No one would describe aluminum’s recent pricing as strong. Since the beginning of the year the price of the metal has fallen roughly 14¢, and was trading at 82¢ per lb. at press time.
But looking deeper into the current price drivers shows that the metal could be in for a more precipitous drop in the coming year.
Not that there is any consensus on such a forecast. In the world of aluminum there are currently two firmly entrenched and divergent camps.
On one side sit the bears, and in their corner is the recent US$11-billion writedown of Rio Tinto’s aluminum assets, the perception of overcapacity, rising interest rates and the prospect that U.S. regulators may soon move to stop some funny business in the aluminum-storage system that may be artificially supporting prices.
On the other side sit the bulls, who point to 7% growth in aluminum demand over the last five years. They also like the fact that end-users of the metal are paying the highest premiums in 20 years — which is not generally the case when there is a surplus of supply.
The bull’s case was furthered by Rusal’s CEO Oleg Deripaska in an interview with the Telegraph back in February. Deripaska argued that surplus in the aluminum market was an illusion because it considers metal stored in warehouses, when in fact that metal is being kept off the market for financial reasons.
The New York Times report at the end of July on Metro International Trade Services sheds more light on such warehousing, and how it leads to premiums being paid by end-users.
In a nutshell, the article, citing several forklift drivers as sources, argues that Metro, which is owned by Goldman Sachs and operates a massive aluminum storage warehouse outside of Detroit, is deliberately sitting on aluminum in a bid to collect more storage fees and create the false perception of low supply.
The result is higher aluminum prices, as end-users — who are fed up with the inexcusably long wait times associated with ordering aluminum from warehouses like Metro — have turned to the metal manufacturers instead, who charge a premium. That premium is passed on to consumers.
The situation has regulators south of the border considering a reversal of a 2003 decision that allowed banks to directly own commodities and the warehouses that store them. But more on that later. For now, let us point out that Goldman did offer a rebuttal to the Times story, but its contention that it is only doing the bidding of its customers is weak, as it does not address the real reason why it, or any other banks, entered into commodity warehousing in the first place: to establish a carry trade.
The banks figured out that in a low interest-rate environment, with treasury yields anemic, a more profitable, risk-free trade existed in the land of commodities.
The nuts and bolts of the trade are relatively simple: borrow money at low rates, buy aluminum and buy the warehouses that store it, and finally sell it on the futures market. What makes the trade profitable is a forward curve — as long as future prices are higher than spot prices, the seller of the future contract (the short) is being compensated to store the metal for future delivery. And when you own the storage facility, you are likely able to store the metal for cheaper than what the future price is compensating you for.
It all means that as long as the forward curve for aluminum remains in contango, which it has been in for some time, there will be support for its price, as banks continue to buy on the spot market and sell at further-out dates in the futures market.
But if the forward curve tilts into backwardation, this carry trade collapses, and holders like Goldman could unwind their aluminum positions.
It can be reasonably argued that this is exactly what happened in the gold market, and that it was one of the key factors that drove the gold price down this year. Simply put, large banks had established big carry trades in gold to generate a yield higher than could be achieved in treasuries. But when the forward curve for gold tipped into backwardation, the trade collapsed, and a lot of gold holders liquidated their positions, pushing down prices.
In the case of gold, the end of the carry trade was likely triggered by dwindling concerns over inflation and the beginning of talk that quantitative easing could soon end.
In the aluminum market, it isn’t so clear what would drive investors to liquidate. One scenario is that they are forced to. Aluminum investors will be paying close attention to the Federal Reserve’s decision this September on whether banks can continue to delve directly into commodity markets.
If the Fed rules that banks are out, big players like Goldman will be forced to sell, and that could drive prices lower.
The other thing to monitor is interest rates. If banks can earn more by parking their money in higher-yielding treasuries, the carry trade in metals like aluminum could be off.
There could be interesting days ahead for aluminum prices, and there is a lot more behind price movements than simple industrial supply and demand. Investors need to be wary.
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