The Hidden Shadow Warehouses and Base Metals

Normally, we do not comment a specific press article. However, after the Christmas holiday, the Wall Street Journal published an article titled “Millions of Tons of Metals Stashed in Shadow Warehouses”. The tenor of this article is that more and more metal would be stored in hidden warehouses not licensed by the LME and that statistics about LME warehouse inventories would be less useful. Furthermore, the article creates the impression that holding inventories outside of LME warehouses would be intended to manipulate the market by banks and hedge funds.

This article contains some errors and inconsistencies. The LME is not the only metal exchange, which has licensed warehouses officially. As long as aluminum futures were traded on the CME, this exchange also had licensed warehouses for that metal and reported inventories daily. Copper inventories continue to be posted daily on the CME website. The Shanghai Futures Exchange has also licensed warehouses and publishes the stocks. Last Friday, these inventories were 186.7 thousand tons of aluminum. Licensing by an exchange means that these warehouses are delivery places for the traded contracts at maturity. If a delivery is due, the seller may deliver the metal by warehouse receipt of an official warehouse. The buyer has no obligation to accept metal, which is not held at one of the official licensed warehouses.

Thus, the statistics about warehouse inventories held on warrant and cancelled warrants provides information about which quantities are available for delivering into the outstanding contracts, counted by the open interest. However, this is only a daily snap-shot. These statistics do not imply that the metal available for meeting delivery obligations in the future are limited as the inventories could increase by delivering metals held outside the official warehouses into the official stocks. Nevertheless, the exchange warehouse inventories provide a good indication about the scarcities of the various base metals.

The author writes correctly that the official warehouses of the metal exchanges are also deposits for non-registered metal stocks. In the industry, the term "crossing the line" is well known and expresses that through easy transport over a certain line of separation, the metal disappears from the statistics, although it has never left the warehouse. But if the metal has left the "official, segregated storage area", then it is no longer directly available for deliveries of exchange-traded contracts. Often, the warehouses providing a financial incentive by lower storage costs to the metal from the official to the unofficial inventory areas.

Unfortunately, the author fails to recognize, why the unofficial stocks have risen so sharply. Here the LME and the warehouses have a significant fault. The LME warehouses function more like a mouse trap. It is easy to get the metal into the warehouse. But, it could sometimes take several months for the holder of a warehouse receipt to receive her metal from the warehouse. For this waiting period, she must bear the storage costs also. Therefore, for consumers of these metals, the pressure has arisen to store more metal outside the warehouses of the exchanges in order to have the necessary flexibility to use the metal for the own production of goods. The LME management would have to solve the problem of long queuing times at their warehouses. Maybe the law suits filed in the US will speed-up this process.

Furthermore, producers and consumers will always hold some inventory outside the official warehouses. Models of inventory holding like the Baumol model also can explain the rise of off-exchange warehouse stocks to some extend by rising global GDP and lower interest rates due to the zero interest rate policy followed by major central banks.

The problem with the so-called shadow storage is an essential one for analysts, who analyze statistics of production and consumption and derive forecasts for price developments from this data. The production figures can be estimated reasonably well. Sometimes this data will be published by national statistical offices. Analysts can also poll mining companies about their production estimates. Nevertheless, also production figures were revised even several years later and thus, have a degree of uncertainty, which should not be neglected. However, for consumption statistics the picture looks completely different. There are no reliable official statistics of metal consumption. Also polling companies using base metals as an input in the production of goods is a mission impossible given the sheer number of companies in the metal processing industry on a global scale.

Therefore, statisticians apply an auxiliary construct that is referred to as apparent consumption. The changes of the inventory holdings are subtracted from the production and the difference is considered as consumption. Therefore the better the actual changes in inventories are recorded, the better consumption could be estimated. If the change of inventories is underestimated, then the consumption is overestimated necessarily and vice versa. Thus, the disadvantage of this approach is a high degree of uncertainty about the effective consumption of base metals. Figures are revised still many years later. Furthermore, it is possible that revisions of data lead to changes in the supply/demand balance by the pen of the statisticians. It had been the case that the market had expected a supply deficit (surplus), but final figures showed a supply surplus (deficit).

This problem of data revisions has considerable implications for quantitative modelling of base metal price developments. Metal prices are based on the information available at the time of trade. If this information is significantly different from ex-post information used in modelling, then the estimates are distorted and could lead to erroneous conclusions. As data about inventories in exchange warehouses is available in a timely manner and is not subject to revisions, it is still preferable compared to estimates of the supply/demand balance.

For some base metals there are international organizations such as the International Aluminum Institute or the International Copper Study Group. These institutions also estimate the total inventory changes, whether held in private storage outside of exchange warehouses or in public strategic reserves. They publish this information on a monthly basis, although the statistics are published with a usual time lag. The stocks in the warehouses of the exchanges, however, are available the next morning.

The author also touches the area of inventory financing. In a number of articles and comments of analysts, the use of existing stocks as collateral for loans is discussed. In some of these articles, the impression is created that the metals are purchased solely to obtain a loan. This is only useful if there are opportunities for arbitrage, which should be exploited without the use of own funds. However for consumers the situation is different. They need to hold stocks for current production as just in-time production is not always possible. This inventory holding ties up capital. And since in many jurisdictions, equity is more expensive than debt financing due to tax treatments, it makes sense to fund the inventory holdings by a bank loan and to use the metal as collateral for the credit. But consumers will only hold higher inventories when they expect also an increase in demand for their products. However, normally consumers would not hold those inventories at exchange warehouses.

For producers, the situation is also different. If a market is in backwardation, they can sell their production of refined aluminum or copper at the spot market. However, if the market is in a contango situation, then it might be a better strategy to deliver the metal into exchange warehouses and to sell the corresponding number of futures contracts. Selling the metal in the spot market would depress prices even further and might lead to a less favorable price for the producer. However, if the producer needs funds, he could obtain a bank loan against the warehouse receipt as collateral.

For many base metals, inventories held in exchange warehouses declined from the peaks reached in 2013. If this metal all went into the “hidden shadow warehouses”, then the exchanges and the LME in particular should be worried and should take measures to reverse this development. The exchanges could also demand from the warehouses to provide figures off metal inventories outside the official zone at those warehouses. However, with respect to the development of global PMI indices, the decline of inventories at exchange warehouse might be more a reflection of a stronger global economy.