London, 18 July 2011: Reuters

The LME will hope that last week's announcement and accompanying press conference will have put an end to the bad publicity it has been getting about its warehousing network. The board, after thinking about it for a month, has now approved the upper-band load-out rate proposed by independent consultant Europe Economics, which was hired last year to look at how to resolve the long queues for LME metal in the United States.

The load-out rate has been hiked to 3,000 tonnes per day for warehouse operators that hold more than 900,000 tonnes in any single location.

MOTORTOWN BLUES

There is only one. It is Metro, owned by Goldman Sachs. The location is Detroit, where Metro operates 21 out of a total 26 LME-listed storage facilities. And aluminium is the metal. As of today Detroit holds 1,132,875 tonnes of the light metal. Of that total 203,075 tonnes have been cancelled and are in the queue for physical delivery. At the current 1,500 tonne per day load-out rate, the waiting time is 135 days. At the new 3,000-tonne per day load-out rate the queue would shrink to "just" 68 days.

That assumes that Metro continues to attract enough aluminium to offset what is being removed. Otherwise, the load-out rate will decrease according to a sliding-scale tonnage formula. Moreover, frustrated deliverers will have to wait until April next year for the new rules to become effective.

And if you're thinking about tapping the 42,025 tonnes of lead, the 39,980 tonnes of aluminium alloy or the 88,650 tonnes of zinc registered in Detroit, remember there's a whole lot of aluminium to be moved first.

As such, it seems fairly unlikely that the LME's "solution" to its warehouse issues is going to be greeted with whoops of joyous jubilation from its physical user-base in the U.S. Midwest.

LIMITED BRIEF, LIMITED SOLUTION

More fundamentally, it's important to remember what wasn't included in Europe Economics' original brief. It was charged only with examining the issues arising from the load-out requirements on warehouse operators. And that's what it did.

By its own admission, "broader issues surrounding allegations of manipulation and the entrance of large financial players are beyond the scope of this report." But it's precisely those broader issues that lie at the heart of the whole warehousing debate, particularly the growing financialisation of the LME's warehousing function as ever more operators tie up with major trading houses.

The recently-announced purchase by CWT Commodities of a majority stake in Swiss metals trader MRI Trading brings to six the number of tied trader-warehouser entities. The others are JP Morgan-Henry Bath, Glencore-Pacorini, Trafigura-NEMS and Noble Group-Delivery Network.

The LME asserts that its rules governing "Chinese walls" between trading and warehousing arms are effective, but information-sharing at the operational level is only the tip of the conflict-of-interest iceberg.

LME chief executive Martin Abbott said at Friday morning's press conference that the LME has received no "official" complaints from consumers. That may be the case, but note that out of the 18 original complaints that stimulated the commissioning of the Europe Economics report, only one was "formal" and that was about Baltimore not Detroit. The others were described by the consultancy as "informal".

Most contentiously, Abbott went on to say that he didn't believe that the long queues at Detroit were affecting the LME's functioning.

THE PROBLEM

There will be plenty who beg to differ. And here are some reasons why. Firstly, the deliverability of the LME's contracts is intrinsic to the exchange's effective functioning as the market of last resort.

It can't be the market of last resort if users have to wait 135 days to get their metal out of its approved warehouses. Reducing the waiting time to 68 days doesn't resolve that fundamental problem.

Moreover, the current nature of LME warehousing, which facilitates massive inflow but only minimal outflow, skews the whole concept towards metal producers at the expense of metal consumers.

Secondly, the concentration of LME inventories in specific warehouse operators in specific locations affects the arbitrage between the LME and the physical markets. The Detroit aluminium queue directly affects premiums, both via the cost of removing the metal (in terms of additional days warehousing rental over and above the normal "out" charges) and via the resulting ability of the warehousing operator to outbid physical market players for free metal.

This, by the way, is not limited just to aluminium. The massive concentration of LME-registered zinc in New Orleans is also affecting physical premiums.

At least zinc is sufficiently well-supplied that users don't need to tap the "market of last resort". If they ever do, there will be a "zinc queue" in the southern U.S. port, which holds 62 percent of all LME-registered metal. Thirdly, the combination of financed metal stocks, long queues and "warehouse wars" undermine market transparency.

LME stock movements are important signals to the whole global metals market. If they reflect nothing more than a shuffling of metal between warehousing companies and/or onto and off market, then clearly they don't signal very much at all about physical supply-demand dynamics.

THE SOLUTION

What else could the LME do? It's a bit late now to think about preventing trading companies hooking up with warehouse operators. That particular horse has long bolted, and short of external regulatory or legal pressure, there's not much point in closing the stable door.

But here are some other thoughts. The Detroit aluminium queue is directly due to one warehousing operator's dominant logistics position in the city. There are plenty of other examples of such dominance across the whole LME network.

The best long-term solution would be to break such dominant positions by enticing more warehousing operators into the system. There are signs that "market economics" are already at work here with companies such as Rhenus beefing up their metals services with an eye on LME registration.

But is the exchange being as proactive as it might be in engaging with the logistics industry? And is it ensuring its approval process is as efficient as it could be? Getting more independent operators into the LME warehousing system will naturally take time and there is always the risk that they too are simply snapped up by logisticshungry trading companies.

Therefore, the LME should devise a mechanism for managing dominant logistics positions in the same way that it manages dominant futures position. Quite simply, if an operator cannot move metal in under a certain number of days, it should be prohibited from receiving more metal until it can.

Interestingly, the LME executive dismissed the idea of "capping" when it commissioned Europe Economics' report because "the idea of setting an absolute limit to the level of stocks in a location goes against the principle that the LME's stocks should expand and contract freely in order to reflect the physical market".

Readers are invited to apply that consideration to what is happening right now Detroit.

Thirdly, the LME should enhance its stock reporting. In the 1990s it moved to daily reports from twice-weekly and included figures for cancelled tonnage. Both changes greatly improved market transparency.

Much of that transparency is being lost. It should consider publishing figures for both metal held off warrant in its warehousing system, as both COMEX and the Shanghai Futures Exchange do, and for "free-float" warranted metal.

That way at least we'd all be able to see what is really going on behind the mass arrivals and cancellations that have come to feature so large in recent stocks movements.

The reduction of the warehousing issues to just load-out rates was always too limited. The very nature of LME warehousing has been transformed in the last couple of years and it's time for the exchange to take a root-and-branch look at how the system is operating.

It almost certainly won't, which is why it should probably brace for a lot more bad publicity about its warehousing function from now on.

Ends --

By Andy Home, Reuters market analyst – for Commodities Now.

The views expressed here are his own.