FOCUS: Aluminum Rallies On Short Covering,Tied-Up LME Stocks

SYDNEY (Dow Jones)--Aluminum prices this week have confounded apparent market fundamentals, moving up on a powerful mix of short covering, rising energy prices and tighter-than-expected metal availability in Asia that could lead the market even higher. The move to a six-month high of $1,701 a metric ton appears to fly in the face of near-record London Metal Exchange stocks at 4.3 million metric tons, and plenty of spare production capacity that should cap any sustained price rally. "The market is heavily short. The rise in the oil price has moved the cost-curve up, prompting short covering and this is what's driving the aluminum price," said Macquarie Bank analyst Bonnie Liu. Aluminum is often referred to as "solid electricity" because of the vast quantities of energy it consumes, making the rally in New York Mercantile Exchange July crude oil futures to a seven-month high of $72.10 a barrel a key driver behind this week's 9% price hike. But market participants say that's only part of the story, with metal availability in Asia unexpectedly tight and access to LME on-warrant material difficult because it's tied up in warehousing and financing deals. Spot premia in Japan have surged to up to $130/ton, from $68-$78/ton last month. Talks to set third quarter aluminum premia for Asia between global producers and major Japanese consumers remain unresolved, but are expected to rise about 25% to around US$75/ton over the LME price. "LME warrants are available in North America, in Detroit and Chicago, but in Singapore and Korea it's very difficult to find material," said a Japan-based physical trader. More Than Half Of LME Stocks Tied Up Traders say more than half of LME stocks are unavailable due to warehousing and financing deals, a common practice that has become more prevalent due to tight credit conditions. Typically a warehouse will offer a preferential storage rate in return for leaving a sizable chunk of material on-warrant for six to 12 months. As long as the market stays in contango, traders are content to hold the metal in LME warehouses while rolling forward short futures positions and pocketing the difference between the higher futures price and the associated interest and storage costs. Off-warrant material is also being placed into LME warehouses as collateral in financing deals, again leaving the material effectively tied up. "Last year, a lot of producers couldn't access credit. So they put inventory on LME warrant as collateral for finance. It's effectively off-warrant material," said ANZ Commodity Strategist Mark Pervan, who believes only about 30% of LME stocks are available to the market. According to LME data that shows concentration of warrant holdings, there is one entity that holds between 40% and 50% of total LME warrants, cash today and cash positions. To get access to metal tied up in warehousing discount deals, buyers need to offer a sufficiently high premium to compensate for fees associated with breaking those contracts, which partially explains the pick up in premia and canceled warrants in the past few days, sources said. LME warehouse stocks fell 3,225 tons Wednesday to 4,274,550 tons with canceled warrants increasing by 7,250 tons to 116,950 tons. China Demand Strength Surprising The tightness has been exacerbated by traders in Japan and South Korea, who earlier this year when domestic demand was flagging and consumers were destocking took advantage of LME prices trading at a discount to the Shanghai Futures Exchange to re-export large quantities to China. Now that the destocking process has mostly finished, those traders are struggling to secure material. To make matters worse, aluminum supply from Russia, which usually supplies about 20% of the metal shipped to Japan and South Korea, has been much more scarce since UC Rusal decided to cut this year's output by 500,000 tons. At the same time, demand from China has stayed strong. Imports of aluminum and aluminum products during May stood at 331,740 tons, down on the month but still up massively from a year before. "Nobody saw this level of physical demand. Trading houses have agreed contracts to deliver metal into warehouses on preferential terms and now they have to stick to them," said a source at a LME warehouse in Singapore that is part of a company with branches globally. "Traders were assuming the Chinese off-take would stop, but that is not happening and that has created a lot of uncertainty," the source said.