The duty-paid futures contract, based on the Fastmarkets P1020 duty-paid aluminium premium, had 15,522 lots of open interest
as of the end of trading on Thursday June 18, compared with 11,605 lots for the aluminium duty-unpaid futures contract.
In March, when the effects of the Covid-19 virus were starting to hit the market, the EDP contract registered a record month in volume of 10,099 lots traded, followed up by another strong month in April with 9,176 lots.
“In April we really saw the big volume on the EDP,” one broker said. “It was a huge month, a lot of business came from banks buying and traders selling.”
“There’s this contango people are taking advantage of and the cash and carry. These swaps are liquid and once there’s a bit of liquidity it is self-fulfilling, before you know it you have everyone on the bandwagon," the broker added.
Month-end open interest for the duty-paid forwards also hit all-time high, with 16,438 lots in May as the market began to move to more speculative trading for the duty-paid market.
“We have had more inquiries and people interested in trying to hedge the other side of the contract, but it’s not just the traders that want to do it, the banks want them as well,” a second broker said.
“The banks want them too as they all want to be safer and more secure. No one wants to risk things at the moment,” the second broker added.
The demand from the financial sector also comes from some looking for exposure in physical aluminium premiums, without the hassle of worrying about storage and insurance costs. The caveat is paying higher for the forward contract compared with a spot physical premium.
"As a financial instrument you don’t have to care about insurance and storage," a trader said.
The CME launched its EDP contract in 2015
. During the last financial crisis in 2009, when demand for metal also evaporated, there were no hedging instruments. Now that there is one for duty-paid metal, market participants are keen to hedge their exposure and have been slowly building liquidity on the forwards since the contract was established for times of financial turmoil such as this.
“The aluminium market feels like 2009 right now, and back then people needed these contracts,” the second broker said. “That is why everyone is taking advantage now. Really, it is a no-brainer to try and hedge and trade on the CME – if things flip either way, you are covered.”
Low demand prompts change
Traditionally a market in which primarily aluminium producers and traders sell to end consumers, the P1020A duty-paid Rotterdam market has seen an increase in speculative trading activity, driven by spreads and premium forwards.
A situation of low spot premiums, London Metal Exchange spreads that cover long-term carrying costs and the CME forward premium that indicates a rise in premiums later in the year, has had traders looking to establish carry positions in the past two months.
Forwards for the duty-paid premium are trading around $130 per tonne in the fourth quarter and 2021. These higher forwards have drawn in more liquidity into those contracts throughout the past two months.
By comparison, Fastmarkets’ assessment of the aluminium P1020A premium, in-whs dp Rotterdam
stood at $100-115 per tonne on Tuesday June 16. The premium is slightly higher after hitting a decade-long low of $90-105 per tonne in April.
“Duty-paid is the vehicle for cash and carry now,” a second trader said. “It’s because of the collapse of demand. Usually, Europe is a big short in aluminium. It doesn’t really make sense for it to be a cash and carry market, but now you have this wide discrepancy between nearby and forward premiums.”
In a “more normal” market, the P1020A premium, in-whs dup Rotterdam is more reflective of speculative trading because there is more flexibility in the locations it can be shopped to, as well as the option to liquidate the metal on to the LME without worrying about the duty.
The spot premium for duty-paid aluminium in Rotterdam is close to its lowest in about a decade and nearly close to being flat with the duty-unpaid premium, following the evaporation of end consumer demand after Covid-19 lockdowns, giving traders a cheap entry point for a carry trade.
Traditionally there is around a 3% difference between the duty-unpaid and duty-paid premiums to account for clearing customs into Europe.
However, that difference had been eroding since the start of the year and the economic effects of lockdown in Europe wiped out the remaining difference.
"[Buying duty-unpaid] becomes too much of a service to whatever consumer you're offering to. You’re going to lose on the clearing," the first trader said.
"There is no way that 3% comes back this year – people need to realize that because the market dynamics are so different now and there is so much duty-paid sitting in Europe with no home to go to,” a third trader said.
With the missing 3% duty-spread bringing the duty-paid premium to a level that was not only cheap enough to establish a carry position, it also brought it to a point where any further downside was limited.
The upside, however, was pre-coronavirus level premiums in the longer-term, making duty-paid aluminium an attractive investment.
"If you have to bet on something, it’s that September will have a recovery," the first trader said.