Last updated: February 5, 2014 10:54 pm

New contract to hedge high aluminium premium

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Aluminium traders and the London Metal Exchange are in advanced discussions over a new contract that will allow consumers to protect themselves against the cost of the surging premiums for the metal.

Demand for a hedging tool has mounted in recent weeks as the gap between the physical aluminium market and the official LME benchmark price has widened leaving industrial buyers exposed.

The US Midwest aluminium premium – the amount payable on top of the exchange price for immediate delivery of metal – surged to a record level in January, rising from $0.12 a pound to more than $0.20. That equates to about $450 a tonne – or more than a quarter of the current LME price for aluminium. European and Japanese premiums have also rocketed to record levels.

The sudden spike in premiums has caused consternation among purchasers of the metal. This is because there are vast stockpiles of refined aluminium sitting in warehouses. Novelis, the world’s biggest aluminium buyer, has complained of a possible “engineered squeeze”.

Aluminum consumers, which make everything from soda cans to car bodies, can easily lock-in production costs by hedging the LME price, which has fallen to four-year lows, at the exchange.

The premium, which represents the cost of physically delivering the metal to the consumer, has historically been modest compared with the all-in-cost of aluminium, and thus left uncovered.

“But with high premiums, the hedge becomes very inefficient,” said Michael Widmer, metals strategist at Bank of America Merrill Lynch. “Contracts to hedge premiums should now be quite attractive.”

The high premiums are partly a result of the lengthy queues at the biggest LME aluminium warehouses, at Detroit and Vlissingen, in the Netherlands, which stretch to more than 500 days. The LME has implemented new rules, effective from April, to reduce warehouse queues.

In a statement on Wednesday, the exchange acknowledged “current market concerns” over the high premiums, and said that it was investigating the launch of a “premium hedging contract”.

According to people involved in talks the proposed premium contract will be physically settled in order to enhance market liquidity. Buyers will deliver warrants for metal in a warehouse with long queues, plus a cash payment, in exchange for a warrant for metal that is immediately deliverable.

The LME move follows a similar initiative by the Chicago-based CME Group, which launched a cash-settled futures contract tied to the Midwest aluminium premium in 2012.

The first trade occurred last August, and there was little more activity – or liquidity – until last month when the US premium surged. Open interest – the number of outstanding contracts – rose in the second half of January from 37 lots to 252 lots, which represents 6,300 tonnes of aluminium. The CME said that some European traders, who have also been stung by high premiums, had been enquiring about the Midwest premium contract.

The LME also announced further steps in its warehouse reform efforts. The consultancy Oliver Wyman has been appointed to conduct a “logistical review” of the warehousing network, while law firm Addleshaw Goddard will conduct a legal assessment. Professor Phillip Crowson will chair the LME’s newly established Physical Market Committee, a forum for the physical industry to put forward its views to the exchange.

Rusal, the Russian aluminium producer, is taking the LME to court in London over the new warehouse rules, claiming that its human rights have been breached.

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