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(The author is a Reuters Breakingviews columnist. The opinions expressed are his own.)
By Kevin Allison
LONDON, Aug 15 (Reuters Breakingviews) - Drab sheds full of aluminium ingots aren't a natural place to go looking for a financial conspiracy. But industrial users say the warehouses - or more exactly the way they are used by big traders which own them - have artificially inflated prices for the metal. A flurry of class action lawsuits have accused Goldman Sachs (GS.N), JPMorgan (JPM.N), and Glencore (GLEN.L) of manipulating prices by encouraging big stockpiles and long wait times.
Complaints about long storage queues have been around since 2010, but they gained more attention this month in a U.S. Senate hearing on banks' commodity business. Along with the lawsuits, the U.S. Department of Justice and Commodity Futures Trading Commission have launched investigations - and the U.S. political comedy television programme, The Daily Show, did a parody sketch.
Breakingviews explains how slick middlemen managed to turn a once-sleepy utility into a money-spinner.
How does metal warehousing work?
The London Metal Exchange, the world's biggest marketplace for industrial metals such as aluminium and zinc, maintains a list of approved warehouses that act as delivery points of last resort for metal producers. The LME doesn't own the buildings, but licenses them and sets rules for how they operate. Suppliers who drop off metal at an approved location receive warrants that can be presented to satisfy LME futures contracts. That makes the warehouses a crucial bridge between physical and financial markets.
Warehousing used to be a sleepy affair dominated by a handful of independent companies. That changed in 2010, when JPMorgan, Goldman and Glencore all bought leading warehouse operators. Today big commodity traders and banks dominate the business, although LME rules require warehousing subsidiaries to be operated at arm's length, with information barriers to avoid conflicts of interest.
What's behind the long warehouse queues?
Long warehouse queues are a result of perverse incentives and rent-seeking by warehouse owners. LME inventories soared after the financial crisis, as metal producers and industrial users responded to weak demand by socking surplus product into storage. So far so good – that's how the LME system is supposed to work. But central banks' ultra-low interest rates also promoted hoarding. Quirks of geography and financial incentives offered by warehouse owners encouraged the concentration of metal in a handful of sites – aluminium in Detroit and Vlissingen, Netherlands; zinc in New Orleans; and copper in Antwerp and Johor, Malaysia, according to Morgan Stanley (MS.N).
Low rates also encouraged a speculative carry trade - buying metal at depressed spot prices, selling it forward at higher prices, and pocketing a profit, even after storage costs.Goldman says long queues at its Detroit warehouses came when financial speculators started clamouring to pull metal out of its LME-approved facilities and put it into lower-cost sheds. But Goldman also exacerbated the problem by taking advantage of arcane LME rules that meant it only had to release a small amount of metal from approved facilities each day, no matter how many customers were asking for it.
What is the effect on prices?
The price of aluminium has fallen 40 percent since the financial crisis, and 10 percent since complaints about long warehouse queues first surfaced three years ago. But end users are still paying more for the metal than they otherwise might. Long waits at the warehouse gate increase competition for metal for immediate delivery – pushing up the premium that beverage can makers and other final users have to pay to get their hands on prompt supplies.
How do commodity traders make money from the warehouse game?
Warehouse owners collect rent as long as metal sits on site – so they have an incentive to encourage long queues. Last month in Detroit, wait times for metal were around 470 calendar days. At the prevailing rental rate of 48 cents per tonne per day, Detroit's aluminium queue alone was worth $220 million, according to Reuters calculations. Traders with ready access to metal benefitted from high premiums for current delivery over a future promise. That's on top of any money they make on carry trades and financing deals.
What happens now?
Whatever the outcome of the U.S. investigations and lawsuits, the warehouse wheeze is probably coming to an end. Goldman and JPMorgan are both thought to be looking for buyers for their warehouse businesses now that owning them has become a public relations headache. Under its new owner, Hong Kong Exchanges and Clearing Limited (0388.HK), the LME has proposed rule changes that should eliminate long queues – Detroit wait times have already fallen to about 300 days in anticipation.
Eventually, higher interest rates will make it more profitable to sell metal promptly and invest the proceeds than to hoard it. Then the traders' lucrative but socially useless warehouse game will be over for good.
- The U.S. Commodity Futures Trading Commission subpoenaed a number of major metals warehousing firms last week, according to sources familiar with the matter.
- The main U.S. commodities regulator is seeking documents and communications sent over the past three years as it looks into allegations that warehousing firms, many of which are owned by big banks and trading houses, have made it more expensive for industrial users to buy metal by trapping it inside warehouses.
- The U.S. Department of Justice is also probing warehouse practices, and several aluminium users have filed class action lawsuits in recent days. JPMorgan, Goldman and the LME have all said the legal action lacks merit. Glencore hasn't commented.
- Reuters: CFTC subpoenas Glencore, others as metals inquiry heats up [ID:nL2N0GD1PK]
- For previous columns by the author, Reuters customers can click on [ALLISON/]
(Editing by Edward Hadas and Viktoria Dendrinou)
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