IN DEPTH: Why aluminium financing deals are here to stay

 

 

market with material, depressing prices, collapsing premiums and triggering supply cuts across the industry. But is this really going to happen? Metal Bulletin Research gives its considered view.

 

 

Inventory financing — otherwise called inventory management — has played a role in the aluminium market for a long time, although the strategy became more prominent in 2009, facilitated by low interest rates and the widening aluminium contango.

 

 

And as financing deals moved from niche to mainstream activity, it was not surprising to see the LME warehouse system playing a bigger role in facilitating the flow of metal held for financing.

 

 

This has stimulated an inflow of aluminium into LME warehouses, which keeps large volumes of metal away from the physical market, causing artificial market tightness, and driving up spot prices and pushing premiums to record highs.

 

 

The implied gross returns on aluminium inventory financing are much lower than they were in 2008, when they were higher than 15% for a cash-15-month position. The return has since declined to 8% but still represents a healthy return compared with alternate investments, such as US government bonds.

 

 

The profitability of aluminium inventory financing depends on low borrowing costs and the futures' contango, as well as on low warehousing costs.

 

 

Although all these ingredients are currently present, both exogenous and endogenous drivers are adjusting to the changing economic situation and are constantly altering the variables, which in turn influence the profitability of aluminium financing.

 

 

So how will these factors influence aluminium financing profits?

 

 

Credit conditions

 

 

For the past year, European banks, which play a major role in providing liquidity for commodity trading and inventory finance, have suffered from either direct or indirect exposure to the sovereign debt crisis.

 

 

Equity prices in most of the banks have dived. Credit default swaps (CDS) have moved higher, bringing banks under the scrutiny of rating agencies for possible downgrades.

 

 

This has forced banks to deleverage: first, by reducing their exposure to commodities and, second, by raising cash on their books as dollar funding became more difficult to obtain, which sparked renewed concerns that dollar-denominated aluminium financing deals could be converted into cash.

 

 

However, there has been no end to credit-crunch-driven financing deals for the following reasons.

 

 

A unique characteristic of an aluminium contango is that it tends to steepen during extended periods of price falls. This is because the front end of the forward curve is more flexible than the back end during increasing price volatility.

 

 

As a result, aluminium financing deals are often more profitable during a period of steep price falls, which tend to occur throughout an economic downturn. The higher returns on forward spreads make up for increases in borrowing rates during periods when there is little liquidity.

 

 

The high returns possible from inventory financing have also attracted a number of banks from outside the eurozone. These banks have not been as badly affected by the crisis and are willing to take the opportunity to expand in what is a relatively low risk, liquid, short-term and counter-cyclical investment, which brings higher returns than the money markets.

 

 

It is also worth noting that the banks' exposure to aluminium financing deals has no direct relevance to the size of their balance sheets. Therefore, despite the tighter credit environment, there is enough appetite from the financial sector to keep aluminium deals rolling.

 

 

Furthermore, the promise from the Federal Open Market Committee (FOMC) to keep the cost of borrowing at record low levels until at least 2014 should keep the cost of finance low; any subsequent rise in borrowing costs is likely to be gradual. This factor plays against hikes in warehouse rents and insurance.

 

 

Metal Bulletin Research estimates that spot-15-month financing deals will still bring positive profits, even with borrowing costs in excess of 5%. So there are grounds for doubting whether the availability and cost of credit will deteriorate to the point that banks will dispose of their lucrative aluminium financing deals, at least for the next two or three years.

 

 

Aluminium curve structure

 

 

As mentioned above, aluminium inventory financing is a function of low borrowing costs and the futures' contango. However, a prolonged period of stronger physical demand would be likely to be associated with an end to both these conditions, rendering financing deals unviable.

 

 

Narrowing of the spreads is likely to be driven by the front-end changes of the forward curve due to rising spot prices. This, though, would require a solid physical demand, with the corresponding supply-demand balance moving into a supply deficit. This is unlikely to happen before 2016, given the large-capacity expansion projects in China and the Middle East.

 

 

Without a significant pick-up in physical prices, a demand shift into backwardation of the aluminium curve is less likely, given that forward-dated contracts will be responding upwards to the continuing risk of securing future energy supplies for aluminium smelting.

 

 

Besides, the back end of the aluminium curve is protecting the contango structure from shifting into backwardation, as sizeable off-exchange-held inventory (about 5 million tonnes) will also provide some resistance.

 

 

Any large deliveries to LME-approved warehouses are likely to widen spreads and counteract a rising cost of capital, and alleviate any shortage of supply, thereby supporting contango and preserving the economics of inventory financing.

 

 

Beside occasional shifts into backwardation around the prompt dates, Metal Bulletin Research saw hints of a diminishing aluminium contango in December 2011, when structural tightness in the January-March 2012 spreads left banks unable to roll over financing deals and forced them to deliver nearly 1 million tonnes of off-exchange-held metal.

 

 

However, in January, the aluminium curve came back to comfortable contango, and that will play into the hands of those looking to renew, or put on new, financing deals, ensuring metal is held tightly.

 

 

Warehousing costs

 

 

More than 80% of LME warehousing is now in the hands of banks or traders. In 2010, JP Morgan purchased Henry Bath, Trafigura purchased NEMS, Glencore purchased Pacorini, and Goldman Sachs purchased Metro International. As a result, the competition for metal among the warehouse owners has intensified, stimulating a reshuffle of aluminium within and out of the LME network.

 

 

This rivalry for the light metal and common discounts to wholesale warehouse rents sparked large warranting in Vlissingen and Detroit, effectively locking material away from the physical market.

 

 

Because many of the institutions involved in inventory financing also own a warehouse, the costs they incur for storage will remain marginal.

 

 

For those who engage in rentals, the wholesale costs could be less than 7 cents per tonne per day, compared with 35 cents per tonne per day offered to those seeking storage for smaller tonnages.

 

 

Storage costs, of course, play a significant part in the profitability of an aluminium financing deal.

 

 

Conclusion

 

 

The combination of large LME inventories and high premiums cannot be sustained indefinitely, but the risk of substantial inventory-held supplies of aluminium suddenly rolling out to the physical market is likely to remain low for some years to come.

 

 

By the time financing deals are no longer viable, the world could be in the middle of the economic cycle, when elevated demand would match the excess inventory on the LME.

 

 

Also, contracts sold forward are likely to be distributed along the curve because of different investors' time horizons, which decreases the possibility of large amounts of metal coming to the market all at once.

 

 

Finally, the proposed sliding change to the LME load-out rates from 1,500 tpd to up to 3,000 tpd will not be sufficient to release significant amounts of metal onto the market.

 

 

For all these reasons, Metal Bulletin Research concludes that — given the expectation of a low-interest-rate environment — financing deals will continue to be a feature of the aluminium market as long as any growth in physical demand does not overtake the growth in production, which would put the market into deficit and absorb vast aluminium inventories.

 

 

That is not likely to happen before 2016.