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Will Aluminum’s Latest Price Spike Last?

After a nine-month period of inactivity, the aluminum market is catching fire…

Aluminum on the London Metal Exchange (LME) rose above $2,000 per metric ton (mt) last week, reaching a 16-month high.

The catalyst?

The Chinese government granted a one-trillion-yuan ($161-billion) loan to China Development Bank to help fund subsidized housing. This stimulus is expected to create a rebound in the Chinese housing market, which should send aluminum demand skyrocketing.

That, along with the fact that LME inventories have dropped by 10% so far this year, has set aluminum prices on a steady upward trajectory.

But that doesn’t tell the whole story…

The Truth About Aluminum Prices

Aluminum’s forward curve was in a healthy contango for the past five years. In the simplest terms, this means that the metal will fetch a higher price in the future than it does today.

The cash-to-three-month contango remained fairly steady in a $40 to $50 range for about nine months, up to April this year.

This allowed select market participants, namely banks, to buy and store massive quantities of aluminum stocks in global warehouses. These banks have seen their aluminum inventories accrue in value, while they sell the metal forward at a profit.

So while LME stocks have dropped (as I mentioned above), the market is still awash in inventories. In fact, aluminum stocks have now reached a staggering 4.94 million mt.

To put that in perspective, that’s roughly the amount of aluminum that would go into manufacturing 2,400 Boeing 747s!

Simply put, these financing deals (like the one-trillion-yuan loan from above) tend to distort the real supply-and-demand picture. That’s because much of this material is being stored outside of LME-registered warehouses, where storage costs are lower.

In July last year, the LME announced an overhaul of its warehousing network aimed at placating consumers who blamed the LME’s policy for logjams. But this has made little impact on the growing mountain of socks. Furthermore, the Chinese have been holding sizable aluminum inventories for use as collateral that hasn’t been accounted for in the LME statistics.

In the United States, physical premiums paid on top of the LME benchmark for delivery have soared to all-time highs. Some will argue that it signifies smelter cutbacks due to earlier weakness in LME prices, thus constraining readily available supplies for end users.

Yet at current prices, cutbacks aren’t the norm. Furthermore, the stocks held in inventory aren’t readily accessible, as there’s a long waiting time to get access to it. Thus, buyers who need the metal in the short term are forced to pay a hefty premium to get it.

Meanwhile, according to the commitment estimates that track the market’s longs and shorts, CTAs are 95% long, pointing to an inevitable correction.

Bottom line: These price spikes just aren’t sustainable. And here are a few potential ways to play the situation…

Several Opportunities to Cash In

Renewed strength in the aluminum markets has carried over into aluminum producer equities, as well, where it’s advisable to sell or take profits. One choice would be Aluminum Corporation of China (ACH), which has spiked to its highest price in a year.

On the other hand, one could consider owning or holding Reliance Steel & Aluminum (RS). While trading at record levels, it’s the largest distributor of metals to manufacturers around the United States. And while the dividend yield is modest (1.32% annualized), the stock has seen a dramatic a 230% jump since 2008.

For a more advanced approach, one can take advantage of aluminum’s current strength via the futures and options markets. It is advisable to short aluminum futures during these price spikes, or to sell hedged options when volatility spikes and trade the futures for additional returns.

Additionally, even while spreads have narrowed, it’s unlikely that there will be any prolonged backwardation. You could take advantage of any temporary flat or backwardated forward curve by selling the nearby and buying the longer-dated futures in expectation of a more typical contango term structure.

Good investing,

Shelley Goldberg

Shelley Goldberg

, Senior Correspondent

View More By Shelley Goldberg