Tuesday, August 6, 2013

“Shuffle of Aluminum” – A Disappointing Investigative Article in the New York Times

On July 20, the New York Times posted an article on its website, “A Shuffle of Aluminum, but to Banks, Pure Gold,” which appeared on the front page of the Sunday edition the next day. The article’s thesis is that Goldman Sachs, through a subsidiary, Metro International, has been keeping the price of aluminum artificially high and collecting unjustified storage fees. The article alleges that they do this by being excessively slow in delivering aluminum out of warehouses designated as good delivery points for aluminum futures trading on the London Metal Exchange (“LME”). Also, the article maintains that Metro shuffles aluminum among around different warehouses in Detroit in order to satisfy LME rule requirement regarding minimum deliveries of aluminum out of approved warehouses.
The article attracted a good deal of attention, especially among those who distrust or have a professional interest in disparaging Wall Street. It was timed to precede by a couple of days a hearing before a subcommittee of the Senate Committee on Banking, Housing, and Urban Affairs focusing on whether financial holding companies, such as Goldman, should be in the physical commodity business at all. There is also now a private lawsuit against Goldman and the LME charging them with antitrust violations by limiting the amount of aluminum available and keeping the price artificially high.

I am not an expert on the aluminum market and do not know whether the allegations against Goldman and the LME have any merit. However, while the Daily Show made fun of those who found the New York Times article confusing, the New York Times article was badly written and, in my view, not ready to print. While the reporter, David Kocieniewski, is on to something, he did not fully explore the issue.
One problem with the article is that the story of a “merry-go-round of metal” appears to be based on interviews with forklift drivers. They are certainly worth talking to, but the reporter did not apparently see or ask for the documentation behind the movements, nor did he obtain an explanation from either Metro or Goldman. In its reply to the article, Goldman states that “it is the 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 to meet their own needs or objectives.” Kocieniewski should have explored this issue.  

The article also does not address how the major purchasers of aluminum obtain the metal. It suggests that they buy it on the LME futures markets and stand for delivery. Futures markets, though, are usually used for hedging and speculation, not as marketplaces used to obtain a physical commodity. Some contracts, of course, culminate in delivery, but the amounts are usually not that significant. The reason for a delivery option is that the potential for or threat of delivery ensures that prices in the cash and futures markets converge at the time that the futures contract matures.
Another problem with the article is that it does not discuss the reason aluminum in storage has increased. On this point, Mr. Charles Li, the CEO of HKEx, the Hong Kong firm that now owns the LME, argues that aluminum producers did not cut production and that the global slowdown in the world economy led to reduced demand. The futures markets started pricing aluminum too high relative to the spot price; that is, the cost of aluminum in the cash market plus the cost of carry (storage, interest, and insurance) is lower than the futures market price. This occurred in a situation where the cost of carry had decrease because interest rates had fallen. In such a situation, the obvious arbitrage is to buy the physical aluminum, put it (or keep it) in storage, and sell an equal amount on the futures market. This effectively locks in a profit, though it is not entirely riskless. The risk to this position is that the short position on the futures market may require variation margin payments if the price of aluminum increases (the loss on the short position is offset by a gain in the market value of the physical aluminum, but that does not bring in cash until the position is sold).

Theoretically, this arbitrage should continue until the futures price equals the spot price plus the cost of carry by raising the spot price and lowering the futures price. The arbitrage also has the effect of locking up some aluminum in storage, and it is owned for a time by arbitrageurs who never intend to use the metal for any industrial purpose.
Goldman, in its rebuttal to the Times article claims, however, that “approximately 95 percent of the aluminum that is used in manufacturing is sourced from producers and dealers outside of the LME warehouse system,” and that “aluminum stored in Metro warehouses amounts to approximately 1.5 million tonnes, compared with global aluminum production in 2012 of about 48 million tonnes.” The Times article should have incorporated a discussion of the sources of aluminum to users and addressed the contention that there is no shortage of aluminum to those who want it.

A point on which both Mr. Li and the Times article agree is that there has been an increase in the “premiums” purchasers of physical aluminum have to pay over the spot price due to the warehouse delays. It is not clear why large companies, such as MillerCoors or Coca-Cola, do not have the ability to strike a more favorable deal on premiums with companies such as Alcoa. There is probably an explanation, but the Times article does not provide it.
Another omission from the Times article, particularly significant due to its timing preceding the Congressional hearing on permissible businesses for financial holding companies, is the apparent intent of Goldman and J.P. Morgan Chase to exit the metal warehouse business. The Financial Times reported on July 14, i.e., before the New York Times article appeared, that these two firms “are seeking to sell their metal warehousing units just three years after their controversial entry to the industry, even as a proposed rule change by the London Metal Exchange is likely to reduce the attractiveness of the business.” The New York Times could have usefully mentioned this.

While one can understand that the Times wanted to publish this article before the Congressional hearings, not all the necessary reporting had been done. The news editors should have insisted that the reporter develop more information. Somewhat surprisingly, the editors of the editorial pages wrote an editorial on this subject that was better than the news article. You can read it here.

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