Aluminum is the metal of choice for investors
Normally, base metals like steel, iron, and aluminum are dependent on market economies. This means that their prices are guided by the demand and supply scenario in the market. Aluminum has become a favorite for investors who want to diversify their portfolios. After the global recession, it’s emerged as a hard asset. Last year, aluminum was the most actively traded metal on the London Metal Exchange.
What drives financing deals for aluminum?
Aluminum prices have been trading in contango, which means that future prices have been trading at a premium when compared to spot prices. The chart above shows the difference between spot prices and prices for a one-year future aluminum contract. As you can see, the future prices exceed the spot prices by a big margin.
The financing deals involve buying the near delivery while making a forward sale. This generates an arbitrage profit, equaling the difference in the two contracts’ prices. As evident, the higher the difference between the two contracts, the higher the profit potential in the transaction. The low interest rate scenario pushed a lot of investors around the world and also arbitrageurs to this market. As per estimates, half of the demand in aluminum has been due to these financing deals.
How long can the party continue?
Almost five million tons of aluminum are lying in warehouses approved by the London Metal Exchange. A lot of these warehouses are owned by companies like Morgan Stanley (MS), Goldman Sachs (GS), and JPMorgan (JPM). To give a gravity of the situation, this quantity is enough to make more than 70,000 aircrafts.
One of the key reasons for such transactions has been the low interest rate regimes and quantitative easing, which made financing such transactions quite cheap and easy. With the Fed announcing tapering and with interest rates expected to go up in the near future, this money-minting machine is expected to turn off.
As the previous chart shows, the difference between spot and future price is down almost to 2% this year. The narrowing difference will drive away a lot of speculators from the market and can negatively impact the aluminum prices. This will also impact aluminum demand. Companies like Alcoa (AA) and Century Aluminum (CENX) and ETFs like SPDR S&P Metals and Mining ETF (XME) will be affected.