warrant limbo.
Both reporting changes would be welcome.
Exchange stocks are a fundamental tool for analysing metal market dynamics. LME stocks have, however, lost much of their signalling power because of the apparently irrational combination of “arrival events”, fast outflows and rapid shifts between on-warrant and cancelled categories.
Transparency has been lost and for markets such as aluminium, this is a real problem with large fund players increasingly wary of a market with seemingly random LME stocks movements and little in the way of other fundamental data.
If the LME does indeed go down this route, though, it’s also an admission that there is no quick fix to magically reinvigorate on-market stock levels.
The opinions expressed here are those of the author, a columnist for Reuters.
Editing by Edmund Blair