An interesting bit of news, by way of the FT’s Jack Farchy and Daniel Schäfer this week:
JPMorgan Chase and Goldman Sachs are seeking to sell their metal warehousing units just three years after their controversial entry to the industry, even as a proposed rule change by the London Metal Exchange is likely to reduce the attractiveness of the business.
The two US banks got in to the niche warehousing business in 2010 at a time when a build-up in stocks following the financial crisis had triggered a boom for storage companies. But their ownership of warehouses struck a nerve when metal users began complaining that warehousing companies were profiting from bottlenecks in the system that have distorted prices.
Most base metals curves are still in contango, so if banks were prompted to buy into warehousing businesses specifically to exploit store-and-forward-sell strategies, now may seem an odd time to start shedding warehousing interests.
The FT suggests the exit is being prompted by the LME’s decision to tackle the phenomenon of unprecedented warehouse queues — related to the fullness of warehouses. These were starting to tarnish the reputation not only of warehouse owners, but of the LME system itself . The delays had been profitable for warehouse owners because they continued to receive rent until the metal actually left the building. The greater the delay, the more rent.
But the LME is now looking to prevent the practice, something that will hit warehouse profits significantly.
Though there could be more to the story still.
Industry sources tell FT Alphaville that another pressure point for industry players is the upcoming move towards LME self clearing.
This is likely to dent profits for those engaging in store-and-sell forward strategies, given that margin costs will be doubled up as soon as traders are forced to clear metals only through LME.
Clearing via LCH Clearnet used to allow major players to net off a variety of different commodities, swaps and derivatives against each other, but now positions in base metals will be removed from the netting process. This would not only see collateral demands increased for outstanding LCH Clearnet positions, but add fresh collateral demands for LME metal positions.
All of which could be enough to limit the profitability of the dark-inventory store-and-sell-forward strategy, even with a continuing contango.
The end result?
Well, according to our sources, it really depends on the nature of the deals. In many cases, however, it’s the producers themselves who have sold supply on discounted terms to banks so as to raise cash-flow in a weak demand environment. This supply has then been stashed by banks in warehouses, and sold back to what are sometimes the very same producers 2-4 years down the line on a repurchase basis.
By clogging up the warehouses, genuine end-user consumers of metals have increasingly been forced to circumnavigate the LME warehouse system and go direct to the producers, where they would have had to pay a premium for the metal over the LME price.
This served everyone (apart from end users) very nicely for a long time. But the strategy could only keep in play for as long as the repurchase obligation was able to be rolled on at a profitable premium (a contango).
But now, we understand, some producers have opted to dodge the repurchase obligations rather by selling them on to the market. This has already exposed the market to a sizeable load of unhedged supply, which has accordingly impacted spot prices.
If banks cannot continue to forward roll the hedges because the margin costs outweigh the benefits, at the same time that clogged inventory is no longer providing an incremental rental income, the profitability of the whole game changes.
And on that basis, if and when the existing stock is unwound, it would be wise to expect either a further fall in prices or an intensification of contango in base metals contracts, in some cases back into super contango territory once again.
Related links:
Cash for copper in China (or whack-a-mole financing) – FT Alphaville
When the Chinese levee breaks, aluminium edition – FT Alphaville
Goldman on metal pawning – FT
Deripaska on the collateralisation of aluminium – FT Alphaville
Let’s count the copper with dust on it – FT Alphaville
The anomaly of higher prices AND higher stocks in copper – FT Alphaville Tumblr
Copyright The Financial Times Limited . All rights reserved. Please don't copy articles from FT.com and redistribute by email or post to the web.