An accident waiting to happen is perhaps the best way to describe aluminium markets – the key swing outlet for caustic soda. Caustic soda is normally a late cycle product, with sales then focused on the mining industry. Industry leader Alcoa’s results confirm the disappointing trend. It lost money in Q1, whilst revenue fell 8% due to a decline in aluminium prices.
Even more worrying, as the chart above shows, based on EuroChlor data, Is that European caustic inventory is already at high levels:
- Inventory jumped 22% in February (red square) versus 2013 (green line)
- This followed an 18% jump in January, and took stocks to 296kt – equal to 2009/10 levels
- The driver was an increase in February operating rates to 81%, after an average 75% in 2012
A further problem is that aluminium stocks in warehouses remain at more than 10 million tonnes, despite a 43% fall in prices from the 2008 peak. As the blog noted in January, this is sufficient to build 2 years’ worth of cars.
Aluminium producers are thus now fighting a war on two fronts:
- Rusal has forced a postponement in the London Metal Exchange’s plan to cut warehouse delivery times
- Rusal and Alcoa have also started to cut production at high cost mines
The warehouse position is the most scandalous, with buyers forced to wait up to 570 days to obtain their own stored material – and to add insult to injury, made to pay large premiums to obtain prompt delivery of replacement supplies.
But whilst Western aluminium producers are finally starting to face up to reality, we can be fairly certain that they will do too little, too late. This is always the problem when markets are unable to operate properly, as wishful thinking rather than reality starts to dominate producer thinking.
They have thus allowed themselves to be lulled into a state of false optimism. They wanted to believe stimulus programmes would restore pre-Crisis growth levels, and they have ignored the fact that the warehouse delays kept unwanted inventory off the market.
But we all know how this story will end. Aluminium demand will continue to suffer under the influence of today’s high prices, whilst in the end the inventory will appear on the market. When this happens, it will be the innocent producers of caustic soda who will suffer just as much as the aluminium market.
Today’s rising inventory are a clear warning that major operating rate reductions are now on the horizon.
When was the last time you told your customers that they would have to wait 570 days for delivery of material for which they have already paid?
You’ve never done this? Well, you need to take lessons from those super-smart people who own the aluminium warehouses, such as Goldman Sachs (pictured above by Reuters). As the blog has noted before, they have created a situation where warehouse stocks now represent enough metal to build 2 years’ supply of cars.
Finally, however, the world’s largest buyer, Novelis, has gone public with its complaints to the Financial Times. They argue that the shortage is “temporary and artificial”, and that the market remains in large surplus with 10m – 15m tonnes of metal stored in warehouses around the world.
They are also upset by a second tactic now common in the market. If you want to obtain prompt material to use today, and you can’t obtain your own material from the warehouse until the end of 2015, you instead have to pay a “prompt premium”. And this isn’t small change. Last week, buyers were paying about $450/t in premium, 26% above the supposed ‘cash price’ at the London Metal Exchange.
Clearly, ‘enough is now enough’ for Novelis. As their chief supply officer, Nick Madden, notes:
“There is more than enough metal to meet the higher consumption levels, but it continues to be held off-market by those who benefit from financing deals and the appreciation in premiums. This increase in costs ultimately does flow down through the supply chain to the end consumer.”
Aluminium is thus another market, like crude oil, where the market is completely failing in its primary role of price discovery. There have been no shortages in either market since 2009 to justify today’s high prices. And the short-sighted greed of those creating these high prices is clearly having major negative effects on those of us who live in the real world:
- Aluminium is used in a wide range of applications, from beverage cans to car bodies
- Its higher prices therefore have to be passed on to consumers
- Equally, caustic soda demand has been artificially inflated by the aluminium stock build-up
- When finally the bubble bursts, chloralkali producers will be the innocent victims as demand disappears
This moment may now be approaching quite quickly. Demand for new cars has begun falling in major markets, as the blog discussed yesterday. And this could well be the trigger for a price collapse, if it continues.
In the meantime, the moral of the aluminium story is clear. As in virtually every area impacted by the Crisis, most regulators and policymakers have let down the people they were supposed to protect.
We all know that strange things have been happening in global commodity markets in the past 5 years. Central banks have been pumping out free cash, which has been used to fund speculative trading by many of the major investment banks. In turn this has taken many prices to new records. And this was all happening when demand growth was weak, whilst supply was increasing rapidly due to the higher prices.
One key development in metals markets was the purchase from 2010 of warehouse capacity by companies such as Goldman Sachs and JP Morgan. They found a loophole in the rules for the London Metal Exchange (LME), whereby they only had to actually deliver product to buyers after a long wait. This provided them with sharply higher income from storage charges, as buyers often had to wait over a year for the product. And it also meant the product could be tied up in futures contracts, forcing market prices higher.
Aluminium has been an excellent example of this trend in action. It is critically important to the chloralkali industry as an outlet for caustic soda, and the blog thus keeps a careful eye on developments:
- As the chart shows, recent price levels have been very different from the spikes in the 1988 and 2007-8 booms
- Both previous spikes were caused by credit bubbles, which temporarily increased demand whilst supply was slow to respond
- But since 2009, prices have risen as buyers faced year-long waits for delivery of their own material from the warehouses
- Buyers have instead been forced to go into the market and purchase extra product at higher prices
The LME rules are now changing, but the profitability of this game has been so large that it seems the major players are reluctant to admit defeat. 5 companies now own 75% of the LME’s warehouses, and they all now own shadow warehouses as well.
Between them, they have created a paradigm shift in stock levels. Stocks were at normal levels of 1.5MT in early 2008, but now seem to be around 10 times higher:
- A year ago, LME stocks had hit a record 5.1MT, with similar volumes in the shadow warehouses – enough to build over a year’s supply of new cars
- An excellent new analysis by the Wall Street Journal suggests LME stocks are now 5.5 million tonnes, whilst stocks outside the LME may be up to 10 million tonnes
- In other words, stocks may now be 25% of total world demand, as the LME stocks were already 10% of demand
- We don’t, of course, have official data on the shadow stocks as the firms are able to keep this private
- It does seem likely, however that current stocks are enough to build 2 years’ supply of new cars
This explosion in stocks has created strong demand for caustic soda in the short-term. But in the end, this supply will have to come back on the market.
And as the WSJ notes, the lack of transparency over inventories means the market is no longer performing its role of price discovery. Instead, prices have remained firm whilst stock levels increased.
Thus the risk of a price crash must be rising day by day.