CRU Aluminum: LME Punts on Russian Metal, Private Companies Act

As a refresher, the LME asked for opinion on three options:

• Do nothing

• Impose limits on the warranting of new metal for delivery against the respective contracts. (This is about more than aluminum!)

• Prohibit new warranting altogether, or delisting of the Russian brands

The Exchange got 42 replies to its request for opinions. Twenty-two respondents said take no action, 17 wanted Russian material to be delisted, and two felt imposing limits was appropriate. One respondent elected not to choose of any of the 3 options.

Cynics would say the LME never had any intention of acting against Russia, preferring to wait for government and the private sector to do the heavy lifting.

Legal considerations tie the LME’s hands

In fairness, the LME faced serious legal exposure had it elected to limit Russian metal deliveries against the aluminum contract or the more drastic action of delisting Russian metals from the exchange.

Any decision by the LME would substantially diminish the commercial value of Russian metal. If lenders saw that Russian metal was no longer deliverable to the LME, it would mean the value of that metal as collateral on loans could evaporate. We all know that the minute banks enter a loan, they begin worrying about loan performance. IF the collateral were no longer fungible through delivery to the LME, the banks would have react as follows:

• Refuse to loan at all on Russian metal

• Reduce the loan to value ratio dramatically, requiring the borrower to use more of their own cash to finance their positions

• There would be a high probability that banks would call outstanding loans where borrowers had pledged Russian metal against the loan

These actions by the banks would effectively strangle Russia’s ability to conduct commercial trade. Comparisons can easily be drawn to the 2018 sanctions against Russia, when US Treasury restrictions shut off the tap on access to the SWIFT banking system.

Traders and consumers holding Russian metal would suffer significant cash flow problems if Russian metal would no longer fungible. Clearly, this would be most problematic for Glencore, which has a large and well-known contract with Russia.

There could also be collateral damage for anyone holding Russian debt on assets or bonds. That includes banks that may have been part of syndicates financing the new Rusal smelter being built at Tayshet, Russia.

It’s likely anyone with Russian exposure would sue the LME.

So, with the threat of litigation hanging over their head, we should not have been surprised that the LME has deferred taking any action. Instead, the LME will wait for protective cover from the US, EU, or other nations to impose sanctions on Russia on geopolitical grounds.

The geopolitical justification for sanctions is very sound

Frankly, it is hard to understand why the US and the EU are procrastinating on levying more substantial sanctions on Russia.

One theory that has been circulating: the US and the EU are concerned that sanctions would trigger a strong price response in aluminum, something that would create even more inflationary pressure. We clearly could expect a price response to sanctions. Just the rumor of US action several weeks ago caused the LME price to rise $100/ton overnight. But it is important to put this into context.

The LME aluminum price was threatening $4,000/ton in Q1 and Midwest physical premiums were approaching $0.40 per pound. Today, we are looking at $2,450 on the LME, and Midwest premium is just below $0.20 per pound.

An outsider looking at the aluminum price today would say, “What’s the problem? Your costs have fallen 39% on the LME and 50% on the regional premiums. Where are your damages?”

Sanctions are never easy to do. But if there was ever time for principled governments to act, now is the time.

Russia’s invasion of Ukraine is illegal, aggressive, and immoral. Their behavior easily falls into the same category as South Africa during the Apartheid era.

Consolidation from the LME Consultation, and more transparency on stock reporting

We believe the LME would act if they had the backing of government sanctions. The private sector, led by Alcoa and Hydro, are arguing forcefully for delisting Russia to avoid destroying the integrity of the LME aluminum contract.

The argument behind their case is that Russian metal has ceased to trade in “normal” commercial fashion. It is heavily discounted to entice physical consumers willing to accept Russia metal. As such, Russian metal becomes a “carve out” in many contracts. We saw this many years ago during the infancy of the Indian primary aluminum industry, when Indian quality was so bad that all contracts routinely stated, “Good Western brands excluding India.” There’s a good chance we are headed that direction with Russian metal.

The fact that Russian metal is now showing up in the LME is confirmation that these discounts are not sufficient to move the metal at current Russian production rates. When delivery to the LME at LME cash par value becomes the best option for a seller, you know they have completely lost the typical physical premium associated with regional dealings.

At that point, the LME runs the risk of being a dumping grounds for Russian metal that no one wants, and the value of the contract falls to its lowest common denominator – Russian metal. This is a big fear of all producers.

The LME has replied to this concern by publishing, for the first time, Russia’s share of stocks in the respective contracts as of October 28, 2022. They are as follow:

• Copper 58%

• Primary High-Grade Aluminum 17.7%

• North Aluminum Special Alloy 27.8%

• Aluminum Alloy 17%

• Nickel 0.5%.

The LME contrasted this reporting with stocks as of October 6, which showed relatively stable stocks. The exchange used this to rationalize the statement that Russian deliveries had NOT been that excessive and that the threat of dumping was not apparent.

This conclusion was premature. While deliveries during October appear to modest in aluminum, it also comes at a time when Russian continues to enjoy delivery options on existing contracts for 2022. The true effects of physical market self-sanctioning will not be tested until we get into 2023.

The ongoing threat of government sanctions is not going away, and it would be naïve to think that holders of Russian metal don’t have substantial stocks poised to go on warrant at LME warehouses if they get any inkling that sanctions are coming.

One of the few good things coming out of this consultation is that the exchange has pledged to start reporting brand holdings in the LME effective January 2023. This will give the market exceptionally good transparency into the Russian share of total stocks.

What is next?

The physical market is not waiting for the politicians or for the LME to act, they are forced to react now. In the past week, we have seen Platt’s seek consultation from the market as to whether they should begin to differentiate Russian prices from other “Good Western brands.” We believe that this will evolve as the market is openly reporting the heavy discounting in markets such as Mexico, Turkey, and Vietnam.

The US has now revoked Russia’s market economy status. which may be a preamble to tougher actions such as an outright ban.

Europe has a much more difficult path to navigate as it struggles to cope with its major smelter closures (more than 1.1 million tons = 16% of annual demand) and how to replace that supply. Cynics are saying, “Well, the reason you have lost the smelters is because of the Russian weaponization of its gas exports. When will you fight fire with fire and apply some punitive measures against them?” The problem is that Europe cannot fully replace some of the higher value Russian exports such as rolling slab and foundry alloys.

It may come down to the US applying pressure and yielding its big stick on the global banking sector. But the US will be listening to Europe carefully before acting unilaterally.

By Greg Wittbecker, Advisor, CRU Group, Gregory.Wittbecker@crugroup.com