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SUNESIS CAPITAL

Confidential Draft

Bank Holding Companies


Manipulation of Aluminum Prices
13

January 2014
Bank control of physical commodities and related businesses raises conflict of
interest, safety and soundness, and market concentration concerns, including
how that activity could affect commodity prices or lead banks to disadvantage
their customers or competitors.
- Senator Carl Levin

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Executive Summary
Key Takeaways

Aluminum Prices Are Prone To Manipulation


The U.S. price of aluminum, referenced as a floating price in the vast majority of
industrial contracts, has two components1:

LME Price

Midwest Premium

The LME price is determined by trading


on the London Metals Exchange. It is the
de facto international spot price,
referenced in many other deals.2

The regional Midwest Premium is the


additional cost that a consumer pays a
producer to deliver the aluminum, much
like shipping and handling.

Determined by the last bid/offer


during one specific five minute
trading session. Only 11 dealers can
trade in this session.3, 4

Determined by Platts, through a


daily survey of spot buyers and
sellers, using a representative
sample of producers, traders and
different types of end users.5

1. The majority of metal flows . . . via long term (generally annual) supply arrangements. Typically these arrangements will be referenced to average LME prices plus an
agreed premium. LME, Public Report of the LME Warehousing Consultation, November 2013, p.36.
2. Noranda. Form 10-K. 20 February 2013. p.6.
3. LME, Trading times and dates. http://www.lme.com/en-gb/trading/times-and-dates/
4. LME, Ring dealing members category 1. http://www.lme.com/trading/membership/category-1-ring-dealing/
5. Platts sets benchmark prices in various markets, including energy and metals. Platts, Methodology and Specifications Guide: Metals, p.2.
4
http://www.platts.com/IM.Platts.Content/methodologyreferences/methodologyspecs/metals.pdf

What Kind of Manipulation?


Submissions to Platts have been investigated for manipulation:
In September 2013, Platts was raided by European antitrust authorities
during an oil price manipulation investigation. Other targets were BP, Shell,
and Statoil.1
In 2006, the CFTC subpoenaed Platts during an investigation into whether
trade data submitted to Platts reflected manipulated prices. It noted that
McGraw-Hill [Plattss parent company] has publicly acknowledged that
some energy companies and individual traders have repeatedly attempted
to manipulate the price indexes produced by publishers such as Platts.2
In 2002, during another CFTC investigation regarding energy prices, two
power companies disclosed that some of their traders provided
inaccurate pricing information to Platts . . . .3
1.
2.
3.

Simon Falush and Douwe Miedema, U.S. Regulators In Talks With EU on Energy Price Probe, Chicago Tribune (Reuters), September 6, 2013.
Memorandum of Points and Authorities, CFTC v. McGraw Hill, 07 Civ. 00169 (RMU), April 30, 2007.
Staff Reporter, McGraw-Hills Platts Receives Subpoena About Energy Prices, Wall Street Journal, October 14, 2002.

Whats Getting Manipulated With Aluminum?


In theory, the Midwest Premium should never be more than the cost
to take delivery of metal bought on the LME, and producers/third
parties should compete to make the price even lower.

But when bank holding companies and trading


firms began to gobble up aluminum warehouses,
they could manipulate the system by which ALL
aluminum prices were set.

The Problem
Industrial Players Claim Inflated Aluminum Prices Are Caused by
Banks and Traders Warehousing of Metal

The premium structure, as we see it today, is a structure that is being driven largely by the
financing structure that we talked about that's in place today. Simply a fact that there is a
large sum of capital available in the world looking to purchase aluminum and stick it on the
ground and it's competing with the physical demand which is leading to the premiums being
driven up . . . .1
- Tim Reyes, Alcoas President of Materials Management

1. Alcoa 2012 Investor Day, Reuters Transcript, November 7, 2012, p. 18.

Industrial Buyers Are Angry


In 2013, a number of industrial buyers of aluminum complained:
The current system does not work. It has cost MillerCoors tens of
millions of dollars in excess premiums . . . . [L]ast year alone, the
[London Metal Exchange] warehouse rules have imposed an additional
$3 billion expense on companies that purchase aluminum."1
- Tim Weiner, MillerCoors Global Risk Manager

What was costing these buyers so much money?


The story begins in 2009
1. Testimony of Tim Weiner, Hearing on: Examining Financial Holding Companies: Should Banks Control Power Plants, Warehouses, and Oil Refinieries, Senate
Committee on Banking, Housing, and Urban AffairsSubcommittee on Financial Institutions and Consumer Protection, July 23, 2013. Available at
http://www.banking.senate.gov.

An Aluminum Surplus
In 2009, during the economic crisis, aluminum producers were making
more aluminum than they could sell to industrial consumers.
But they found unexpected demand for the metal from speculative
financial players trading on the London Metal Exchange, a global
market for aluminum. So they put the aluminum into warehouses and
sold it on the Exchange.

2009
Aluminum
Producers

Industrial
Users

Warehouse

Speculative
Demand

In 2009 the aluminum market had a surplus of over 2.3 million metric tons. (Loyd OCarroll, Quarterly Aluminum Outlook, The OCarroll Aluminum Bulletin.
Davenport & Company. June 27, 2013). See also Jack Farchy. Metals Warehouses: Storage Stacks Up For Traders, Financial Times, July 17, 2012.

Growing Financial Demand


And as financial demand grew, financial players bought up warehouses to store
the metal as well.1
[B]ig banks, financing companies and warehouses...are not able to
get their huge tonnage of metal fast enough2
- Chris Evans, LME Manager of Business Development

2010
Aluminum
Producers

New Financial Demand


Due to Advantageous
Funding Costs

Industrial
Users
Warehouse

1. Jack Farchy, Metals Warehouses: Storage Stacks up for Traders, Financial Times, July 17, 2012.
2. Pratima Desai, Goldmans New Money Machine: Warehouses, Reuters, July 28, 2011.

10

The Result is a Massive Financial Stockpile


Macquarie Research estimates total current aluminium stock
to be 11.9 million tonnes (October 2013 Commodities
Research). This includes both LME and off exchange metal.
The LME currently has 5.4 million tonnes of aluminium onwarrant, which implies that an estimated 6.5 million tonnes of
aluminium is being held off warrant.1
For comparison purposes, 2011 primary aluminum production
in the U.S. was 2 million tonnes and demand was 3.5 million
tonnes.

1. LME, Public Report of the LME Warehousing Consultation, November 2013, p.12.

11

Two Questions
Why did banks and traders suddenly buy
LME warehouses in 2010?

And how have their warehouses


increased the price of aluminum?

12

Aluminum Financing Trades


Banks and Other Commodities Traders Buy Metal and Buy
Warehouses to Engage in Speculation and Arbitrage

13

London Metal Exchange


Traders participate in the aluminum trade through the metals
global market, called the London Metal Exchange or LME.
LME: an exchange for spot metal and derivative
contracts; used by industry to hedge and traders to
speculate. It publishes metals prices used in contracts
around the world.
When spot metal is traded on the LME, the physical metal does
not change hands. Instead, an LME warrant (essentially an
official ownership title) is the means by which a batch of metal
is delivered. Actual delivery occurs in only a very small number
of trades.
Notably, most aluminum is not bought through the LME.
Industrial consumers purchase the metal directly from
producers.

14

LME Warehouses
Aluminum traded on the LME (e.g. delivered at the end of an
LME futures contract) has to be kept somewhere.

LME Warehouse: a private warehouse approved by the


LME to inspect and store metal traded on the exchange.
Aluminum warehouses are located where there is supply,
demand, logistical support, and space. Major warehousing hubs
are Detroit, MI and Vlissingen, Netherlands.
The aluminum warehousing system should make the LME a
physical market of last resort and smooth out swings in
demand: with thin demand, extra metal can be sold into
warehouses; and in booms, needed metal can be found there.1
1. The warehousing system is not, however, suited to industrial buying because the seller of the metal delivers into the warehouse of its
choice. Therefore metal could wind up halfway around the world from the buyer.

15

Aluminum Futures Contracts


An aluminum futures contract is a derivative contract in which one party agrees
to sell aluminum to the other at a price agreed upon today, but with delivery and
payment occurring on a specified date in the future.
The party who agrees to buy the metal at the delivery date is the buyer of the
futures contract, and is said to be long on the trade.
The party who agrees to sell the metal at the delivery date is the seller of the
futures contract, and is said to be short on the trade.

The Players
Buyers and sellers generally fall into one of two categories: Hedgers and
Speculators. Hedgers, typically industrial players, are aluminum buyers or
sellers, and they trade futures to protect themselves against price fluctuations
that could hurt business. They seek to lock in future prices to eliminate risk.
Speculators, typically financial players, are not net buyers or sellers; instead they
are betting on future prices going up or down and will seek to turn a profit.
Either party may sell their position to a third party in order to exit the contract.
16

Aluminum FuturesA Simplified Hypothetical


Today, say aluminum costs $1800/mt. No one is certain what it will cost in six months.
A can maker knows it must buy more
aluminum in six months. It is concerned about
significant price increases, and the damage
they could cause to its business. To eliminate
risk, it offers to buy a futures contract for
delivery in six months for $2000/mt, locking in
a higher but fixed, riskless price. The can
maker is a hedging buyer of the contract.

Risk

A trader does not need to sell aluminum in six


months, but it believes the market price of
aluminum on the delivery date will be less
than the $2000/mt the can maker is willing to
pay, and it wants to take a bet on this belief,
profiting if correct, losing money if wrong. So
it agrees to sell aluminum to the can maker in
the future. It is a speculative seller.

In six months, at the delivery date, say aluminum costs $1900/mt.


The trader goes to the spot market and buys aluminum for $1900/mt, and then sells it to the can
maker for the agreed-upon $2000/mt, turning a $100 profit. Though the can maker pays higher than
market prices, in return it has eliminated all risk that prices would move the other way. The
speculator, in return for taking on risk of loss, gets a chance to profit. The exchange of risk allows both
parties to get what they want. The reason only the seller assumes risk stems from the fact that the
seller, unlike the buyer, will be exposed to the spot price of aluminum. If that spot price is lower than
the futures price, it wins. If higher, it loses. The buyer, however, because it must acquire aluminum,
will take the aluminum at the delivery date, and will not be exposed to the future spot price.
17

Aluminum Contango
Buyers who want aluminum in the future would prefer to have sellers store it
until delivery. This generally makes it more expensive to order for future delivery
than to order for immediate delivery, and creates a contango.

Contango: when the futures price of a commodity is


greater than todays spot price.1
Price to have
delivered in future

Price to take
home today

1. The term contango is sometimes used to mean different, but related, things. For an excellent explanation, see Khan Academys videos starting at
https://www.khanacademy.org/economics-finance-domain/core-finance/derivative-securities/forward-futures-contracts/v/contango
Data from LME (www.lme.com). The curve shown is for September 22, 2013. Historical data on LME prices before 2013 is not freely available.

18

Contango Arbitrage
An arbitrage is possible: a trader simultaneously buys aluminum at the lower spot
price and sells it for delivery in the future at the higher futures price. The
difference, or spread, in prices creates revenue.
Buy at the low
spot price

Warehouse the Metal

Sell at the higher


futures price

Revenue

As long as the traders expenses to hold the metal during the life of the futures
contract are less than the spot-future spread, the result is a true arbitrage:

Riskless Profit

19

Contango Arbitrage Expenses


Expenses to arbitrage contango generally fall into three main categories:
Financing Interest: To make the arbitrage worth it, traders have to buy a lot
of metal. This is a big up-front cost, so they typically buy the metal with
borrowed money. The interest due is a contango expense.
Storage Rents: Arbitrageurs need a place to keep the aluminum after they
buy it, but before they deliver it in the future. They typically store the
aluminum in a warehouse, which charges rents.
Insurance Premiums: To protect their investment, arbitrageurs buy
insurance against theft of or damage to the metal. This requires payment of
premiums.

20

Contango Arbitrage Expenses


In theory, the contango spread between a spot price and a futures price should
only be as big as the costs of holding the metal until delivery:

Contango Spread financing + storage + insurance


This is because if the spread ever increases above these amounts, an
arbitrageur will step in and buy spot aluminum and sell futures. This drives up
the spot price and brings down the futures price until the contango is no longer
profitable. An equilibrium should be created by arbitrageurs.

But not all arbitrageurs are the same.


21

Contango Expenses: Financing


For banks like Goldman and JP Morgan, financing interest expense is
negligible because they borrow at less than 1% interest.
Expenses with
Bank Borrowing

Expenses with
Commercial
Borrowing

Storage
55%

Profit
1%

Storage
55%

Profit
24%

Financing
36%

Financing
13%

Insurance
8%

Insurance
8%

Storage is assumed to be 50% of the published LME rate. At the full storage rate, the trade is not profitable. See Lloyd OCarroll, Stock Financing Presentation at CRU North
American Trends Conference 2013, March 12, 2013. OCarroll assumes a $148/mt contango, LIBOR of .81%, commercial borrowing of 2.31%, insurance of $12/mt, half-price
storage costs of $82/mt, and self storage costs of $33/mt.

22

Contango Expenses: Storage


And if the arbitrageur buys the warehouse and therefore stores the metal
at cost, storage costs are greatly reduced, making the contango trade
even more profitable.
Bank Borrowing, Third-Party Storage

Storage
55%

Bank Borrowing, Self-Storage

Profit
24%

Profit
56%

Financing
13%

Insurance
8%

Financing
13%

Storage
22%

Data from Lloyd OCarroll, Stock Financing Presentation at CRU North American Trends Conference 2013, March 12, 2013.

Insurance
8%

23

Purchase of Warehouses
This is just what they didall in early/mid 2010.

1. Javier Blas, Goldman and JP Morgan enter metal warehousing, Financial Times, March 3, 2010.
2. Jesse Riseborough, Glencore To Buy Pacorinis Metal Warehousing Business, Bloomberg, August 2, 2010.
3. Pratima Desai and Veronica Brown, Trafigura Buys Metals Warehousing Company NEMS Ltd. Reuters, March 1, 2010.

24

Goldmans LME Warehousing in Detroit


In the U.S., nearly all LME aluminum is in Detroit.1,2 And in Detroit, nearly
80% of LME warehouses are owned by Goldman Sachss subsidiary, Metro
International.3

29

1. Lloyd OCarroll, Metals: Proposed LME Rule Change No Obstacle to Our Bullish Physical Premiums Outlook, Davenport. July 22, 2013.
2. Ian Bremmer, Finance Deals Put Growing Mountains of Metal Out of Reach, Reuters, February 21, 2013.
25
3. LME Active Listed Warehouses, September 18, 2013. http://www.lme.com/~/media/Files/Warehousing/Approved%20warehouses/LME%20listed%20warehouses.pdf

Glencores LME Warehousing in Vlissingen


The other major stock of LME aluminum is located in Vlissingen,
Netherlands. There, Glencore, a major commodity trading and mining firm,
owns 96% of LME warehouses though its subsidiary, Pacorini Metals.1

54

11

Other
1. LME Active Listed Warehouses, October 16, 2013 (see previous slide).

26

Goldman Owns Metal and Warehouses?


LME rules require that warehouse companies cannot own metal or trade on the LME.1

But

-Technically Compliantbut violates the spirit of the rule

$$

$$

Warehouse

Aluminum Storage

J. Aron
Goldmans
commodities sub.

We think that it is no accident that the bulk of warehousing space is now owned by banks or
commodity traders who conduct stock financing both for their own account and for clients.
(Stock financing at a conglomerate such as Goldman or Glencore must be transacted at
subsidiary other than the warehouse, since warehouses cannot own metal under LME rules.)2

But because The Fed does not require disclosure by BHCs of ownership of physical
commodities, we cannot know the full spectrum of Goldmans trading activities.
1.
2.

http://www.goldmansachs.com/media-relations/in-the-news/current/goldman-sachs-physical-commodities-7-31-13.html
Lloyd OCarroll, Metals: Proposed LME Rule Change No Obstacle to Our Bullish Physical Premiums Outlook, Davenport, July 22, 2013.

27

Recap: Banks Low Costs = High Profits


Commercial loan, Third-party storage

BHC loan, Third-party storage

Profit
1%

Storage
55%

Profit
24%

Storage
55%
Financing
36%

Financing
13%

Insurance
8%

Insurance
8%

Bank loan, Self-storage

Profit
56%
Financing
13%

Lloyd OCarroll, Metals: Proposed LME Rule Change No


Obstacle to Our Bullish Physical Premiums Outlook,
Davenport, July 22, 2013.

Storage
22%

Insurance
8%

28

Warehouses Allow Manipulation of Perceived Supply


Aluminum sitting in warehouses generally falls into three categories:
On Warrant: This means the metal is warranted, sitting in an LME warehouse, and can be
traded on the Exchange. The LME reports this tonnage daily.
Cancelled Warrant: A metal owner can cancel its LME warrant, which then becomes no
longer available for trade on the LME. The metal sits in the LME warehouse until removed
by the owner or re-warranted. This tonnage is also reported by the LME. Rents are highest
for this category of metal.

Off Warrant: Once the metal is removed from the LME system, it is no longer warranted
and falls into so-called dark inventory. We dont know how much dark inventory exists.

Importantly, warrant cancellation is viewed by the market as an indicator of


physical demand.1 This means that an ability to cancel a large number of
warrantswhich is reported publiclycan signal increased industrial demand.
However, the metal may never leave the warehouse. Cancelled metal can be rewarranted, indicating less demand. Or, it could simply be moved to dark
inventory, where its later use becomes unknown.2
1.
2.

MetalBulletin Glossary, http://www.metalbulletin.com/Glossary.html


Isabella Kaminska, The Curious Case of Un-Cancelled Warrants, FT Alphaville, June 2, 2011.

29

Warehouses Allow Manipulation of Perceived Supply


Owning an LME warehouse allows a metal trader to shift metal among these
three categories quickly and cheaply, thereby affecting perception of supply in
order to move the market to the traders advantage. The metal/warehouse
owner can switch the metals category near-instantly, and store it at cost without
ever having to actually move it out.1

On Warrant

On
Warrant

Dark
Inventory

The owner flips a switch


to reduce reported
inventory, and thus
drives up prices by
creating a perception of
reduced supply.

1.

Isabella Kaminska, The Curious Case of Un-Cancelled Warrants, FT Alphaville, June 2, 2011.

Dark Inventory

Only the
warehouse/metal owner
knows where this dark
inventory metal is.

30

Warehouses Allow Manipulation of Perceived Supply

So what the [Financial Times] is saying is that by canceling a few


warrants but not actually taking them out of the warehouse, or at
best simply moving them into a non LME warehouse the market is
being conned into thinking physical demand is picking up. When
enough people believe that to be the case guess what? Up goes the
price.1
This manipulation has a name: Painting the Tape2

1.
2.

Stuart Burns, When Cancelled Copper Warrants Arent What They Seem, MetalMiner, March 18, 2010.
John Dizard, FT: Copper Market Looking Tarnished, Financial Times, March 14, 2010.

31

Bottlenecks at the Warehouses


Goldman and Glencore Create an Aluminum Funnel at their LME
Warehouses

32

The Value of an LME Warehouse


When aluminum is traded on the LME, it is inspected and held on
warrant in an LME warehouse. Thus, arbitrageurs and other traders who
buy metal are forced into the LME warehouse system.1 This, as well as
reliability, should allow LME warehouses to charge higher prices.
To avoid paying higher LME rents over the course of a contango arbitrage
(which could last 16 months), arbitrageurs may buy the metal from an
LME warehouse, and then seek to cancel the warrant and move the
metal out to store more cheaply in non-LME warehouses. When the deal
closes, they return the metal into the LME system.

But Metro and Pacorini wouldnt let the metal leave.


1. Metal contracts on the LME can be settled only by offset (which is not suited to arbitrage) or delivery of LME warrants. See LME Rulebook, Sections 9.6 and 9.7. 20,
March 2013. Available at: http://www.lme.com/~/media/Files/Regulation/Rulebook/Full%20Rulebook/Rulebook%20as%20of%20March%202013.pdf.
On inspection of primary aluminum, see Rulebook, Part 6, Sections 1-6.
33

Warehouse Queues
Instead, they jacked up rents on metal on its way out, and then
delayed delivery of that metal. They delivered out only at the
slowest pace allowed by the LME: 3,000 mt/day.1

According to The New York Times, Metro would even deliver metal
from one warehouse to another, in order to game the system, and
keep the queues long and the high rents rolling in.2
Its like giving your keys to the valet attendant, but then watching
him shuffle your car from line to line instead of driving it to you.

So the queues grew and grew.


1. Andy Home, LME Versus LME Warehouses Round Three, Reuters, July 3, 2013.
2. David Kocieniewski, A Shuffle of Aluminum, But to Banks, Pure Gold, New York Times, July 20, 2013.

34

Warehouse Queues

The aluminum loadout wait time has increased about tenfold since Goldman bought Metro.1

1. David Kocieniewski, A Shuffle of Aluminum, But to Banks, Pure Gold, New York Times, July 20, 2013.

35

Warehouse Queues
Metro claims the queues are due to the difficulty in accessing metal
from within the warehouses.

But thats not what a former forklift team leader says:

Its all in rows. You can find and get anything in


a day if you want. And if youre in a hurry, a
couple of hours at the very most.1

1. Anthony Stuart, quoted in: David Kocieniewski, A Shuffle of Aluminum, But to Banks, Pure Gold, New York Times, July 20, 2013.

36

Incentives Artificially Distort Supply


At the same time, Metro paid incentives to aluminum producers to store
aluminum in its warehouses and sell into the LME, rather than sell to
industry.1
Industrial Fabricators

Aluminum Producers

Incentive payments were


as high as $145/mt, or
about 8% of the market
price of aluminum.1

Warehouse

LME: [I]t has become common practice for warehouse operators to offer incentives to metal
owners to attract load-in of metals, with such incentives being funded by the charges which will be
paid by the party subsequently acquiring that warrant on the LME.2 In other words, incentives are
funded by higher premiums.
1.
2.

Anne Riley, Aluminum Spot Premiums Reach Record Highs, American Metal Market, April 15, 2011.
LME, Public Report of the LME Warehousing Consultation, November 2013, p. 32.

37

Incentives
This creates a cycle.

Incentives

More
Speculation
& Storage

Speculation
& Storage

Slow
Delivery

More
Rent
Collected

More
Incentives
Paid

Slower
Delivery

Even
More
Rent
Collected

Even
More
Incentives
Paid

Even
More
Speculation
& Storage

etc
38

The Big Aluminum Funnel


The practical effect of these LME warehouse rules is to essentially create a
funnel, with a wide end at entry and a very narrow end exiting out . . . . Just
imagine a warehouse with a big garage door marked in and the small front
door of your house marked out.1
- Tim Weiner, MillerCoors Global Risk Manager

1.

Tim Weiner, Statement before Subcommittee on Financial Institutions and


Consumer Protection, July 23, 2013.

39

And Glencore/Pacorini Did The Same


Fresh material is being bid slightly because Pacorini are
paying big incentives to get metal there, in Vlissingen.
Then they deliver it to market and whoever holds it cant
actually get it for a year.1
--

1. Maytaal Angel and Melanie Burton, Glencore Profits From Metals Backlog in Dutch Port, Reuters Business, April 27, 2012.

London-Based Trader

40

The Results
Macquarie Research estimates total current aluminium stock
to be 11.9 million tonnes (October 2013 Commodities
Research). This includes both LME and off exchange metal.
The LME currently has 5.4 million tonnes of aluminium onwarrant, which implies that an estimated 6.5 million tonnes of
aluminium is being held off warrant. 1 For comparison
purposes, 2011 primary aluminum production in the U.S. was
2 million tonnes and demand was 3.5 million tonnes.
Aluminum inventories tracked by the LME have risen to their
highest level since September 2012, meaning even more
financing transactions are taking place.2

1. LME, Public Report of the LME Warehousing Consultation, November 2013, p.12.
2. Agnieszka Troszkiewicz, LME Aluminum Stocks Jump Most in a Year as Financing Continues, Bloomberg, October 17, 2013.

41

The Results
Inventories in Vlissingen alone (where Glencore, through
Pacorini, owns 54 out of 56 LME warehouses) are at their
highest level since at least January 1999.
As much as 80% of stockpiled aluminum may be tied to financing
transactions and is thus unavailable to consumers.

The October spread between the LME spot price and three
month futures price is $47. The spread was $50.65 in August, the
widest since November 2008, the height of the financial crisis.

All data from: Agnieszka Troszkiewicz, LME Aluminum Stocks Jump Most in a Year as Financing Continues, Bloomberg, October 17, 2013.

42

And Industry Is Angry About It


The situation has been organized artificially to drive [aluminum]
premiums up.
- Dave Smith, Coca-Cola Strategic Procurement Manager 1

U.S. benchmark physical aluminum price is $20 to $40 a tonne


higher because of the backlog at the Detroit warehouses.
- Nick Madden, Novelis Chief Procurement Manager2

1. Tatyana Shumsky and Andrea Hotter, Wall Street Gets Eyed in Metal Squeeze, Wall Street Journal, June 17, 2011.
2. Pratima Desai, Goldmans New Money Machine: Warehouses, Reuters, July 28, 2011.

43

But the LME Didnt Seem To Care


After numerous complaints, the LME decided in 2011 to increase the minimum load-out rate
from 1,500mt/day to 3,000mt/day starting a year later. But for industrial consumers this
was hardly a solution.
We believe a higher [load-out] rate is necessary . . . . We are also concerned
that this change will not take effect until April 2012. This unnecessary delay
will prolong anomalous pricing and supply chain issues for both manufacturers
and consumers in the market.1
The new rules were Too little, too late.2
- Nick Madden, Novelis Chief Procurement Officer

Could this have had anything to do with the fact that the
LME gets ~1% of the rents from storage? 3
1. Jack Farchy, LME Rule Disappoints Aluminum Consumers, Financial Times, July 15, 2011.
2. Jack Farchy, Delivery Curbs Spark Aluminum Price Row, Financial Times, June 21, 2011.
3. Pratima Desai, Goldmans New Money Machine: Warehouses, Reuters, July 28, 2011.

44

And Guess Who Owned The LME

10.8% stake
9.53% stake
In 2012, the LME was sold to Hong Kong Exchanges and Clearing. But before then, the
LME was owned by 92 banks, trading firms, and others.1

1. Andrea Hotter, Table of Key LME Shareholders Eligible To Vote On Sale, DowJones Newswire, June 15, 2012.
Jack Farchy, End Of An Era As LME Is Sold For 1.4bn, Financial Times, July 25, 2012.
Jack Farchy, The Challenge Of Selling The LME, Financial Times, March 9, 2012.

45

Goldman Had A Hand In It All


At one point in time, Goldman Sachs owned the metal, the warehouses that
held it, and the exchange that traded it.
Bank holding companies are not
required to report physical
ownership of commodities.
Therefore, we dont know how
much metal J. Aron or other
subsidiaries of Goldman actually
own.

J. Aron
Traded
13

46

Effect of Warehousing on Physical Market


Fabricators and industrial consumers generally do not buy metal
from LME warehouses. Instead, they get it straight from the
producerscompanies like Alcoa and Rusal.
Yet these buyers complain that warehouses actions have
increased the price of aluminum.
LME warehouses store only a small portion of the aluminum
available in the U.S., yet they seem to have a disproportionate
effect on its price. Why?
Lets examine the production chain
47

The Aluminum Production And


Fabrication Chain
The Price of Aluminum is Determined in a Complex and Arcane
Manner

48

Aluminum Smelting
Bauxite
Aluminum, a chemical element, is the most abundant metal on earth. Because it is highly reactive, it is
rarely found in its pure form. Instead, nearly all metallic aluminum is taken from an ore called bauxite.

Alumina
After bauxite is mined, its processed to extract alumina (a/k/a aluminum oxide, or AlO).

Aluminum
Alumina must then be reduced to elemental aluminum by removing the oxygen from the compound. This
requires an energy-intense smelting process. First, alumina is dissolved into another compound at about
1000F; then a strong electrical current in the presence of carbon produces a chemical reaction that yields
pure molten aluminum and carbon dioxide. Massive amounts of electricity are needed for this process, as
the electrical current both maintains the high temperature and drives the chemical reaction. In a single
smelting cell, hundreds of thousands of amps may be needed.
49

Aluminums Key Characteristics


Aluminum is used in vast numbers of products. The reasons it contains your
soda are the same reasons it contains you at 35,000 feet and 500mph.
Lightweight
Easily shaped into many forms, from sheets to wires to complex extrusion
profiles
Corrosion resistant and non-reactive (after outer oxidation)
Non-Toxic
Non-magnetic
Good looking
Good thermal and electrical conductor

Frequently, aluminum is alloyed with small amounts of other


elements to improve its properties, typically to make it stronger
while still keeping it lightweight.
50

Aluminums Industrial Supply Chain


Aluminum Producers
Producers turn bauxite into
aluminum. They shape the
metal into ingots and sell it.
They also produce
aluminum alloys.

Industrial Fabricators
Fabricators buy the aluminum
or alloy and shape it into
somethinga beer can,
aerospace sheeting,
extrusions, aluminum foil, an
Altoids box, etc

Industrial Consumers
Consumers buy the
fabricated aluminum to use
in their final products, like
aircraft, cars, soft drinks,
fences, appliances, and the
list goes on and on...

51

The Price of Aluminum: Midwest Price


The price of aluminum that underpins major, long term, industrial contracts
between an aluminum producer and fabricator in the U.S. is known as the
Midwest Transaction Price.1

Midwest Transaction Price


$
Aluminum Producers

Industrial Fabricators

But most aluminum contracts do not quote just a simple Midwest Transaction Price.
Instead, they break the price down into two more complex components . . .

1. Noranda, 10K for Year Ended 12/31/12, February 28, 2013, p.6.

52

Components of the Midwest Transaction Price


The Midwest Transaction Price of aluminum has two components:
one international and one regional.1

LME Price
The LME price is determined by
trading, mostly by hedgers and
investors, on the LME. It is the
de facto international spot price,
referenced in many deals.2

Midwest Premium
The regional Midwest Premium
is the additional cost that a
consumer pays a producer to
deliver the aluminum, sort of
like shipping and handling.3

Notably, both of these component prices move over time, meaning the Midwest
Transaction Price is a floating price during the course of the long term contract.
1. The majority of metal flows . . . via long term (generally annual) supply arrangements. Typically these arrangements will be referenced to average LME prices plus
an agreed premium. LME, Public Report of the LME Warehousing Consultation, November 2013, p.36.
2. Noranda, 10K for Year Ended 12/31/12, February 28, 2013, p.6.
53
3. Platts, Methodology and Specifications Guide: Metals, p.2. Web: http://www.platts.com/IM.Platts.Content/methodologyreferences/methodologyspecs/metals.pdf

Where Does The Midwest Premium Come From?


The Midwest Premium is calculated and provided by commodities
reporter Platts, a division of McGraw Hill that sets benchmark prices
in various markets, including energy and metals.

To calculate the premium, Platts conducts a daily survey of a handful of spot


buyers and sellersthat is, entities negotiating prices bilaterally, not tied to any
benchmark. Such entities represent the minority of buyers and sellers of
aluminum. Then, using this survey information, Platts calculates a single price for
the metal. The difference between this single, all-in spot price and the LME price is
the premium, which Platts then publishes. Platts will derive premiums for different
markets. The US premium is the Midwest Premium.

54

Where Does The Midwest Premium Come From?


So heres the hitch:
The Premium is derived from a small number of spot traders, who
may choose to report to Platts or not. But this premium affects a vast
number of long term industrial contracts that reference it.
Industrial Price = LME + Floating Premium

Platts survey
of some spot
transactions

Floating
Midwest
Premium

Zero transparency;
based on selfreporting

Millions of tonnes of
industrial metal is
pegged to this floating
premium and affected
by the Platts survey

55

Components of the Midwest Premium


Different factors affect the size of the Midwest Premium.
Its components may include1

Premium

LME

1.
2.

Prepaid Rent (for time in queue)


Load-Out Fee
Shipping Cost
Regional Supply/Demand

In the 11 quarters starting with the first quarter of


2011, Alcoa made $649 million more on premiums
than it would have made had premiums stayed at
their average (6 cents/lb) from previous years. Rusal
made an extra $790 million. Thats about a 60%
increase in premium revenue for each company.
Premium revenue at Alcoa, Rusal, and Rio Tinto
totaled $5.6 billion in 2011 and 2012.2

Lloyd OCarroll, Stock Financing Presentation at CRU North American Trends Conference 2013, March 12, 2013.
Matt Day, Alcoa and Rusal Are Beneficiaries of Warehouse Logjam, TheWall Street Journal, October 23, 2013.

56

Manipulation Involving Platts Is Possible


The process of setting a premium via a survey of traders, who have a monetary
interest in Plattss determination, seems arbitrary and ripe for manipulation.

In September 2013, Platts was raided by European antitrust authorities during


an oil price manipulation investigation. Other targets were BP, Shell, and
Statoil.1 In a private lawsuit in New York, defendants are alleged to have
deliberately reported inaccurate, misleading and false information regarding
Brent Crude Oil prices and transactions to Platts.2
In 2006, the CFTC subpoenaed Platts during an investigation whether trade data
submitted to Platts reflected manipulated prices. It noted that McGraw-Hill
[Plattss parent company] has publicly acknowledged that some energy
companies and individual traders have repeatedly attempted to manipulate the
price indexes produced by publishers such as Platts.3
In 2002, during another CFTC investigation regarding energy prices, two power
companies disclosed that some of their traders provided inaccurate pricing
information to Platts . . . .4
1.
2.
3.
4.

Simon Falush and Douwe Miedema, U.S. Regulators In Talks With EU on Energy Price Probe, Chicago Tribune (Reuters), September 6, 2013.
McDonnell v. Royal Dutch Shell PLC, 13 Civ. 7089 (S.D.N.Y., October 3, 2013) p.4.
Memorandum of Points and Authorities, CFTC v. McGraw Hill, 07 Civ. 00169 (RMU), April 30, 2007.
Staff Reporter, McGraw-Hills Platts Receives Subpoena About Energy Prices, Wall Street Journal, October 14, 2002.

57

And Even the LME Agrees

The Premium . . . is collected via survey pricing based


on transactions reported by market participants. This
process is, by definition, imprecise and potentially
inaccurate, and the resultant figures are treated with
suspicion by market participants.1

1. LME, Public Report of the LME Warehousing Consultation, November 2013, p. 40.

58

Aluminums Industrial Supply Chain


Like all supply chains, at each step, costs are incurred, and passed along the
chain. Each customer must pay back up the chain for value added.

Aluminum Producers

Industrial Fabricators

Industrial Consumers

$$

Midwest Price = LME + Premium

$$$

You

Producers charge fabricators for the raw metal. This is LME + Midwest Premium.

Fabricators charge industrial consumers for shaping and constructing the metal. Typically, fabricators use
pass-through contracts, meaning increases and decreases in the price of aluminum are passed directly to
the industrial consumer. (Without pass-through contracts, fabricators could not stay in business.)

Higher and lower costs of aluminum are either absorbed by the industrial consumer, or passed along to the
retail consumerYOU.
59

Warehouses in the Supply Chain


Warehouses can play a role in the industrial supply chain. Because of the
high energy and high quantities of molten metal in the smelting process, its
not cost effective to shut down smelters in temporary times of low demand.
So, instead, aluminum producers continue production but put the aluminum
in a warehouse and sell to investors. In times of high demand, the
warehouses are a source of extra supply.
Aluminum Producers

Industrial Fabricators

Industrial Consumers

Warehouse

Warehouses and investors function as a type of buffer, smoothing


out the effects of jumps and drops in industrial demand.
60

Warehouses in the Supply Chain


The warehouse also serves, in a sense, as a governor on the Midwest
Premium, and thereby the Midwest Transaction Price. Because if the
premium charged by a producer goes above the cost to remove metal from
a warehouse and ship it to final destination, a buyer would simply buy on
the LME and order from a warehouse, cutting out the producer altogether.

Warehouse
Aluminum Producers

$
Industrial Fabricators

Industrial Consumers

61

Warehouses in the Supply Chain

-BUTWhen warehouses began to pay incentive fees, jack


up exit rents, and vastly slow down exit times, their
aluminum funnel threw the whole system
off the rails.

62

Warehousing Leads to Price


Increases That Affect You
Warehouses Actions Have Increased the Midwest Premium in a
Few Ways, and These Increases Are Passed on to You.

63

Midwest Premium Has Doubled


The Midwest Premium has more than doubled since financial
holding companies bought LME warehouses.
Increase
of 106%

275

MW Premium ($/mt)

255
235

4/3/2013, 259.04285

215
195
175
155
135
115

1/6/2010, 125.66334

95

Data from Bloomberg

7/1/2013

5/1/2013

3/1/2013

1/1/2013

11/1/2012

9/1/2012

7/1/2012

5/1/2012

3/1/2012

1/1/2012

11/1/2011

9/1/2011

7/1/2011

5/1/2011

3/1/2011

1/1/2011

11/1/2010

9/1/2010

7/1/2010

5/1/2010

3/1/2010

1/1/2010

11/1/2009

9/1/2009

7/1/2009

5/1/2009

3/1/2009

1/1/2009

75

64

Increase in Premium: Less Supply


One reason for the increase in premium is that so much aluminum was taken
off the industrial market. Financial demand made aluminum scarce for
industrial producers, who had to pay more.

So the fact that the inventory


that exists today is not
available to the marketplace
largely is one of the reasons
that premiums are being
driven up as demand for the
product grows.1

1. Tim Reyes, Alcoa President of Materials Management, Alcoa 2012 Investor Day, Reuters Transcript, November 7, 2012, p. 18.

65

Increase in Premium: Less Supply


[T]here is a large sum of capital available in the world looking
to purchase aluminum and stick it on the ground and its
competing with the physical demand which is leading to the
premiums being driven up.1
- Tim Reyes, Alcoa President of Materials Management

There are still a lot of [industrial] customers that are short [of
aluminum]. I think they got lulled into sleep thinking theres a lot
of metal around, and theres not.2
- Aluminum Trader, quoted in American Metal Market

1. Alcoa 2012 Investor Day, Reuters Transcript, November 7, 2012, p.18.


2. Anne Riley, Aluminum Spot Premiums Reach Record Highs, American Metal Market, April 15, 2011.

66

Increase in Premium: Incentives


Because warehouses paid incentives to producers to place aluminum with them,
producers diverted aluminum to warehouses, even after 2010, when industrial
demand began to rebound. Warehouses bid up the premium paid above the LME
price; to compete with warehouses, industrial buyers had to pay more.

$$
Price pressure

Industrial
Fabricators

Aluminum
Producers

Warehouse
67

Increase in Premium: Incentives


Smelters continue to ship aluminum directly into London
Metal Exchange-bonded warehouses in Detroit in exchange
for incentives of as much as $145 per tonne, keeping new units
from reaching consumers directly.1
- American Metal Market

If I were a consumer Id be livid with Alcoa and Rio Tinto,


who continue to give metal to Detroit at $140 and say Screw
our customers.1
- Aluminum Trader, quoted in American Metal Market

1. Anne Riley, Aluminum Spot Premiums Reach Record Highs, American Metal Market, April 15, 2011.

68

Increase in Premium: Queues


And these incentive fees were funded by high rents collected while metal sat in
queues. While queues lengthened, the amount of rent paid while in the queue
increased eightfold.1 These funds were used to bid up premiums. Additionally,
higher costs for sellers pulling metal out of the LME could lead to higher spot prices.

$$
Price pressure

Industrial
Fabricators

Aluminum
Producers

$
Warehouse
1.

Financial
Buyers

Rent increased from $20/mt in April 2010 to $165/mt in July 2013. Lloyd OCarroll, Metals: Proposed LME Rule Change No Obstacle to Our Bullish Physical
Premiums Outlook, Davenport, July 22, 2013.

69

Increase in Premium: Queues


With intolerably long waits and high rents to take metal out of a
warehouse, the warehouse system no longer functioned like a
governor on the Midwest Premium, and instead pushed its
prices higher.

[T]he LME considers that . . . the fundamental role of


the queues is to increase premiums . . . . 1
[N]o manufacturing business can tolerate a 19-month delay between buying
metal and achieving delivery . . . . Novelis ruled out Detroit as a source of
physical metal in 2011.2
- Nick Madden, Novelis Chief Procurement Officer

1. LME, Public Report of the LME Warehousing Consultation, November 2013, p.6.
2. Jethro Wookey, Goldman Sachs Swap Offer No benefit to Novelis, Metal Bulletin, August 2, 2013.

70

Increase in Midwest Premium


Producers could charge industrial buyers whatever warehoused
buyers would pay, or more. So, while warehouses were directly
increasing rents for only a few, they were indirectly increasing prices
for everyone by bidding up premiums, increasing costs, and
restricting supply.
Although producers say they sell to consumers only, they are selling their
surplus metal into the [LME] market, benchmarked to the [incentive] paid
for metal in Detroit, which is around $140 a ton. This makes the market
one of first resort for producers, who can potentially play off consumers
against warehouses.1
-Andrea Hotter, Industry Reporter for Dow Jones Newswire

1. Andrea Hotter, Guide to Warehousing as LME Board to Discuss Potential Changes, Dow Jones Newswire, June 16, 2011.

71

And the Consumer Pays


$$

Price pressure

Aluminum
Producers

Industrial
Fabricators

$$$

Industrial
Consumers

$$$$
You

Higher premiums are passed down to the consumer.

$
Warehouse

Financial
Buyers
72

The Winners: Banks and Traders


By forcing high rents on LME holders of aluminum, the
warehouses owned by banks and commodities firms have:
1.

Made it less profitable for others to arbitrage contango, thus


increasing the spread between LME spot and futures prices (the
forward curve), and leaving the contango profit all to their parent
companies.1

2.

Driven up the price of industrial aluminum by causing increases in


the Midwest Premium.

3.

And collected more in rents.

1. The significance of rents is that the markets contango structure is impacted by the cost of storage in general, the greater the cost of storage, the more steep the
73
gradient of the forward curve. LME, Public Report of the LME Warehousing Consultation, November 2013, p.6.

The Winners: Banks and Traders


Additionally, through their superior information regarding
queues and premiums, and their ability to flip metal on and off
warrant, they gain an edge in the marketplace.
Merchants and brokers . . . do benefit from the existence of metals
premiums, as the more opaque nature of this market (in contrast to the onexchange nature of the LME price) conveys an advantage to the expertise of
merchants and brokers, who have built-up strong modelling capabilities
around premiums and queues[,] . . . render[ing] the LME market extremely
difficult for normal users to participate.

But the problem is that reporting requirements regarding


commodity holdings are lax, so we cant know the full benefit to
these financial players.
1. LME, Public Report of the LME Warehousing Consultation, November 2013, p.29.

74

The Winners: Industrial Producers


Warehouses accumulation of metal has provided a benefit to producers
companies like Alcoa and Rusal. First, they collect incentive fees to ship metal to
warehouses. Financing deals create demand, but the metal doesnt add to
industrial supply. Second, they charge industrial buyers more due to increased
Midwest Premiums referenced in long term contracts.
According to the LME, Particularly in the aluminium industry, smelters believe that
they benefit from the queues at the warehouses, as they associate these with
premiums, and hence a greater achievable price for their metal.1

According to The Wall Street Journal, in the 11 quarters starting with the first quarter of
2011, Alcoa made $649 million more on premiums than it would have made had
premiums stayed at their average (6 cents/lb) from previous years. Rusal made an extra
$790 million. Thats about a 60% increase in premium revenue for each company.
Premium revenue at Alcoa, Rusal, and Rio Tinto totaled $5.6 billion in 2011 and 2012.
Thats nearly double what they made in the comparable period through the first half of
2010.2
1. LME, Public Report of the LME Warehousing Consultation, November 2013, p.27.
2. Matt Day, Alcoa and Rusal Are Beneficiaries of Warehouse Logjam, Wall Street Journal, October 23, 2013.

75

The Winners: Industrial Producers


Furthermore, some industrial producers would rather see higher
premiums than higher LME prices, because some of their costs (e.g.
electricity) are tiedas a hedgeto the LME price.
Analyst: Whats better for your bottom line or profitabilitya $100 per ton increase in
aluminum price or $100 increase in premiums?
Chris Ayers, Alcoas President of Global Primary Products: I almost wonder if thats a
trick question . . . . There may be some components of cost that are attached to the LME.
So if we were to see movements in premium, I guess in an extreme case, you could draw
the conclusion that that would be a better movement for us.1

So it should come as no surprise that Alcoa and Rusal have


recently become vocal critics of LME proposals to change its
rules to reduce load-out times at warehouses.2
1.
2.

Alcoa 2012 Investor Day, Reuters Transcript, November 7, 2012, p. 24.


Jack Farchy, Aluminum Producers Vent Fury at LME Changes to Warehousing Rules, Financial Times, October 10, 2013.

76

And The Winners All Know Each Other


LME Aluminum Committee
Gavin Prentice
Gary Borner

Spectro Alloys Corp

Scott Bull

Pace Industries

Tristan Busch

Trafigura Beheer B.V. Amsterdam

Andrew Caplan

Glencore International AG

Steve Hodgson

RUSAL Marketing GmbH

Nick Madden

Novelis Inc.

Jean Marchand

Rio Tinto Alcan Inc.

Nicholas Martin

Norsk Hydro ASA

Michael Parker

Alcoa of Australia

Frans Pettinga

Koch Metals Trading Ltd

Wolfgang Zwingenberger

Audley Capital Advisors

Marcos Castro

The London Metal Exchange

http://www.lme.com/about-us/corporate-structure/committees/aluminium-committee/

77

And The Winners All Know Each Other


LME Warehousing Committee
Fabian Somerville-Cotton

ADM Investor Services International


Limited

Shon Loth

BTG Pactual

Charles Bucknall

North European Marine Services Ltd

Mike Dudley

International Commodity Services

Graham Hawkins

Henry Bath & Son Ltd

Chris Jonker

C. Steinweg-Handelsveem BV

David Lilley

RK Capital Management LLP

Simon Maddocks

CWT Commodities Pte Ltd

Thorleif Schjelderup

Hydro Aluminium

Brian Smith

Scotiabank

Peter Marc Waszkis

Pacorini Metals AG

Chris Wibbelman

Metro International Trade Services LLC

Marcos Castro

The London Metal Exchange

http://www.lme.com/about-us/corporate-structure/committees/warehousing-committee/

78

The Losers: Fabricators and Consumers


Fabricators take the first hit, as they have to pay the higher prices to buy aluminum.
However, many fabricators contracts with their buyers are pass-through contracts,
meaning the higher premiums are directly passed on in a higher price charged for
fabricated metal. But, a fabricator can still be harmed by lessened demand due to higher
prices, and can be crippled if it doesnt rely on pass-through contracts.

Industrial consumers on the other end of pass-through contracts must either eat the
higher premiums, or pass on the higher costs to their customersthe public.

Its no wonder then that Coca-Cola (a massive industrial


consumer and retail seller) has loudly complained to the LME
about warehousing delays.1
1. Tatyana Shumsky and Andrea Hotter, Wall Street Gets Eyed in Metal Squeeze, Wall Street Journal, June 17, 2011.

79

The Losers: YOU


Cars Paper Clips Toaster Ovens Fences Window Frames Car
Parts Beer Altoids Pill Bottles RVs Baseball Bats Hubcaps
Bicycles Macbooks Cookie Sheets Airplane Tickets Ladders
Hockey Sticks Soda Roofing Sliding Doors Bridges Telecom
Towers Bathroom Faucets Chewing Gum Construction
YouDeodorant
pay more
forEquipment
all sorts
of goods
.
Siding
Farming
Eyeglasses
Frames
Foil Antennas TV Dinners Refrigerators Wiring Spatulas
Screens Heat Sinks Paint Watches Flashlights Mail Boxes
Golf Clubs Staples Kitchen Sinks Patio Furniture Pots & Pans
Door Knobs Airplanes Trains Bug Spray Picture Frames
Refrigerators BBQ Grills Wind Chimes Phones CDs Canoes
Motorcycles Trash Cans Curtain Rods Batteries Water
Bottles Ships Buses Mirrors TVs Satellite Dishes Handrails80

The Losers: YOU


And to make matters worse,
its your tax dollar that is subsidizing banks
low borrowing rates.
You are paying for a system that turns around
and creates higher prices for the things you
buy.

81

(Lack of) Oversight


And the Federal Government Has Only Made It Easy for Banks to
Engage in this Behavior

82

Federal Funding
Bank Holding Companies access to the discount window means for the past 5
years they could borrow from The Fed for close to nothing. This safety net in
turns means their cost of borrowing from other banks is less than 1%.
(Today a 30 year mortgage costs over 4% interest.)
Metal is typically financed for one year at a rate just above LIBOR. In this cycle,
short-term interest rates (including one-year rates) have been extremely low,
approximately zero. In other words, there is almost no cost to finance metal. 1
- Lloyd OCarroll, Aluminum Industry Expert

. . . central bankers around the world have pledged unlimited


monetary assistance for the foreseeable future.2
- Lloyd OCarroll

1.
2.

Lloyd OCarroll, Metals: Stock Financing the Major New Factor Affecting This Aluminum Cycle, Davenport, June 25, 2012.
Lloyd OCarroll, Metals: Proposed LME Rule Change No Obstacle to Our Bullish Physical Premiums Outlook, Davenport, July 22, 2013.

83

Regulation
Since 1999, Banks have been permitted to engage in commercial
business under very wide and porous limits.

Curiously, between 2000 and 2012, the Board [of Governors of


the Fed] used its authority almost exclusively to approve
physical commodity and energy trading activities as
complementary to . . . trading in commodity derivatives.1
- Saule Omarova, Associate Professor, UNC

1. Testimony of Saule Omarova, Hearing on: Examining Financial Holding Companies: Should Banks Control Power Plants, Warehouses, and Oil Refinieries, Senate Committee
on Banking, Housing, and Urban AffairsSubcommittee on Financial Institutions and Consumer Protection, July 23, 2013, p. 5.
84

And Its Not Just Aluminum


Goldman Sachs, Morgan Stanley, and JP Morgan own various
metal stocks, power plants, pipelines, railways, mines,
warehouses, oil, gas, tanks, mixers, coal . . .

This expansion of our financial system into traditional areas of commerce


has been accompanied by a host of anti-competitive activities: speculation
in the oil and gas markets; inflated prices for aluminum and potentially
copper and other metals; and energy manipulation.1
- Sherrod Brown, U.S. Senator from Ohio

1. Press Release, At Senate Banking Hearing, Brown Presses Regulators on Bank Holding Companies Controlling Price and Supply of Physical Commodities, Effect on
Consumers and Manufacturers, July 23, 2013. Available at http://www.brown.senate.gov.
85

Opacity
But its very hard to understand all the repercussions.
[T]here is no meaningful public disclosure of banking organizations assets
and activities related to physical commodities and energy 1
- Saule Omarova, Associate Professor, UNC

[T]hese institutions are so complex, dense, and opaque that they are
impossible to fully understand . . . . Their physical commodities activities are
not comprehensively reported they are buried deep within various
subsidiaries . . . . Their specific activities are not subject to transparency and
are often buried in arcane regulatory filings. 2
- Senator Sherrod Brown

However, according to SEC Chairman Mary Jo White, the SEC is


examining these disclosure problems.3
1. Testimony of Saule Omarova, Hearing on: Examining Financial Holding Companies: Should Banks Control Power Plants, Warehouses, and Oil Refinieries, Senate Committee
on Banking, Housing, and Urban AffairsSubcommittee on Financial Institutions and Consumer Protection, July 23, 2013, p. 5.
2. Press Release, At Senate Banking Hearing, Brown Presses Regulators on Bank Holding Companies Controlling Price and Supply of Physical Commodities, Effect on
Consumers and Manufacturers, July 23, 2013.
3. Christian Berthelsen, Jamila Trindle, Dan Fitzpatrick, Senate Panel Opens Probe of Banks Commodities Businesses, The Wall Street Journal, July 30, 2013.
86

The End of Exemptions?


In 2008, Goldman Sachs and Morgan Stanley were given five years to
justify their commercial commodities business to the Fed.1 But weve
heard nothing since the clock stopped.
In September 2013: [f]or more than a year the Fed has been reviewing its
policy on banks role in physical commodities businesses . . . . [U]ntil the
central bank formally weighs in banks will be left in a sort of holding pattern.
Existing rules allowing banks to own commodities would remain in place until
the Fed acts.1
- The Wall Street Journal

1. Michael Crittenden, Fed Misses Perceived Deadline on Commodity Ownership Review, The Wall Street Journal, September 23, 2013.

87

Investigations
However, some in government have taken notice.
In August 2013, the Commodity Futures Trading Commission subpoenaed a
number of metals warehousing firms, including Goldman Sachs/Metro, JP
Morgan/Henry Bath, and Glencore/Pacorini. The subpoenas sought all
sorts of information, including anything that relates to moving metal
from one warehouse to another within the same company . . . and
procedures for loading out.1
Inside sources have also reported that the Department of Justice has
begun a preliminary probe into warehousing, including visiting at least one
warehousing firm in the U.S.1

These investigations suggest the government is examining two


potential lines of malfeasance:
Commodities Market Manipulation and Antitrust Activity
1. Josephine Mason, CFTC Subpoenas Glencore, Others As Metals Inquiry Heats Up, Reuters, August 12, 2013.

88

U.S. Senate Involvement


The Senate Permanent Subcommittee on Investigations
Run by Senator Carl Levin and known for its hearings on Wall Streets role
in the financial crisis, the committee has sought information in recent
months from JP Morgan, Goldman, and Morgan Stanley regarding their
commodities businesses.1

The Senate Banking Committee, Subcommittee on Financial


Institutions and Consumer Protection
On July 23, 2013, the subcommittee held a hearing entitled Examining
Financial Holding Companies: Should Banks Control Power Plants,
Warehouses, and Oil Refineries? Witnesses included Timothy Weiner
from MillerCoors, and Saule Omarova, a law professor at UNC Chapel Hill.
On January 15, 2014, it held a followup hearing entitled Regulating
Financial Holding Companies and Physical Commodities.

1. Christian Berthelsen, Jamila Trindle, Dan Fitzpatrick, Senate Panel Opens Probe of Banks Commodities Businesses, The Wall Street Journal, July 30, 2013.

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Finally, the LME is Doing Something


In November 2013, the LME issued a detailed report, in which it agreed
that the fundamental role of the queues is to increase premiums . . . .
So, it issued new rules to cut down on queues and reduce premiums.
They are:
Warehouses with queues over 50 days must load-out more metal than
they load in.
Re-warranted metal will not count as loaded-in metal.
The LME may compel warehouses to say how much they pay in incentives
and to whom. If they do pay incentives, the LME may impose higher loadout requirements.
LME may publish information about the metal in the warehouses.

LME, Public Report of the LME Warehousing Consultation, November 2013, p.76.

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Potential Legal Remedies?


Though Its Hard to See Into Such an Opaque System, Private Law
Suits Have Been Filed

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Private Legal Action: Antitrust


To date, more than a dozen cases have been filed against warehouse owners,
their parents, and the LME, alleging collusion and monopolization leading to
higher aluminum prices.
Benefit of an Antitrust Suit: Damages

If successful, a class of plaintiffs could receive treble damages and fees. This means
that a large potential class could receive from defendants 3x the total extra premiums
paid on metal purchased over the course of a few years.
Complication of An Antitrust Suit: Indirect Purchasing

A collusion/monopolization claim against Metro or Pacorini may very well succeed for
plaintiffs who stored aluminum in the warehouses and who allege that rents violated
antitrust laws. But this isnt a very big case. A big class suit would include all buyers
of aluminum, whether from a warehouse or not. But Metro/Goldman and
Pacorini/Glencore never sold aluminum.
To avoid such a complication, plaintiffs should emphasize that defendants used their
collusive/monopolistic power to constrict supply, whether owners of the metal or
not. Therefore, the complex detailing as to how premiums increased can wait for the
damages phase of the case (if it gets there).
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Private Legal Action: Antitrust


Further Antitrust Questions
State Suits by Indirect Purchasers: A number of states have antitrust laws that are
significantly more tolerant of indirect purchaser suits. This would make it easier for
industrial players down the industrial chain (e.g. Coca Cola, MillerCoors, Boeing) to
bring suit, or even for consumers to bring suit. However, such plaintiffs would still
eventually need to show how increases in rents and queues drive up aluminum prices
and hurt them.
State attorneys general could bring suit, putting their subpoena power to work.

LME Buyers: Do financial players, who were forced into an allegedly monopolized,
manipulated LME/warehouse system, have a good antitrust claim? Because they had
to buy metal on the LME, they found themselves at the mercy of the LME warehouses,
who could use their outsized market power to force delays and high rents.
What about claims against the producers?: Producers benefit from increased rents
and warehouse delays, because of the higher premiums and constricted supply; thats
why theyre very content with the status quo. But why has the market not found a
workaround for the inefficient and bizarre pricing methodology behind aluminum?
Why are producers often charging the same inflated price for metal (LME + Premium),
and not competing with each other? Is this just a version of conscious parallelism, or is
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something more going on?

Private Legal Action: Commodity Manipulation


The Commodity Exchange Act (CEA) makes it unlawful to manipulate the price
of a commodity and certain of its derivatives.
Benefits of a CEA Suit: No Need to Show Collusion, and A Wide Plaintiff Pool
A benefit to this type of suit over antitrust is that a plaintiff doesnt need to show
collusion or monopolization. Furthermore, anyone who traded in the commodity (or its
futures), and alleges damages from manipulation, generally has standing.
Complications of a CEA Suit
Proving market manipulation requires showing that a party specifically intended to
generate a price determined by forces other than supply and demand. Thus, a plaintiff
would need to show how Goldman and Glencore intentionally sought to artificially
alter the price of aluminum (rather than just collect higher rents). A motive is helpful
here, but its hard to pin down given the systemic opacity in the commodities business.
Perhaps the traders held stocks of metal outside the LME system, which it in turn could
sell for higher prices due to higher premiums? Perhaps owning a warehouse facilitates
the process of moving metal on and off warrant to alter prices?
Its unclear how futures contract holders have standing. First, LME futures do not
contain a premium component. Second, futures traded on the LME in London may not
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fall under the jurisdiction of the CEA.

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