Banks’ Role in Metal Trade Deserves Scrutiny

Are big U.S. banks colluding to drive up the price of a metal crucial to the production of everything from beer cans to airplanes? A first look at the empirical evidence suggests the possibility is worthy of authorities’ attention.

A number of large users of aluminum in the U.S., including the Coca-Cola Co. and MillerCoors LLC, allege that big banks -- some of which own aluminum warehouses and play a big role in the market -- have intentionally created bottlenecks, with the end effect of driving up prices and boosting their profits. In recent Senate testimony, MillerCoors estimated that the practice cost buyers of aluminum about $3 billion last year alone.

Some observers have suggested that the market dislocation could actually be the perfectly normal result of increased interest in aluminum as an investment. During the period in question, forward prices for aluminum were higher than spot prices, allowing investors to make a profit by buying aluminum now and contracting to sell it for future delivery. Such trades, the logic goes, tied up a lot of aluminum, naturally pushing up the price.

The debate centers on the role of a specific set of aluminum warehouses, which are located in the Midwest and part of a network approved by the London Metal Exchange. The LME warehouse system was set up to act as a buffer, absorbing aluminum when producers’ supply exceeded demand and releasing the metal in times of shortage.

Proper Role

The question is whether the LME system has been playing its proper role in recent years, particularly after a number of banks and trading firms -- including Goldman Sachs Group Inc., JPMorgan Chase & Co., Glencore International AG (now Glencore Xstrata Plc) and Trafigura Beheer BV -- gained control of a large portion of LME warehouses, including in the Midwest. According to aluminum buyers, the banks and traders have been preventing metal from leaving the warehouses, resulting in long waits for delivery, large storage fees and higher prices.

One way to begin assessing the warehouses’ role is to look at the relationship between aluminum prices and inventories. In a normally functioning market, higher prices should be associated with lower inventories, as warehouses release metal to satisfy demand or absorb metal when there is too much supply. That’s not what has happened since the financial crisis and especially after banks and traders got involved. Since 2009 (see chart), prices and inventories have risen sharply and simultaneously. Meanwhile, the warehouses in the Midwest have charged steadily increasing storage and transportation fees compared with the cash price of aluminum.

If the market for aluminum warehousing is competitive, why aren’t we seeing one of the warehouses undercutting competitors’ premiums? And with LME inventory having increased during the last four years to record highs, why can’t aluminum get out of the warehouses as quickly as it went in? One possible explanation is that the warehouse operators are indeed colluding to manipulate the supply of aluminum. Aside from collecting more storage fees and selling their stocks of metal at higher prices, the banks and trading firms could benefit through derivative positions and their influence on LME benchmark prices.

Even now, Midwest warehouse premiums remain high, despite a decline in aluminum cash prices. The warehouses share some of the premium in the form of incentive payments to producers, encouraging them to maintain production levels and making them less willing to sell directly to users such as Coca-Cola and MillerCoors.

Flawed Structure

What should be done depends in large part on what is really going on. U.S. authorities -- particularly the Department of Justice and the Commodity Futures Trading Commission -- must sort out whether warehouse owners have engaged in illegal behavior to keep inventories and premiums high. If the observed patterns are simply a consequence of a flawed market structure with inadequate incentives and conflicts of interest, further changes in the warehouse rules to ensure that aluminum is promptly delivered might suffice. If there’s more going on, the LME’s structure and governance may need an overhaul, and criminal prosecution may be required to make the bad actors change their ways.

(Rosa M. Abrantes-Metz is an adjunct professor at New York University’s Stern School of Business and a principal in the antitrust, securities and financial regulation practices of consulting firm Global Economics Group in New York.)