London, 28 November 2011: Reuters

Fear is again stalking the London Metal Exchange ( LME) industrial metal market. Fear of what at this stage looks like imminent European recession. Fear of eurozone sovereign default. Fear that engineered slowdown in China will spin out of control into hard landing.

Three-month metal prices are either trending steadily back down to the September/October lows (copper), testing those lows (nickel) or already punching out new lows (aluminium). Yet short-dated time spreads have been tightening, in the case of nickel to the point of real pain for short-position holders.

The benchmark cash-to-three-month nickel spread flared into backwardation last week and although the back has narrowed to "just" $2 per tonne as of last Thursday's evaluations, pockets of tightness are still scattered through much of the period. The equivalent zinc spread dipped into $1 backwardation lastWednesday.

In aluminium it is the Feb-to-three-months spread that is in backwardation. Prior to last week it was the Dec-Jan spread. Lead isn't in backwardation. But it was as recently as mid-October, the latest in a series of baffling periods of front month tightness that have characterised trading in the heavy metal this year.

The only other major base metals that do not feature backwardation in the front part of the curve are tin and copper. That's all the more curious since it is these two metals that most analysts agree have the tightest fundamental dynamics right now.

So what is going on?

SELLER (AND BUYER) BEWARE!

There are some common themes at work here. Firstly, large parts of the market are structured short and, in the case of the CTA "black box" funds, massively so. Profit-taking on those short positions, many of them dating back to the original September sell-off, have to be adjusted across the LME prompt date system, creating borrowing pressure.

The fact that this is happening over the year-end period is probably also a factor. The December prompt in any year is characterised by high open interest. That's why the LME has replaced the 15-month and 27-month prompts with December prompts in its "official" price series.

Adding some spice to this already heady mix is the index reweighting that takes place in January. Weaker metals prices over the last year mean that indexes such as the S&P GSCI and Dow Jones-UBS Commodity Index need to buy more to maintain their weightings. So too will a host of replica indexes that mirror the big two.

The largest purchases will be of under-performers nickel and zinc and since everyone knows this, front-month tightness may include some strategic positioning ahead of the anticipated buying.

Then, of course, there are dominant long positions in play, most pertinently in nickel, where the flare-out of cash-date tightness over the last few days has been linked to Barclays Capital.

Whether for its own account or for that of a customer is always difficult to say in the multi-player game of bluff that is LME spread trading. Yet even taken together, these possible explanations for tightening spreads don't explain why copper and tin aren't in backwardation.

Both have been battered by technical short-sellers as much as any of the other metals. Copper has the same December concentration of open interest as other contracts. Both also feature large long positions. In copper one entity controls 40-50 percent of LME stocks. In tin two entities control somewhere between 70 and 90 percent of stocks.

STOCKS DISCONNECT

Tin and copper also stand out because LME stocks are historically low and falling. In the case of tin the decline is a precipitous one. Open tonnage, meaning metal that has not yet been cancelled prior to physical drawdown, has slumped to under 11,000 tonnes, its lowest level since March 2009.

Tin spreads have been tightening but not to the point of front-month backwardation. The cash-to-three-months spread was valued on Thursday at $10 contango. True, those metals in backwardation have also seen stock draws in recent days but outright inventory levels are historically high.

Consider nickel. LME stocks have surprised just about everyone by falling consistently over the course of 2011, at least up until this week when the backwardation has triggered a flurry of deliveries into warehouse. Last week LME inventory recorded a 2011 low of 83,220 tonnes, at which stage it was down by 53,670 tonnes, or 39 percent, on the start of the year. But by any historical yardstick such stock levels could not be termed low or certainly not low enough to occasion front-date tightness. Remember that back in 2005 LME inventory fell to below 5,000 tonnes. Now that's low!

And how to explain zinc's sudden tightening? Sure, LME stocks have fallen by around 150,000 tonnes from their July high of 894,825 tonnes but at 741,600 tonnes what sits in exchange warehouses still represents 28 days worth of global usage.

It's not exactly a pinch point and cash tightness in zinc seems as unlikely as in the aluminium market with its four million plus tonnes of LME inventory.

THE MISSING LINK

Aluminium of course provides the clue as to what also connects nickel, zinc and lead in terms of tight spreads. All that aluminium sitting in LME sheds hasn't prevented periods of front-month tightness because most of the metal is locked up in financing deals.

The available pool of liquid stocks, in the form of free-float warrants, is a fraction of the total stocks picture and, as is now well known in the aluminium market, largely concentrated on just one location, Detroit.

So how much zinc stock is really available to the market? It's impossible to say, but as with aluminium high stocks have pushed the forward curve into persistent contango, which is one of the building blocks of the stocks financing business.

One of the noticeable features about copper over the same time period is that the forward curve has remained in backwardation, rendering stocks financing a non-starter. As for tin, the market is too small and LME inventory too negligible for stocks financing to be a viable option. It is indicative of the upside-down financial world we live in, characterised by ultra-cheap money, that tightness is most common among those metals carrying the highest inventory.

But understanding that tightness is highly problematic because the market lacks the one key bit of information that would explain it, namely how much metal in LME warehouses is really available at any one time.

LENDING GUIDELINES OUTDATED?

This is not just a question of visibility or the lack of it in LME stocks. The LME's lending guidance, which determines how cash date tightness is managed, is also based on stocks. Dominant positions on the exchange are calculated as a ratio of warrant, cash-date and tomorrow-next date positions to "live" tonnage in LME warehouse.

Right now there are close to 700,000 tonnes of "live" LME zinc warrants. But "live" doesn't mean that they are available to the market. What's available is the free-float total, which only the LME compliance department knows.

Maybe it's time for the LME to have another look at how it calculates what constitutes a dominant position. It's not as if this stocks financing business is a temporary blip and with more and more of the big financiers getting into the warehousing business it may prove to be a lasting feature of the market, even under a fast-receding scenario of "normal" interest rates.

At the very least some more transparency would be useful to short position-holders before they learn the hard way in the form of unexpected because unforeseeable front-date tightness.

Ends --

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

The views expressed here are his own.