(The opinions expressed here are those of the author, a columnist for Reuters.)
By Andy Home
LONDON, Jan 9 (Reuters) - The way in which industrial metals are priced is starting to change.
Whereas once there was a single forum for trading metals such as aluminium, lead and zinc, there are now three.
The London Metal Exchange (LME) has long dominated global pricing, its benchmarks hard-wired into much of the world’s physical trade.
The last year, however, has seen LME prices sway to the increased gravitational pull of China’s Shanghai Futures Exchange (ShFE).
In the United States, meanwhile, CME Group has launched five industrial metal contracts over the last 12 months as it seeks to challenge the LME’s global franchise.
To some extent this is a phoney war. The LME has just experienced a second year of falling volumes but is not going to lose its metallic trading crown any time soon.
However, the fracturing of metals pricing from a unipolar to a multipolar model is starting to alter price formation at a structural level in some markets, while the sense of heightened competition is pushing the LME itself into opening up whole new markets for exchange pricing.
Graphic on LME volumes annual change:
Graphic on LME volumes by contract:
If volumes were the only metric, the LME’s historic role as global base metals price-setter would seem to be troubled.
Total activity on the London exchange fell by 7.7 percent last year, the second consecutive year of declining volumes.
All major contracts experienced lower volumes ranging from the marginal in the case of nickel to the catastrophic in the case of molybdenum, which lapsed into disuse around the middle of the year.
Flat, bearish markets were one factor in last year’s contraction. It’s noticeable that the only month in which LME volumes increased year-on-year was November, when copper staged a massive upside break-out from its trading range.
But somewhere in the mix is the thorny issue of trading fees, hiked at the start of 2015 and readjusted downwards in August last year.
The exchange’s part-reversal of the increases on short-dated carries may have been a case of too little, too late since volumes have failed to respond in any appreciable way.
Take that least glamorous of metals, lead. LME lead volumes fell 16 percent last year after slipping by 1 percent in 2015. Core to that decline has been the drop-off in trading of “tom-next”, the shortest-dated carry of them all, which has seen volumes slump by 31 percent over the two-year period.
All of which is in stark contrast to what has been happening in Shanghai, where trading in the ShFE lead contract more than tripled last year with consecutive records hit in November and December.
It is tempting to view this tale of two lead-trading cities as a head-to-head battle for global pricing supremacy.
But it is not. There is no evidence whatsoever that the industrial supply chain is changing its pricing basis from LME to ShFE.
Rather lead seems to have made it onto the radar of the investment crowd that ran amok across all China’s domestic commodity exchanges last year.
ShFE remains first and foremost a domestic market, protected from outside influence by its own membership rules and the great capital wall that still largely seals China from the rest of the world.
That is not to say ShFE prices don’t influence LME prices through arbitrage and sentiment, but those who have stopped trading LME short-dated carries have not decamped to Shanghai.
Nor have they switched to the CME’s lead contract, which has notched up just 25 lots since its launch in June and none whatsoever in the fourth quarter of 2016.
Trading of industrial metals, in other words, is not a zero-sum game but rather one of two, or potentially three, parallel evolutions.
Graphic on CME aluminium premium contract volumes:
Things, however, start to look a bit different when you consider what’s happening in the world of aluminium trading.
As with lead, there is no obvious direct linkage between the 10 percent decline in LME volumes and the near-doubling of ShFE volumes.
But CME’s physical premium contracts have gained traction. It launched two new ones last year, covering Japan and European duty-paid metal, adding to its existing Midwest and European duty-unpaid products.
All four have recorded respectable volumes and seen market open interest trending higher.
These complement, rather than directly challenge, the LME’s aluminium contract. The CME’s own “all-in” price contract, which does represent a direct challenge, is still struggling to gain momentum. It traded 8,241 lots last year, compared with the 68,872 lots traded on the Midwest premium contract and the 4.5 million traded on the LME.
But the split in aluminium pricing, with the basis set in London and the physical premium set in the United States, seems to be hardening.
And there may be more to come in the aluminium space. CME has also launched aluminium alloy and alumina contracts.
While the latter has so far failed to take off with just 60 lots traded in three months of existence, the alloy product is ticking over, albeit slowly.
Watch both spaces in the year ahead.
While the LME’s core role in industrial metals pricing remains largely intact, fear of the increased potential competition coming from west and east has pushed the exchange into opening up new markets for exchange trading.
In November 2015 the LME launched two new steel contracts, one for scrap and one for rebar. Volumes reached 49,099 lots and 8,637 lots respectively last year.
CME had first-mover status in the ferrous space but its hot-rolled coil contract saw volumes slide 8 percent last year, while its scrap contract saw only minimal activity and its billet contract none at all.
The LME has made no secret of its ambition to expand further its steel product suite, raising the prospect of a steady creep of exchange pricing into a market that has so far been largely resistant to the concept.
Both those steel contracts are cash-settled and indexed against third-party price assessors, a break with the LME’s past of making physical deliverability a core function of its contracts.
Now it has a template, however, expect more new products to be launched with esoteric markets such as ferrochrome possible targets.
And this is the real creeping revolution in the way industrial metals are priced. Although direct competition between the three exchanges is still muted for now, there are no guarantees that this will remain the case.
Future battlefronts are being opened up and some of these are going to trigger more structural changes in metals pricing.