Goldman's
new money machine: warehouses
(Reuters) - In a rundown patch of Detroit,
enclosed by a cyclone fence and barbed wire, stands an unremarkable warehouse
that investment bank Goldman Sachs has transformed into a money-making machine.
The derelict neighborhood off Michigan Avenue
is a sharp contrast to Goldman's bustling skyscraper headquarters near Wall
Street, but the two operations share one important element: management by the
bank's savvy financial professionals.
A string of warehouses in Detroit, most of
them operated by Goldman, has stockpiled more than a million tonnes of the
industrial metal aluminum, about a quarter of global reported inventories.
Simply storing all that metal generates tens
of millions of dollars in rental revenues for Goldman every year.
There's just one problem: much less aluminum
is leaving the depots than arriving, creating a supply pinch for manufacturers
of everything from soft drink cans to aircraft.
The resulting spike in prices has sparked a
clash between companies forced to pay more for their aluminum and wait months
for it to be delivered, Goldman, which is keen to keep its cash machines
humming and the London Metal Exchange (LME), the world's benchmark industrial
metals market, which critics accuse of lax oversight.
Analysts question why London's metals market allows big financial
players like Goldman to own the warehouses which store huge quantities of metal
even as they trade the commodity. Robin Bhar, a veteran metals analyst
at Credit Agricole in London says the conflict of interest is so acute he wants
U.S. and European anti-trust regulators to weigh in.
"I think it makes a mockery of the
market. It's a shame," Bhar said. "This is an anti-competitive
situation. It puts (some) companies at an advantage, and clearly the rest of
the market at a disadvantage. It's a real, genuine concern. And I think the
regulators have to look at it."
Goldman said its warehouse subsidiary Metro
International Trade Services has done nothing illegal, and abides by the LME's
warehousing rules. "Producers have chosen to store metal in Detroit with
Metro," a Goldman spokeswoman said. "We follow the LME requirements
in terms of storing and releasing metals from our warehouses."
The London Metal Exchange defends its rules.
"There is a perception that consumers have not been able to get to their
metal when the reality is that it is big banks, financing companies and
warehouses that are not able to get to their huge tonnages of metal fast
enough," said LME business development manager Chris Evans.
BUSINESS MODEL
Goldman's warehouse business relies on a
lucrative opportunity enabled by the LME regulations. Those rules allow
warehouses to release only a fraction of their inventories per day, much less
than the metal that is regularly taken in for storage.
In the year to June 30 Metro warehouses in
Detroit took in 364,175 tonnes of aluminum and delivered out 171,350 tonnes.
That represented 42 percent of inventory arrivals globally and 26 percent of
the metal delivered out, according to the London Metal Exchange said.
The metal that sits in the warehouse
generates lucrative rental income.
Little wonder that so many want in. Metro was
acquired by Goldman in February 2010, while commodities trading firm Trafigura
nabbed UK-based NEMS in March 2010, and Swiss-based group Glencore
International acquired the metals warehousing unit of Italy's Pacorini last
September.
Henry Bath, a warehousing firm and founding
member of the London Metal Exchange in 1877, has been owned for about 40 years
by traders or banks including Metallgesellschaft in the 1980s and failed U.S.
energy trader Enron at the turn of the century. It now comes under the umbrella
of JP Morgan, which bought the metals trading business of RBS Sempra
Commodities in July last year.
Despite its rental income, Goldman's
warehouse strategy apparently hasn't been enough to snap a slumping performance
in commodity trading, with the company reporting a "significant" drop
in revenues from a year ago in its latest quarter, the sixth time in the past
10 quarters that it has failed to expand.
The long delays in metal delivery have buyers
fuming. Some consumers are waiting up to a year to receive the aluminum they
need and that has resulted in the perverse situation of higher prices at a time
when the world is awash in the metal.
"It's driving up costs for the consumers
in North America and it's not being driven up because there is a true shortage
in the market. It's because of an issue of accessing metal ... in Detroit
warehouses," said Nick Madden, chief procurement officer for Atlanta-based
Novelis, which is owned by India's Hindalco Industries Ltd and is the world's
biggest maker of rolled aluminum products. Novelis buys aluminum directly from
producers but is still hit by the higher prices.
Madden estimates that the U.S. benchmark
physical aluminum price is $20 to $40 a tonne higher because of the backlog at
the Detroit warehouses. The physical price is currently around $2,800 per
tonne. That premium is forcing U.S. businesses to fork out millions of dollars
more for the 6 million tonnes of aluminum they use annually.
It has also had a knock-on impact on the
global market, which is forecast to consume about 45 million tonnes of the
lightweight, durable metal this year.
Also pushing aluminum costs higher are bank
financing deals, which are estimated to have locked up about 70 percent of the
4.4 million tonnes of the metal sitting in LME-registered warehouses around the
world. ME inventories hit an all-time record above 4.7 million tonnes in May.
In a typical deal, a bank buys aluminum from
a producer, agrees to sell it at some future point at a profit, and strikes a
warehouse deal to store it cheaply for an extended time period.
The combination of the financing deals and
the metal trapped in Detroit depots, means only a fraction of the inventories
are available to the market. Premiums for physical aluminum -- the amount paid
above the LME's cash contract currently trading at $2,620 a tonne -- in the
U.S. Midwest hit a record high of $210 a tonne in May, up about 50 percent from
late last year. In Europe, the premium is at records above $200 a tonne, double
the levels seen in January 2010.
The ripple effect into Asia has seen the
premium paid in Japan increase 6 percent to $120 a tonne in the
third quarter from the previous quarter, the first rise in nearly six quarters.
You won't hear banks like Goldman
complaining. Rental income continues to pour in at the 19 Detroit area
warehouses run by Metro as of June.
From the outside one recent afternoon, a
depot in the Detroit suburb of Mt Clemens appeared to be deserted. But
neighbors say the place is a whirl of activity in the early hours of the
morning when metal is usually delivered for storage.
The LME says the current maximum rent, set by
warehouse operators, is 41 U.S. cents per day per tonne. At that rate,
Goldman's warehouse operation in Detroit -- said to be holding more than 1.1
million tonnes -- could be generating as much as $451,000 per day or about $165
million a year in revenue.
An exact figure cannot be calculated because
many clients negotiate lower rental rates and Goldman declined to detail its
income from its warehouse business. But when Swiss-based trading company
Glencore listed earlier this year it revealed that its metals warehousing unit
generated $31 million in profit on $220 million in gross revenue in 2010.
LONG HISTORY Caught between consumers and
warehouse operators is the 134-year old LME, one of the world's last exchanges
with open-outcry trading. Sessions take place in a trading ring with red padded
seats while visitors can watch from a gallery. Traders juggle multiple
telephones and use archaic hand signals to fill orders from consumers,
producers and hedge funds.
The ring is a perhaps more civilized version
of the tumultuous trading pits made famous in Chicago. Each of six major
industrial metals including copper and nickel are traded for five minute bursts
in the morning and afternoon. Only 12 firms have access to the ring, arranged
in fixed positions in a circle, with many others involved via the ring dealers
and on the LME's electronic trading system.
Longer sessions in the late morning and
afternoon allow trading of all metals simultaneously and are known as "the
kerb" from the days when dealers continued to trade on the kerb, or
sidewalk, after leaving the exchange.
The LME certifies and regulates the Detroit
sheds as part of a global network of more than 640 warehouses. The network is
meant to even out swings in volatile metals markets. During recessions, surplus
metal can be stored until economies recover and demand picks up, when the metal
can be released.
But that function is now being undermined by
the backlog in Detroit.
LME rules stipulate that warehouses must
deliver a certain amount of metal each day. However the rules apply not to each
warehouse but to each city that a company has warehouses in. At the moment, a
warehouse operator needs to deliver just 1,500 tonnes a day per city, whether
it owns one warehouse there or dozens. That means each of Metro's Detroit
warehouses need to release only 79 tonnes of aluminum a day. At that rate, it
would take two years to clear the stocks held by Goldman's Detroit warehouses.
The backlog sparked outrage last year,
prompting the LME to task London-based consultancy Europe Economics to look
into its rules. Europe Economics recommended the exchange raise its minimum
delivery rates and earlier this month the exchange announced a new regime for
operators with stocks of over 900,000 tonnes in one city.
From April 2012 the minimum delivery rate
will double to 3,000 tonnes a day.
Critics dismiss the move as too small to have
any real effect, especially because of the delay until it comes in.
"The move is too little and too late to
have a material effect in the near-term on an already very tight physical
market, particularly in the U.S.," Morgan Stanley analysts said in a July
note.
A senior executive at a metals brokerage told
Reuters "the recommendations won't change anything. The problem will still
be there six, nine months down the line." "If Detroit has 1.1 million
tonnes at the moment, what's to say it won't have 2 million tonnes next
year," he said.
MOVING
MORE METAL
One obvious solution would be to impose
minimum delivery requirements per warehouse or per square meter of warehouse
space rather than per city. It's not as if the warehouses can't cope with
delivering more stock: large operations can shift much more than 3,000 tonnes a
day, warehousing sources say. An experienced forklift driver takes about 20
minutes to load one 20-tonne truck with aluminum in the United States. That
means one warehouse in Detroit with two doors, two forklifts and an eight-hour
working day could move out as much as 1,920 tonnes of metal every day.
"If you take Detroit in particular,
those warehouses historically extracted metal at a faster rate ... the
infrastructure is there," a senior analyst in the metals industry told
Reuters.
Madden at Novelis said: "I don't know
the specific details of every warehouse but our view is that they seem to be
able to absorb metal coming in at almost an infinite rate and so we feel
there's a lot more they can do on the output side to push up the (load out)
rates."
The LME could also crack down in the same way
it did in 1998 when it banned Metro from taking any more copper into its Long
Beach and Los Angeles warehouses. Then the complaints were said to have come
from copper consumers worried that 80 percent of total copper stocks in
LME-approved warehouses were held in California. The exchange argues that any
change right now might disrupt the market.
"Changes to the delivery out rate have
required careful consideration because it will impact the cost structure for
those holding metal, and were those costs to rise sharply it could affect the
way that metal is stored and traded," said the LME's Evans.
The exchange could also rule that a warehouse
cannot charge rent once aluminum has been purchased, no matter how long it
takes to ship it. But a change like that would hit the LME itself as it
receives about 1 percent of the rental income earned by the warehouses it
approves.
LEGAL
FEARS
Nobody at the LME will say whether the Europe
Economics study -- industry sources said it talked to more than 40 companies --
advised more radical measures, arguing that such information is
"proprietary." In any case, say metal markets sources, LME officials
may be hesitant to make bigger changes because they fear legal action from the
likes of Goldman, which could argue that Metro's business model has been based
on existing LME warehouse rules.
The LME declined to comment on possible legal
challenges, but its Chief Executive Martin Abbott said at a recent briefing
that the warehouse delays were not causing market and price distortions.
"No, I don't believe it is," Abbott
said, when asked if the situation was causing distortions in the market. Abbott
said the exchange had received no official complaints from consumers about
bottlenecks at warehouses. The LME also dismisses concerns about banks trading
metal and owning the warehouses where it is stored.
While a British parliamentary committee
raised the issue in May, Britain's Office of Fair Trading declined to open a
probe. The U.S. Commodity Futures Trading Commission, which regulates the futures
and options markets, said it would not comment. Britain's Financial Services
Authority, which regulates exchanges where commodity futures are traded but not
warehouses that store physical material, declined to comment.
WHAT
NEXT?
The lack of real change has some in the
industry questioning the very structure of the LME, which, unlike its publicly
owned U.S.-based rival commodities exchanges, is owned by many of the financial
institutions that trade there.
"The belief is that they are focused on
serving their shareholders; most of them being the banks ... We see our clients
and contacts trying to avoid the LME as much as possible now," said Jorge
Vazquez, Managing Director of the Aluminum Intelligence Unit at HARBOR
Commodity Research.
That concern is growing. Critics of the
exchange point to a potential problem with zinc supply though New Orleans,
where inventories now account for 61 percent of total LME-registered stocks.
Most of the warehouses in New Orleans are owned by Goldman and Glencore.
Metal industry sources believe regulators
should take a closer look at the possible conflict of interest that arises when
trading houses also own the warehouses.
"If the whole thrust of regulation and
regulatory reform is increased transparency and open and above board
operations, letting banks own warehouses seems to run entirely counter to
that," said Frances Hudson, global thematic strategist at Standard Life
Investments said.
The LME says it enforces a strong separation
between warehouses and the trading arms of their owners. Just this week it
proposed that companies which own warehouses should engage an independent
third-party to verify the robustness of Chinese walls.
"We enforce it through regular audits of
warehouses," said the LME's Evans. "If people say Chinese walls are
leaking then they should bring us evidence and we'll investigate."
(This
story was updated to add details about how much aluminium was taken in and
delivered by Metro warehouses in Detroit in the past year (paragraph 13) and to
correct who sets the maximum rent for metal storage—it’s the warehouse owners,
not the LME (paragraph 30). In paragraph 5 “a trickle” of aluminium leaving the
warehouses was changed to “much less is leaving the depots than arriving…”)
(Pratima
Desai, Susan Thomas and Melanie Burton reported from London; Clare Baldwin
reported from Detroit; with additional reporting by Chris Kelly in New York and
Karen Norton in London; Graphics by Vincent Flasseur; Editing by Eric Onstad,
and Richard MablySimon Robinson)
(Created
by Simon Robinson)