London, September 2011: Reuters

The LME's physical delivery function has attracted a lot of attention over the last few months thanks to the queue of aluminium awaiting drawdown from registered warehouses in Detroit. Delays in getting metal out of what is supposed to be "the market of last resort" have put the spotlight on broader issues such as the ownership of warehousing operators by trading houses and the stocks financing vogue.

The net result has been a damaging breakdown in the arbitrage between LME prices and the physical market. A similar breakdown seems to be happening in the steel billet market, albeit for quite different reasons.

LME STOCKS. GOING, GOING, GONE?

As of today LME-registered warehouses hold 51,415 tonnes of steel billet. The vast majority of that inventory, 43,550 tonnes, equivalent to 84.7 percent, has been cancelled in preparation for physical drawdown.

Open tonnage, which is the real liquidity pool for LME trading, accordingly stands at just 7,865 tonnes. That's the lowest it's been since the early days of 2008, when what were then two regional billet contracts had just been launched.

The LME often cites stock movements as a sign of liquidity, particularly in its relatively new steel and minor metal contracts. But when so much stock has been cancelled in such a short time with no counter-balancing inflow, something is evidently not quite right.

PHYSICAL ARBITRAGE

The life-blood of the LME's billet contract since its launch has been the arbitrage relationship with the physical market. True to the LME contract's germination as a Mediterranean billet contract, the physical leg of that arbitrage has tended to be free-market assessments of Black Sea port FOB prices.

There are various Black Sea price-series published, including a weekly report from Reuters. But the most commonlycited "benchmark" is the weekly assessment from Steel Business Briefing (SBB), recently purchased by Platts. The way the arbitrage should work is that metal flows out of the LME when there is a sufficient premium in the physical market to attract it. And in theory the flow should reverse if the LME price moves to a premium over the physical price.

LME warehouse "out" charges have to be factored into the equation. Free-on-truck rates for most LME steel locations are currently in a $30-35 per tonne range. Most steel traders seem to use $50 as a rule-of-thumb maximum logistics cost.

As the chart shows, the arbitrage has worked pretty well with a strong correlation between physical market premium and LME cancellation activity.

Well, it did up until a couple of weeks ago.

Ends --

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

The views expressed here are his own.