Platts Aluminum Symposium Warehouse Financing Issues

Transcription

1 Platts Aluminum Symposium 2014 Warehouse Financing Issues by Lloyd T. O Carroll, CFA The O Carroll Aluminum Bulletin LTOCarroll@Comcast.net

2 The information provided in this presentation was meant for informational purposes only, it is not a solicitation to purchase or sell any security. This information has been compiled from sources believed to be reliable; however, there is no guarantee of its accuracy or completeness. Any opinions expressed here are statements of judgment on this date and are subject to future change without notice. This information may contain forward looking predictions that are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Securities discussed in this presentation may not be suitable for all investors due to different needs, objectives, and financial resources. Please see important disclosures at the end of the presentation.

3 Agenda Recap of Warehouse Financing Implications What Drives Physical Premiums? LME Rules Change 2012 Action Result LME Rules Change 2014 Major Issues Transparency & Premium Contracts

4 Recap of Warehouse Financing

5 Economics of Warehouse Financing Drivers: Contango (futures price less cash price), Financing costs (interest rates plus a small insurance fee), Warehousing costs. Investors finance aluminum by buying physical metal at the cash price and simultaneously selling a forward contract for the metal using borrowed money. This locks in a risk-free profit, or arbitrage

6 $/mt /lb cents/lb cents/lb Contango Is Countercyclical 3,500 3,000 Historical Forward Prices June-07 March Month Contango vs. LME Cash LME (RHS) Contango (LHS) , , , , Months Source: Bloomberg, Davenport & Co '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 Source: Platts Metals Week, Davenport & Co 50

7 percent Financing Costs Interest Rates '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 Source: The Federal Reserve Board 0

8 Financing Costs Issues Not all financers can borrow at or close to LIBOR on their own balance sheet LME warrant is excellent collateral Thus, some inventory will remain on warrant Borrowers with very good balance sheets do not need to remain on warrant

9 Storage Costs LME rental rates are high stock financing does not work with full rent Ways to make storage affordable: Rent discounts The financer owns its own LME warehouse Move the inventory off warrant either physically to another facility, or off warrant in the same facility

10 Implications

11 Implications Almost all (80-90%) of warrant holders are financers Warrant holders will continually seek lower rents, especially as warehouses raise rental rates Canceled warrants represent efforts to cut rent cost (either to a self-owned warehouse or off warrant) Only a very small portion of canceled warrants are physical buyers or other commercial transactions This suggests a risk of major outflow (over 50% of inventory) from LME system over time Financed metal not available to physical market pushes premiums higher whether on warrant or off warrant

12 Changes Are Coming Banks exiting warehouse financing due to Volcker Rule prohibitions such as: Proprietary trading (trading for their own account) Most non-financial operations including warehouse operations & commodity brokerage Some actions already taken, others announced, more to come Affects: Commercial banks in the U.S.; may not include some investment banks or non-u.s. banks with no U.S. operations Implies a major reshuffle in the players in commodities and in firms engaging in stock financing Lending for stock financing & other commodity transactions will continue

13 What Drives Premiums?

14 US Premium ( /lb) US Supply Balance (kmt) Baltic Dry Index Oil Price (WTI) Long-Term Drivers of Premiums 12.0 USA: Premium vs Supply Balance 4,500 7,200 Drivers of Higher Freight Costs ,750 6, ,000 4, ,250 3, ,500 2, , US Midwest Premium US Supply Balance Source: Platts Metals Week, Davenport & Co estimates Baltic Dry Index Oil price Source: Platts Metals Week, Davenport & Co estimates

15 Long-Term Drivers of Premiums Logistics costs over the last 10 years have risen for two key reasons: 1. Freight rates and oil prices have trended higher over time, taking costs higher for both ocean freight and for port-tocustomer delivery costs, and 2. The marginal supplier to the U.S. market to satisfy the net deficit is now further away. Today s marginal tonne for the U.S. market comes from: Gulf today vs. Quebec decades ago Hence, much higher logistics costs Implies MW Premium of 8-10 /lb today, not the 2-5 /lb seen from the 1970s through 1990s

16 Short-Term Drivers of Premiums Large increase in premiums over the last two years not explained by increase in logistics costs Historically, a higher premium was a sign of stronger local demand, but local demand is only part of the puzzle Premiums rose in Europe, U.S. and Japan simultaneously Other factors affecting premiums include: Effects of stock financing Extended warehouse queues Speculative activity Changes in sentiment Anticipation of regulatory changes including LME rules changes

17 LME Rules Change 2012

18 LME Rules Change 2012

19 LME Rules Change 2012

20 Pricing Since 2011

21 Fundamentals with Visible Inventory

22 Fundamentals with Off-Warrant Inventories

23 Estimated Total Aluminum Inventory

24 Implications Total inventory estimated at 12.5 mmt, much higher than 8 mmt of visible inventory Off-warrant inventory over 4 mmt today Stock financing and rules changes could push another 3-4 mmt off-warrant leaving LME on-warrant inventories a relatively minor piece of the puzzle With no authoritative source for off-warrant inventory data, it becomes much more difficult to estimate supply-demand Could lead to bad decisions by producers, consumers, hedgers, and others Pricing is likely much more volatile Greater uncertainty in markets leads to lower prices

25 LME Rules Change 2014

26 LME Rules Change 2014 Messy consultation with what I see as a biased process based on language in the Public Report Penalty increase in load-out rates for Detroit & Vlissingen Objections by producers & others

27 LME Rules Change 2014 Issues Will warrant holders respond like in 2012? How will warehouses respond with rent hikes? How will speculators try to game the rule change? What will happen to premiums as a result of the rule change? What will happen to LME prices as a result of the rules change? If these rules do not reach the stated goal of lower premiums, what else will be done? How much inventory remains in the LME system at the end of the process?

28 Major Issues Resulting from Warehouse Financing

29 Major Issues Transparency Transparency is critical to efficient price discovery Substantial transparency has been lost with more to come How can transparency be regained? Possible Changes Positions of traders holdings, transactions; aggregates or individual Warrant holders identity aggregates or individual Identification of warrant holders cancelling warrants Destination of inventory loaded out

30 Major Issues Transparency SEC reporting requirements for stocks 1. All holders over minimum size report all holdings by stock at quarter-end 2. Published with lag 3. All holdings taking ownership above 5% of outstanding reported that week 4. All short positions also reported

31 Major Issues Premium Contracts Unable to hedge premiums a major flaw in risk management Efficient price discovery could be enhanced through the use of exchange contracts Current OTC swaps very illiquid, expensive, counter-party risk, either physical or financial settlement Premium contracts vital for both U.S. & Europe Other locations could be useful Product form upcharge (i.e. billet) should be explored

32 The O Carroll Aluminum Bulletin Covers aluminum supply, demand, and price trends on a global basis and macroeconomic trends. This service consists of four key publications: 1. Quarterly Aluminum Bulletin 2. Monthly Aluminum Update 3. Quarterly Economic Bulletin 4. Special Studies Lloyd T. O Carroll, CFA (804) ltocarroll@comcast.net

33 Q & A