lme warehousing
Anyone willing to explain basics of how physical traders interact with LME warehouse?
I'm quite confused. If we can buy contracts and take physical deliveries, why don't we also sell the futures and deliver directly to warehouse/take it to expiry? So we don't even need customers and can just lock in our spreads and deliver to the warehouse on settlement? Or is it because, if you sell to LME, you don't get a premium?
Sorry if stupid question just can't seem to find anything online.
Good question. If you sell a regular LME contract to expiry and deliver to the exchange you get the LME with no premium. So if spreads are in a backwardation and physical prems are small, you might be tempted to deliver. But when prems are elevated that is pretty much the last thing you would want to do unless the backwardation is absolutely huge.
The exchange is the buyer of last resort, otherwise as you say, why even bother with customers and suppliers?
"So if spreads are in a backwardation and physical prems are small, you might be tempted to deliver."
Is this because we have an open short LME position, so if market was in backwardation, we would have to roll our hedge by borrowing forward, causing a spread loss. However, if there was a contango and premiums are small, we could actually make a gain by borrowing. The risk is that no one knows if premium might become even smaller in the future, so potentially you sit on inventory a long time.
Also,
If you don't mind answering hopefully a related simple question about the LME official cash price. I'm a little confused and I don't know if it's me or LME but their explanations often imply you already know half of everything... I understand that each day the second ring establishes a price used to price the physical industry/contracts. But this DOESN'T mean that the "trading" price can't differ right? So for example, if it's Monday and we're trading the Wednesday prompt for copper, and the "official price" comes out around 12:35 at $2500, there is still room for fluctuation for that Wednesday prompt right, eg. it could end up at $2530 or $2495 at 19:00 when electronic trading closes? But for a brief second/minute at 12:35 both the reference price and the "traded" price are the same? So if we were pricing a copper purchase today, and had entered a hedge a month ago at $2000, we could potentially have unwinded that hedge at exactly 12:35, so that our physical purchase price and financial sell price cancel each other out. Or, we could wait till say 3pm to unwind it, and potentially expose ourself to a little bit of variation?
Yep that’s absolutely the logic on borrowing which you will have to do to roll a hedge on any physical inventory you hold. Prems are at risk of declining in backwardations because weaker hands are tempted to sell if the pain of borrowing is too great. Note that a lot can go into prems so the correlations on that is far from perfect. But prem is essentially: reference market supply/demand + logistics + spread impact. Wouldn’t consider financing too relevant given how different the cost is for different players and how low rates have been for the past 12 years.
For your second question you can settle things against the official, that number that is reached in the ring is essentially the netting out of the orders settling against that day’s cash number. No risk there unless you told your counterparty you were settling against the cash price but then didn’t put an order for that in, which is not a great idea. Of course you can take a view on price but that’s probably not the best avenue for that.
One more for you on metals if that's ok.
I've been reading that trade firms tend to hedge most of their flat price risk, or at least claim to do so. I'm a little confused how that works on for example, a five year supply deal/offtake. Assuming there is such a thing as a typical trader, would hedging in this case mean at the very moment they enter the contract on say January 2020, they go out and buy the relevant LME months + sell the LME months they intend to deliver? My hunch is no (just because that feels "too simple"), so maybe for the offtake in May 2021 they would wait till March 2021 to lock in prices, etc., instead of doing it when they sign the deal on say January 2020 etc. In which case for this trader, they would be exposed to flat price for a certain period of time for this long term deal basically?--in other words, they're not really completely hedged all the time, they're just "eventually hedged" for all sales/purchases?
I get that it's probably more complicated/variable, but I just wanted to get a sense of whether I'm thinking in the right direction. Thank you!
You hedge on the reference price you are buying at. So if you have a 5 year deal pricing on the average of month of delivery that goes from 2021 through 2025, you would hedge your December 2025 metal in December 2025 (selling the pro-rated tonnage every day on the cash settlement to average it out). You then roll your position until you sell your physical and thus buy futures, closing out your position.
Of course you probably have multiple purchases and sales going on at the same time so you have to net that all out.
You could fix one price for the whole deal but for a decent size deal going that far out, that will represent major slippage given liquidity and more importantly a lot of credit/performance risk. If your supplier’s mine or plant blows up in year 1, you have a massive open short. All good if the market’s down but if it’s up a lot you and probably your firm are goners. Even the margin payments could become a problem for a position that big.
Thanks for your patience. Almost cried when I saw your answer but I'm glad because I after rereading I think I'm starting to see where I'm getting confused (posted another huge thread recently and got quite beaten down).
I've been under the impression that "hedge" means, for example, ON Jan 2020, for the Jan 2025 quota/purchase, we buy the LME expiring in Jan 2025 and simultaneously sell the LME expiring in the month you expect to sell, say March 2025. That lets you lock in a contango spread. I had previously thought what you said about "hedging against the reference price in 2025" is actually UNWINDING this action in Jan 2020, so that you pocket the "buy" part of the borrow. Then in March 2025 you repeat the same, but in the opposite direction, thus pocketing the "sell" part of the borrow (so in this scenario, my actions would be the same as you proposed, but they would be linked to the initial actions in 2020). So even though five years went by, your profit was known/fixed from the very start.
Based on your answer, you're not thinking about anything before 2025 right? So when you're thinking about hedging it's really just 'do the opposite of my physical action' (this is what a trader kept telling me, but I just couldn't process the thought process, because I felt the need to "link the hedge back to an initial action"). In this case, is my above paragraph basically all wrong or is it just a different scenario?
Seems like you are getting kind of deep in the weeds here, pretty rare to understand this coming into the industry. You have to look at your physical purchases and sales separately unless they are pure back-to-backs. In which case you sell futures on whatever pricing period you purchase physical at. You then have zero price risk until you purchase futures to hedge your physical sale, aside from the rolling of your hedge through which your will accumulate contangos and backwardations depending on the month.
It is exceedingly rare unless you are in a very liquid market to fix prices 5 years out and there are very few suppliers/consumers in metals who would want to look at that. Nothing on the LME is liquid enough to make that interesting in most cases and the risks are just too great.
What you are talking about there is taking a view on spreads which you should treat separately to a degree. Basically if you think spreads are attractive at a certain time, you would borrow that spread now, rather than at a time in the future where you are afraid of a backwardation forming. If the contango in cash to say 6 months from now will easily cover your financing, storage etc.. you could borrow that spread right now rather than roll every month and be vulnerable to a squeeze. I highly doubt there are too many people doing that 5 years out, the liquidity is just not there.
If you'd have time to just clarify once more, would TRULY appreciate it, as I hate this feeling of my brain going in circles. After that will stop bothering you and will wait till I start the job to think about this.
- Scenario: supply/purchase deal entered in 2020 with monthly deliveries up to 2025. Quotational/pricing period = shipment month. To keep things simple, say pricing is fixed for the third Wednesday of every month.
- For the January 2025 shipment, when the last trading day for the third Wednesday arrives (Tuesday of the third week I believe), your purchase price becomes fixed on the second bell. At the same time, you sell the third Wednesday January 2025 contract. This is called the hedge. The two cashflows exactly offset.
- HOWEVER, on Tuesday, you immediately have to Borrow, because otherwise LME will force you to deliver (you have an open short futures position). So in effect, you have now rolled that open short to the next month, when you expect to sell.
- Every month that you don't sell, you just keep Borrowing, and depending on back/contango you will have a spread PnL.
- If you find a buyer in Feb 2025, pricing on 3rd Wed that month, you would buy back the Feb 2025 futures contract on that same day. Same as January, the two physical and financial cashflows exactly offset. You have no more obligation to the LME because you are neither short nor long the LME contract.
- Ultimately, your PnL was determined by your Borrow + premium gains/losses. It was not determined by actual physical purchase/sale price, because they were all hedged.
Thanks so much for your contributions here. I wish there were some powerpoints or guides that actually give you some concrete examples of a trader doing some hedging, but most of what I can find will only show you part of it and it's just very hard to understand how things fit together.
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