Pushing tin: Goldman and the metals mirage

Major banks like Goldman Sachs have started to own and store physical metals, rather than just trade contracts. It has the conspiracy theorists in a lather.

Recent news claiming Goldman Sachs is hoarding inventories of aluminium has led to calls for the US Federal Reserve to review its 2003 decision to allow regulated banks to trade in physical commodity markets.

The banks have been accused of boosting prices of aluminium and other base metals through their control of London Metal Exchange (LME) warehouses, which have reportedly been slow to deliver metal to customers. This is apparently having a direct effect on the cost of finished goods sold to consumers. The claim is that this situation has boosted price premiums for physical metal thus allowing the banks to profit from the rent they earn on metal storage.

So why are banks interested in owning physical metal and the associated commercial activities of storage? Is this really a matter for regulators?

First, we need to put the claims in context. The vast majority of base metals used in US manufacturing, and indeed in global manufacturing, comes from producers and traders who completely avoid the LME supply system (World Economic Outlook, April 2011: Tensions from the Two-Speed Recovery Unemployment, Commodities, and Capital Flows, International Monetary Fund Staff, 2011). The LME merely uses warehouses to support the physical delivery of commodities from futures contracts traded through its system. To operate the metals futures market, the LME warehouses allow metal producers, who are generally unable to react to very rapid changes in demand, to store its excess inventory for a fee.

But producers who mine, refine and smelt base metals simply don’t need to even enter the LME trading process. They sell their products directly to customers. Producers obviously prefer to do this because it is they — and not the banks or traders — who benefit from price premiums over the “spot” price. Admittedly the price that base metals are sold for is based on the LME price, but the ability of speculators to influence this has been debunked many times in recent years and has proven to be completely unfounded.

Second, while annual global aluminium production is around 50 million tonnes, the total volume of aluminium stored in LME warehouses owned by US banks is, at most, 2 million tonnes. The LME warehouses in Detroit account for around 80 per cent of US aluminium stockpiles tracked by the LME, but this is a very minor component of the volume of aluminium consumed in the US. Inventory levels at LME warehouses have historically been low due to the small volume of futures contracts that result in delivery. However the inventory level of aluminium in LME warehouses in the US tripled from 1.2 million tonnes to more than 4.5 million tonnes in 2009 as a result of weaker demand during the credit crisis. Other base metals experienced a roughly similar behaviour in storage demand.

The majority of miners kept producing base metals during the GFC, hoping that demand would eventually stop declining. But this didn’t happen. Instead, they had no alternative but to sell their products through the LME system at historically low prices. In fact, during the GFC warehouse construction, companies were having trouble keeping up with the demand for more warehouse storage space licensed to the LME. Large amounts of metal accumulated at not only all LME warehouses in the US, but also in a range of other stockpiles around the world.

There are accusations that warehouse owners are deliberately creating aluminium and other base metal shortages, and that they move inventory from one warehouse to another in order to earn additional “rent” fees. These claims do not make a great deal of sense. The warehouse owner has no control over the volume of movement of metal it stores. It is rather the legal owners of the metal who direct warehouse operators to dispose of stored metal or transport metal from LME-approved warehouses to warehouses outside the LME system.

A company can buy aluminium from metal producers at any time. In recent years, there has been more production than consumption. The sourcing of aluminium through the LME system would be a last resort for a corporate end-user given that it always takes a certain amount of time to get inventory out of a warehouse. Delivered aluminium prices are nearly 40 per cent lower than they were in 2006, so the notion that owning aluminium is earning the banks a hefty profit is ridiculous. Owning aluminium would have to be one of the worst investments over the last seven years, except perhaps investing in Greek bonds or Tasmanian paper mills.

So why do Goldman Sachs have an interest in physical storage? It could be one of three reasons. Firstly as a rental property, on its own merits, it earns a fair return and banks invest to make money. They might earn a decent return on storage, but it is hardly an attractive way to make a quick buck for the likes of Goldman Sachs. Second, they gain better market intelligence on the behaviour of physical metal flows, which allows them to get the jump on their competitors when trading in the commodity markets. This is bogus because inventory levels must be reported and Goldman Sachs traders would be prohibited from trading on inside information relating to non-public changes to physical storage. Thirdly, Goldman Sachs makes money on the carry trade since the base metals markets are currently in contango (the forward price trades at a premium to spot), and have been for a while. Goldman Sachs stores metal and makes a profit by forward selling it on the futures market, letting the owners of the asset pay rent until it has to be delivered. There may be some merit in this argument but it is not illegal, they don’t have sufficient volumes to move the market and, in any case, it provides liquidity to the system.

The US Federal Reserve might “review” a landmark 2003 decision that first allowed bank holding companies to trade in physical commodity markets but such a move certainly won’t send shudders through Wall Street. While it is true that banks have entered the world of physical commodity trading and all the trappings of arbitrage and market intelligence it provides, they can only look on with envy at the trading houses and large commodity producers — usually miners — who freely trade in these markets beneath the eye of regulation. The banks simply want a part of the action and believe they can do it better and cheaper than producers and traders. They are probably right.

Jason West does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.

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