The LME - Henry Bath

London Metal Exchange
LME 130th Anniversary Supplement
Contents
Editor
LME editorial consultant
Group editorial director
Managing editor
Sub-editor
Editorial assistant
Joanne Hart
Thom Lant
Claire Manuel
Samantha Guerrini
Nick Gordon
Lauren Rose-Smith
Group art director
Art editor
Designer
David Cooper
Nicky Macro
Zac Casey
Group production director
Tim Richards
Group sales director
Andrew Howard
Client relations director
Natalie Spencer
Deputy chief executive
Publisher and chief executive
Hugh Robinson
Alan Spence
Picures: Reuters, Getty, Corbis
Repro: ITM Publishing Services
Printed by Buxton Press
ISBN: 1-905435-53-3
Published by Newsdesk Communications Ltd
5th Floor, 130 City Road, London, EC1V 2NW, UK
Telephone +44 (0) 20 7650 1600
Fax +44 (0) 20 7650 1609
www.newsdeskmedia.com
Newsdesk Communications Ltd publishes a wide
range of business and customer publications. For
further information please contact Natalie
Spencer, client relations director, or Alan Spence,
chief executive.
Newsdesk Communications Ltd is a Newsdesk
Media Group company.
On behalf of the London Metal Exchange
The London Metal Exchange Limited
56 Leadenhall Street
London, EC3A 2DX UK
Telephone +44 (0) 20 7264 5555
Fax +44 (0) 20 7680 0505
www.lme.com
4
A warm welcome
Foreword by Martin Abbott,
chief executive of the LME
6
The future of trading
Martin Abbott explains how the Exchange
has kept pace with events
9
130 years of the LME
After 130 years, the LME remains true to its
roots. Richard Northedge reports
12 The LME – a brief history
Significant events for the LME, and the world,
from 1877 to the present day
15 Sign of the times
Helen Dunne compares the life of an LME
trader in the early days of the Exchange to
today’s trader
18 The evolution of risk
Managing risk has always been a central
function of the LME. Chris Flood reports
21 Sea change
Tim Webb analyses the importance of the
sea trade over the years
24 Onwards and upwards
Phil Thornton discusses emerging markets
© 2007. The entire contents of this publication are protected by copyright. All rights reserved. No part of
this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any
means: electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the
publisher and the London Metal Exchange.
Information provided in this publication on any services of the London Metal Exchange is designed to
give the reader an overall impression of the facilities available. It is not intended to be exhaustive.
The views and opinions expressed by independent authors and contributors in this publication are
provided in the writers’ personal capacities and are their sole responsibility. Their publication does not
imply that they represent the views or opinions of the London Metal Exchange or Newsdesk
Communications Ltd and must neither be regarded as constituting advice on any matter whatsoever, nor
be interpreted as such.
The reproduction of advertisements in this publication does not in any way imply endorsement by the
London Metal Exchange or Newsdesk Communications Ltd of products or services referred to therein.
LME 130th ANNIVERSARY SUPPLEMENT
1
The LME in the late 1990s
Introduction
A warm welcome
T
his year, the LME celebrates 130 years of providing services to the base metals
industry. Like its users, the Exchange has witnessed an era of profound global,
technological, political, environmental and social change; changes in fact, that
touch every aspect of life.
While the core business of the LME is still recognisable, there are subtle developments
that have been made, responding to the demands of LME member firms and their clients and
reflecting the value of regulation and market transparency.
In this special anniversary supplement we look back at some of the changes that have taken
place in our industry since the LME’s inception, which have helped the LME achieve its
position as the world’s leading exchange for the trading of non-ferrous metals.
But it is important to note that this market is constantly moving. As an exchange, we never
stand still, we are never complacent and we are always looking for ways to improve what we
already do. We continue to explore entirely new areas, where we feel we have the experience
and skills to add real value, most recently with plastics and in 2008, with the launch of steel.
We are in constant contact with the physical industry and our member firms to ensure
that we evolve and grow as their needs change and develop.
In celebrating the Exchange’s achievements in the past 130 years, we look forward to
providing valuable risk management services for the next 130 years, and beyond.
Martin Abbott
Chief Executive
London Metal Exchange
LME 130th ANNIVERSARY SUPPLEMENT
5
Interview
The future
of trading
Trading activity has evolved
dramatically over the past 130
years. LME chief executive
Martin Abbott explains to
Joanne Hart how the Exchange
has kept pace with events
6
LME 130th ANNIVERSARY SUPPLEMENT
T
he Ring has been the mainstay of the LME since its
inception. Back in 1877, it was the only avenue offered by
the Exchange for companies to trade and manage risk.
Today, phone and electronic trading are an integral part of
the LME. Nonetheless, the Ring continues to be the place
where all but the most basic trades are carried out.
In today’s world, this is unusual. Many other exchanges have
abandoned floor trading completely. Electronic trading dominates and,
in certain cases, algorithmic black boxes are connected directly to
exchanges’ servers, firing thousands of orders a minute, based on
complex mathematical formulae. Trading is executed remotely,
without the intervention of a human being.
Clearly, this way of conducting business works in a number of
markets, but not all.
“The reality is that this is a different trading environment,” says LME
chief executive Martin Abbott.
“The LME was one of the first exchanges to embrace technology and
become a side-by-side market, running electronic trading in parallel
with floor and phone trading. But we have not made the next transition
to algo-trading and the reason for this goes back to the LME’s constant
mantra: we are different from other markets.”
Interview
This difference is fundamental and it is based on the very nature of
what is traded on the Exchange and the way that trades are executed.
“Commodity markets are very complex. Take copper. We trade cash
prices, three months ahead, every day in between, then weekly, then
every month forward to 63 months and the relationship between all these
prices all the time. These are not plain vanilla markets,” says Abbott.
A further difference between the LME and other markets is that
clearing members of the Exchange operate on two levels. They run
their own books and they conduct business for customers. This means
they can make markets and execute business on the spot.
“This is a huge advantage for customers because it means that the
market is extremely flexible. Customers can look at the published
prices on the Exchange and go with them, or they can decide to do
something a little bit different and get a bespoke quote,” says Abbott.
Essentially, business on the Exchange can be conducted in a variety
of different ways depending on the nature of the business and the
demands of the end-customer. Simple trades are largely carried out
electronically nowadays, but more complex transactions are executed
on the floor or by phone.
“This system has evolved over 130 years. We are not where we are by
accident. We are where we are because it works,” says Abbott.
“
THE LME WAS ONE OF
THE FIRST EXCHANGES
TO EMBRACE TECHNOLOGY
”
LME 130th ANNIVERSARY SUPPLEMENT
7
Interview
“
THIS SYSTEM HAS
EVOLVED OVER 130
YEARS. WE ARE NOT WHERE
WE ARE BY ACCIDENT. WE
ARE WHERE WE ARE
BECAUSE IT WORKS
”
Currently, 80 per cent of simple, three-month turnover is
executed electronically, but 80 per cent of so-called ‘date spreads’
are executed on the floor or by phone. These trades form a huge part
of the LME’s business.
“We have no plans to phase out any of the three platforms or to
change the resources we apply to them. Being member-owned it is the
members who will decide the best trading models, and they will make
this decision based on what their customers want. Personally, I see no
reason why the side-by-side method of trading cannot continue for a
very long time,” says Abbott.
Select, the LME’s electronic platform, is open from 1am to 7pm GMT
to allow traders from all round the world to trade whenever they want.
These opening hours may be extended in time, but most commodity
traders appreciate the Ring hours because they provide periods of
intense focus.
The Ring model dictates five-minute periods of intense liquidity,
which concentrate trading into short bursts of activity. This type of
trading is inherently transparent and attracts a variety of users to the
LME, including the professional investment community.
“The business that we get from the financial industry has been
driven by the increased acceptance of commodities as a recognised
asset class, but it is also testament to the robustness of our model.
Ultimately, what everyone wants from a market is liquidity. Whether it
is a fabricator trying to hedge price risk or a hedge fund trying to
fabricate a deal, they are both looking for liquidity and that is what we
provide,” says Abbott.
Looking ahead, this balance is expected to persist, but it will have
little impact on the way in which trading is conducted on the Exchange.
The three trading methods, electronic, telephone and the floor will all
continue to be used on a daily basis by a variety of different traders,
with different demands, different needs and different time horizons.
Over time, more option business may be transacted electronically
but, by and large, users of the LME concur that most commodity trades
do need human intervention and that involves the Ring and the phone.
“Ultimately, the market will decide how trading evolves. Ring users
are not charities. They use the Ring because it works for their business
model and because their customers want it. We continue to deliver year
on year volume growth and we continue to attract new members, too.
Even after 130 years, we are still a growth business,” says Abbott.
Joanne Hart is the editor of the LME 130th Anniversary Supplement
8
LME 130th ANNIVERSARY SUPPLEMENT
History of the LME
130 years of the LME
The LME has changed significantly
since the Victorian era. But in certain
respects, it remains true to its roots.
Richard Northedge reports
T
here has been a vibrant metals market in London since
the reign of Elizabeth I, with traders taking their place
among other brokers of commodities and securities in
the new Royal Exchange. When that space proved too
cramped they overflowed into local coffee houses. When
they were ready to trade, a ‘ring’ was formed in the sawdust on the floor
and the merchants dealt.
The Ring was formalised in 1877, when the London Metals &
Mining Company opened its exchange above a hat shop in Lombard
Court. The Industrial Revolution had by now turned Britain from an
exporter of base metals into a voracious importer and that meant
long delivery times. Whereas the coffee houses had traded physical
contracts, the new LME allowed merchants to forward-sell to
guarantee their prices.
“
WHEN THEY WERE
READY TO TRADE, A
‘RING’ WAS FORMED IN THE
SAWDUST ON THE FLOOR AND
THE MERCHANTS DEALT
”
Communication was becoming easier too – both physically, with the
opening of the Suez Canal and development of steam ships, and
electronically with the telegraph and, subsequently, the telephone.
Delivery could be accurately forecast, and the LME’s standard threemonth contract reflected transport times for copper from Chile and tin
from Malaya.
The formalised market proved highly successful, resisting Frenchled attempts to corner the copper market in 1889, for instance.
19th-century traders
LME 130th ANNIVERSARY SUPPLEMENT
9
History of the LME
The refurbished LME Ring
at Whittington Avenue, 1961
“
THE FORMALISED
MARKET PROVED
HIGHLY SUCCESSFUL,
RESISTING FRENCH-LED
ATTEMPTS TO CORNER
THE COPPER MARKET IN
1889, FOR INSTANCE
”
As Britain’s self-sufficiency in tin and copper ended, an increasing
number of European traders started using London, not only for the
main metals, but to deal in antimony and quicksilver too, though this
was outside the LME’s remit.
Soon the Exchange had more than 300 members, forcing a move to
a purpose-built site in Whittington Avenue, Leadenhall Market.
However, there were fears that such a large membership was
disorderly and at the start of the last century, the Exchange’s ruling
committee imposed tougher regulations to reduce the numbers. This
move enhanced the market’s reputation and volumes increased
despite the smaller membership.
In 1903 a lead contract was added to the Exchange’s staples and in
1915, zinc was introduced. The LME closed briefly during the Great War
but then functioned much as it had done from the turn of the century –
until trading was suspended because of World War II.
The Exchange did not re-open until 1954 and the post-war world was
very different both in working methods and trading patterns. Brokers
had become more sophisticated and volumes were much higher.
Member firms started to divide into pure brokers and those with the
balance sheet strength to act as market-makers.
In 1963, the Exchange opened its first European warehouse, in
Rotterdam. Today, it has a network of over 400 warehouses from 35
locations in 13 countries.
In the 1970s, new contracts were introduced to reflect changing
manufacturing conditions. Primary aluminium was introduced in 1978
and nickel the following year.
In 1985, the Exchange, by now rehoused in Plantation House, found
itself entwined in a crisis caused by the International Tin Council
(ITC). Demand for tin had fallen while supply from countries outside
the ITC, such as Brazil, had risen. The ITC kept buying to support the
price, but was left with an enormous buffer stock and an inability to
pay. After tin’s price plunged the LME was forced to suspend the tin
contract for six months.
In 1988 the LME became a cleared and regulated market, effectively
protecting clearing members from the risk of business failure by other
clearing members. This has greatly contributed to the growth in
volumes the Exchange has seen since then. Confidence in the LME as a
recognised and well regulated forum for trade has also risen. Indeed,
the regulatory position and the LME’s own governance have helped to
maintain its reputation and underline its commitment to orderly markets.
But there have been many other developments over the past decade,
too. The Exchange has introduced two regional contracts for aluminium
alloy, extended forward trading for copper and aluminium out to 63
months and developed new contracts, such as plastics and steel.
From January 2000, The London Metal Exchange Limited became a
wholly owned subsidiary of a new company - LME Holdings Limited. The
former members of The London Metal Exchange Limited retained their
membership of the Exchange and were offered shareholdings in LME
Holdings Limited on a scaled basis according to the type of member.
Left: Plantation House, The LME’s location from 1980 to 1994
10
LME 130th ANNIVERSARY SUPPLEMENT
History of the LME
“
JUST AS THE METAL
DOES NOT PHYSICALLY
NEED TO BE IN LONDON,
NEITHER DO THE TRADERS
The London Metal Exchange Limited has up to 13 directors –
comprising up to two invited directors with substantial experience of
the metals industry and trade; up to three independent directors; up to
six shareholder representative directors of LME Holdings Limited, who
are elected from the membership; a trade director; and, the LME chief
executive. The chief executive also leads an executive committee
charged with the day-to-day operation of the Exchange.
An LME member returning to the ring from Victorian times would
not immediately notice these changes. He would not notice the clearing
”
system introduced in 1988, or the fact that LME prices and market data
are seamlessly distributed to the four corners of the globe 24 hours a
day and relied upon by all aspects of the world’s metals industry.
Neither would he recognise that despite the word ‘London’ in the
name, more than 95 per cent of the LME’s business comes from
overseas. And he would not initially be aware that Ring dealing is only
one of the three ways that LME members can trade.
The telephone allowed traders to stay in their offices. Now 24-hour
screen-based dealing means members in any time zone can deal
through the LME. Just as the metal does not physically need to be in
London, neither do the traders. The number of Ring-based member
firms has fallen while non-Ring members, often investment banks with
huge amounts of capital, have expanded. Clients are now as likely to be
financial institutions as manufacturers or mining companies.
Yet the Ring remains the source of official prices, the Exchange is
still largely owned by its members and it is the City’s last open-outcry
market. In many respects, our Victorian member would feel at home.
Richard Northedge writes for the Sunday Telegraph and Financial News
LME 130th ANNIVERSARY SUPPLEMENT
11
History
The LME – a brief history
1877 LME opens for business, trading
copper and tin
1877 Queen Victoria assumes the title of
Empress of India
1903 Good Soft Pig Lead contract
introduced
1905 Albert Einstein publishes his
General Theory of Relativity
1912 Standard Tin contract launched
1912 The Titanic sinks on her maiden
voyage, killing 1,500 people
1914 World War I breaks out
1915 Virgin Spelter (zinc) contract
launched
1917 Bolsheviks stage a coup in Russia.
1953 COPPER TRADING RESUMES
Tsar Nicholas abdicates and is sent
to Siberia
1932 Import Duties Act passed in the UK, with 10 per cent tariff on
non-Empire lead and zinc, market thrown into disarray
1933 Adolf Hitler becomes Chancellor in Germany
1939 Outbreak of World War II brings market to a standstill
1949 Tin recommences, followed by lead and zinc
1952 Princess Elizabeth becomes Queen Elizabeth II
1953 Copper trading resumes
1962 LME premises on Whittington Avenue refurbished. First
non-UK delivery point approved in Rotterdam
1963 President John F Kennedy is assassinated
1952 CORONATION OF QUEEN ELIZABETH II
12
LME 130th ANNIVERSARY SUPPLEMENT
1965 Vietnam war begins
History
1966 ENGLAND WINS THE WORLD CUP
1966 England wins the World Cup
1971 Britain introduces decimal coinage
1973 Britain joins the European Economic Community
1978 Primary Aluminium contract launched
1979 Nickel contract launched
1979 The first commercial cellular telephone network is
launched, in Japan
LME 130th ANNIVERSARY SUPPLEMENT
13
History
1994 LME MOVES TO LEADENHALL STREET
2005 LONDON AWARDED 2012 OLYMPIC GAMES
1996 The Chechnya peace agreement is signed
2000 LME is demutualised
2001 LME Select launched
2001 The World Trade Center in New York is destroyed in a
terrorist attack – thousands killed
2001 Apple launches iPod
1980 LME moves to Plantation House
1985 International Tin Council defaults on contracts,
2002 North American Special Aluminium Alloy contract
(NASAAC) launched. Copper and Primary Aluminium
contracts extended out to 63 months forward
triggering the tin crisis. Tin trading suspended
2003 Iraq war breaks out
1987 UK Financial Services Act passed, LME becomes a
cleared and regulated market. LME opens its first
non-European warehouse in Singapore. Traded options
contracts also launched
2005 PP and LL plastics contracts launched
2005 London announced as host for the 2012 Olympics
1988 LME becomes a Recognised Investment Exchange (RIE)
2006 LMEminis launched
1989 Tin contract relaunched
2007 PP and LL regional plastics contracts launched for
Asia, Europe and North America
1990 First North American warehouse opened
2007 LME announces plans to launch steel billet contracts
1990 Nelson Mandela is freed from prison in South Africa
1991 Trading period for LME
copper, aluminium and zinc
extended from 15 to 27
months
1992 Aluminium alloy contract
introduced. Copper and
lead switch to dollar-based
trading
1994 LME moves to Leadenhall
Street
14
LME 130th ANNIVERSARY SUPPLEMENT
in 2008
Then and now
Sign of
the times
When the LME first opened, members wore
stiff white collars, formal suits and top hats.
They smoked in the Ring and took lunch
extremely seriously. Helen Dunne finds the
mood has changed
O
n New Years’ Day 1877, copper dealers heard the words
“ring, ring” for the very first time. Only a few days
earlier, traders had conducted business by gathering in
groups in the crowded premises of the Lombard
Exchange and Newsroom, just a few minutes walk
away in Lombard Street.
But the formation of The London Metal Exchange Company on
19 December 1876, by ten firms led by Arthur Bird of Sanford & Bird,
introduced more formality into the proceedings.
The members who joined the new Exchange, paying annual
subscriptions of £5 5s, had long associations with the metals industry.
Some had begun their careers in the iron foundries; others had worked
in copper and tin mines; a handful had worked at the docks, where they
sold metals direct from the ships.
“
THREE YEARS AFTER IT
OPENED, A TELEPHONE
WAS INSTALLED IN THE
LOMBARD COURT OFFICES
”
The members were elderly and patrician, uptight in their stiff white
collars, formal suits and top hats. The clerks were less formally dressed,
usually in their thirties, spending their days running to the booth at the
back of the floor where each member firm kept a drawer.
When the LME first opened, Charles Davies of Charles Davies & Co
used to draw rings on the floor in chalk, after the ‘Change’, as it was
called, opened for the day’s business. He would then call dealers in
copper and tin to gather round and trade. They were the only metals
that could guarantee quality, timely delivery and be sold in standard
lots. Ring dealers would accept an offer with a nod of their head, or a cry
of “yes” or “I’ll take 50”.
LME 130th ANNIVERSARY SUPPLEMENT
15
Then and now
“
EVEN ON A HOT
SUMMER’S DAY,
NOBODY WAS ALLOWED TO
LOOSEN THEIR COLLARS
”
Their counterparts in lead and zinc, where both delivery and quality
could be erratic, found it impossible to trade in the confinements of a
Ring, and continued dealing on a one-to-one basis.
Three years after it opened, a telephone was installed in the Lombard
Court offices, and clerks were able to consult with clients, link up with
exchanges in Liverpool and Amsterdam, and hear the opening and
closing Glasgow prices of pig iron.
But there were also the first grumblings of discontent. The older
dealers were hostile to Ring dealing, arguing that open bidding was
prone to price manipulation by speculators. And, in December 1880,
Ring dealing was abolished; dealers who defied the ruling were expelled
from the Exchange.
It took almost 18 months, and the impending move to new purposebuilt premises at Whittington Avenue, for Ring dealing to be
reintroduced between 11.50am to noon, and 3.40pm to 3.50pm, formally
timed by chairman J Pitcairn Campbell.
When iron dealings were admitted, in 1890, the Ring sessions were
split into separate metals, beginning with a tinkle of the secretary’s bell
and the cry, “copper, gentlemen, copper”.
While the original format may seem formal and antiquated, some
dealers today remember a similar, stiff atmosphere when they first arrived
at the LME almost 100 years after it was founded.
“When I started in 1972, the dealers who sat in the Ring were usually
the owners or directors of the companies, and were aged in their fifties
or sixties,” recalls Malcolm Leonard of MF Global UK Ltd. (Benches
were introduced around the Ring in 1886; firms were assigned seats.)
“The clerks were aged between 30 and 35, and couldn’t speak to the
dealers unless spoken to. I was one of the younger, new breed. Now, you
16
LME 130th ANNIVERSARY SUPPLEMENT
The LME, situated next to the
entrance to Leadenhall Market in
London, 30 December 1971
Then and now
can’t deal in the Ring unless you are 21, but then it would have been
unheard of for a dealer to be 21. And today, the owners are usually based
back at the office.”
Alex Heath, director and head of base metals at RBC, adds: “The
dealers wore frock coats and pinstripe trousers – some wore top hats –
and white shirts. Coloured shirts were not allowed. Even on a hot
summer’s day, nobody was allowed to loosen their collars.” Clerks wore
red badges with their name and company; dealers wore green.
Some things at the Exchange have not changed: there is still a dress
code and conduct in the Ring is strictly monitored to ensure orderly
trading, with fines issued for breach of the LME’s rules.
In recent years though, advances in technology and communications
have transformed the way business is conducted. For more than a century,
most Exchange firms relied on a collection of phone booths to Ring their
main offices or clients because direct lines were expensive to install.
“There was a large room of telex operators who would send out
messages,” recalls Heath. “Then technology developed and screens
brought live running commentary, and even more price transparency.”
“In many ways, the LME is still the same but there are a lot more
metals and contracts now, such as plastic, and the floor is open for a lot
longer,” adds Andrew Patterson, trader at Calyon Financial.
The Exchange today also sees a huge amount of international
participation, the UK time zone being ideally suited for capturing the
end of Asian trading and the beginning of US trading. Since 2001 the
Exchange has also offered electronic trading, open from 1am to 7pm
and telephone trading 24 hours a day, in addition to the more
traditional open-outcry method.
Round-the-clock trading has put paid to long lunches previously
enjoyed by the dealers. “The lunches were legendary,” concedes one
dealer. “They would last from 1.30pm to 4pm, when the Ring opened for
the afternoon. Many dealers would just sleep through. But the arrival of
American firms changed that.”
Not before one summer’s afternoon, however, when an inebriated
dealer rode onto the floor on a unicycle, cycled around the Ring and
threw sweets at the other dealers, who could not trade if they left their
seats. “I think he’s a City alderman and high sheriff now,” confides Heath.
Sweet throwing was a common occurrence in those days. An ashtray
was always in the centre of the Ring too, but it was only when kerb
trading commenced (a practice formally approved in 1906) that
smoking was permitted. “It was like a gentleman’s club,” adds Leonard.
“The dealers would light up cigars and pipes.”
“The biggest change?” asks Patterson. “The fact that the floor is now
smoke free.”
Helen Dunne is senior consultant for The Business and editor of
CorpComms magazine
LME 130th ANNIVERSARY SUPPLEMENT
17
Risk management
The
evolution
of risk
Managing risk has been a central
function of the LME since its
inception. But, as Chris Flood
discovers, times have changed and
so have risk management techniques
18
LME 130th ANNIVERSARY SUPPLEMENT
I
n the modern era of instant communication, market
participants can only marvel at how the merchants who
founded the LME managed to conduct their business without
the vast array of information – real time prices, daily inventory
reports, regularly updated forecasts of global supply and
demand – which inform and drive metals markets today.
The arduous and uncertain voyages of the last century to bring
copper from Chile or tin from Asia provided opportunities for huge
profits or catastrophic losses. These opportunities, and the need to
share the risks that arose from them, drew merchants together in the
coffee houses of London to do business.
Those earliest meetings shared the central role which the LME still
performs today – the management of risk in the metals industry.
Although the core functions of the LME have remained consistent,
the Exchange has a history of innovation that has facilitated the
development of increasingly sophisticated risk management strategies
among its members.
The published prices, which the early merchants based their trading
decision on, have now become global reference prices for non-ferrous
base metals. They provide an array of opportunities to hedge against
the risks inherent in price fluctuations.
Risk management
“
THE EXCHANGE HAS A
HISTORY OF INNOVATION
WHICH HAS FACILITATED THE
DEVELOPMENT OF
INCREASINGLY SOPHISTICATED
RISK MANAGEMENT STRATEGIES
”
The LME’s role as a terminal market and its development of a global
warehouse system has also allowed market participants to make or take
delivery of metals across the world at times when regular buyers or
suppliers have been unable to meet their requirements.
New contracts have been added along the way and credit risk has
been minimised by the establishment of clearing in 1987 via
LCH.Clearnet.
The expansion of LME reports on metals inventories in its
warehouses has helped market participants gain a clearer
understanding of global supply and demand balances and thus
improved transparency. And the development of traded options has
allowed market participants to benefit from favourable price
movements beyond the contracted forward price.
Many metals prices including copper, nickel, lead, tin and zinc have
reached record levels in recent times, driven largely by soaring demand
from countries such as China, India and Brazil.
Global demand for aluminium, for example, has risen from 2.5 per
cent a year in the 1980s to 5.5 per cent annually in the 21st century.
Copper demand has risen from 1.8 per cent to 2.5 per cent, lead demand
from 1.6 per cent to 2.6 per cent, nickel demand from 2.4 per cent to 3.4
per cent and zinc demand from 1.5 per cent to 3.9 per cent.
Supplies have struggled to match demand so stocks have fallen to
just a few days’ worth of daily global consumption. Therefore, any
potential interruptions to supplies feed through into more volatile
price reactions.
Volatility is a risk faced by all market participants and the need to
manage exposure to potentially damaging price swings has been a key
factor attracting metals consumers and producers to the LME.
Many mining companies are running their operations close to full
capacity to take advantage of the buoyant pricing environment. High
prices and expectations that global demand will remain robust are also
encouraging new investment in mines and processing capacity.
PricewaterhouseCoopers’ annual review of mining trends, for example,
reported an 83 per cent rise in investment spending last year for the top
40 mining companies.
However, the timeframe to bring new projects into operation can be
ten years. So investment banks involved in financing these projects
often demand that developers engage in hedging programmes to
ensure loans can be serviced and debts repaid.
Increased confidence in the outlook for prices has also prompted a
wave of mergers and acquisitions across the mining sector. The
resultant enlarged companies are keen to manage risk around new
LME 130th ANNIVERSARY SUPPLEMENT
19
Risk management
“
RISING METALS PRICES
HAVE PROMPTED
INTEREST IN THE ROLE OF
COMMODITIES AS PART OF
AN OVERALL PORTFOLIO
STRATEGY TOO
”
production capacity and often use hedging tools to do so.
Joe Hamilton, chief executive of African Copper, advocates a
judicious approach to hedging price risks and says it is vital for
companies to understand what they are trying to achieve with hedging
strategies. A mining company's input costs will involve exposure to oil
prices for fuel, rubber prices for tyres, and local currency labour costs
among others. There are considerable challenges for any company
involved in hedging these input costs. Hedging revenues against
downside price risks appears more straightforward. However,
Hamilton says that if the revenue line is locked in by a price hedge and
input costs escalate, operations can become unprofitable.
African Copper’s approach is to apply price hedging to a portion of
production, allowing a revenue level that is just sufficient to cover
expected annual operating costs. The remaining revenues are left
unhedged so profits will increase if metals prices rise or if production
exceeds expectations.
The type of hedging instrument is important, too. African Copper
prefers ‘naked puts’, which protect against lower commodity prices but
still allow higher prices to be realised. In effect, African Copper is
buying insurance against falling prices while allowing its shareholders
to benefit if metals prices do rise.
James Southwood, of the consultancy firm CRU, has seen increasing
demand from base metals consumers and producers to protect their
capital and earnings from uncertainty. Southwood analyses prices by
breaking them up into key components, including the importance of
exchange rate fluctuations, energy prices and inventories. He then
develops a probability distribution for prices, which allows investors to
see the consequences of their assumptions and to place them in
context, enabling producers and consumers to gauge the risks of their
pricing actions.
In this way, risk can be evaluated on a continuous basis and
participants can take steps to protect themselves as circumstances
change. The parallel is with complex manufacturing processes, which
continuously check safety and technical tolerances.
Martin Woodhams, global head of commodity structuring at Barclays
Capital, says that Barclays has seen a slew of new corporate clients
looking for risk mitigation in their commodities investments.
Woodhams says the growing involvement of these corporate
clients has helped promote price transparency, liquidity and
20
LME 130th ANNIVERSARY SUPPLEMENT
accessibility. The growth in volumes traded on the LME’s Select
electronic trading system has also increased.
Rising metals prices have prompted interest in the role of
commodities as part of an overall portfolio strategy, too. A growing
body of academic evidence has encouraged long-term investors such as
pension funds to invest in commodities to improve returns and protect
their portfolios against inflation.
These investor inflows into commodities markets are predicted to
grow significantly. JP Morgan recently estimated that the total
market allocation to commodities stands at over $100 billion (or
around 1.5 per cent of total assets under management) and that over
the next five years, this could grow to more than $400 billion (5 per
cent of total AUM).
Any increase in liquidity can only be a good thing for those looking to
offset risk from the physical industry; enabling them to get in and out of
the market relatively easily. The ‘threat’ of physical delivery means that
LME prices converge with physical market prices on delivery, which
ensures credibility and confidence in the price.
Chris Flood writes for The Financial Times
Shipping and contracts
Sea
change
LME metals have been transported by sea for hundreds of years. Even today,
a quarter of all seaborne trade is related to metals. Tim Webb reports
O
nly a fraction of the billions of dollars of trades made on
the LME every day actually result in the physical
delivery of a commodity. But the option of delivery is
integral to the LME and the credibility of its pricing, and
this is made possible by the network of LME-approved
warehouses around the world which facilitate the delivery option.
Perhaps less obvious in this process are the seaborne workhorses,
the 10,000-odd bulk cargo ships that ferry metals and other
commodities around the world. While today, for many members of the
LME, it may be a case of out of sight, out of mind, it was not ever thus.
Some 150 years ago, shipping times and the length of future contracts
were closely interlinked. As anyone with a passing knowledge of the
LME knows, traders can buy forward contracts with a daily expiry date
for up to three months in advance. The three-month period was used
because that was how long it took for ships to carry copper from Chile
to Europe in the 19th century. Following the opening of the Suez Canal
in 1869, this time was matched by ships delivering tin from Malaya,
setting the three-month contract in stone.
Of course, in those days, taking delivery of a cargo three months in
advance was a much riskier bet than it is today, as the chances of ships
LME 130th ANNIVERSARY SUPPLEMENT
21
Shipping and contracts
“
IN THE EARLY YEARS
OF THE LME, YOU ONLY
KNEW FOR SURE THAT YOUR
CARGO WAS NOT LYING AT
THE BOTTOM OF A DISTANT
SEABED WHEN THE SHIP
ARRIVED AT THE DOCK
”
sinking or disappearing were much higher. And in the early years of the
LME, you only knew for sure that your cargo was not lying at the
bottom of a distant seabed when the ship arrived at the dock. Because
communications were so patchy – and in many cases non-existent – it
helped to have some inside knowledge.
In Britain, like other trading nations at the time, there were close
links between the government and the large trading houses. Before the
age of the telegraph, global communications were largely handled by a
country’s diplomatic service, staffed by ambassadors who passed on
written messages via courier around the world. Traders privy to leaked
diplomatic messages, for example saying that a war had started or cargo
ships been sunk, could take a position and profit from the knowledge.
There was nothing stopping kings and ministers profiting from such
inside knowledge too – and they frequently did.
The invention of the telegraph in the second half of the 19th century
changed everything. It made it much easier to track ships’ progress and
loosened governments’ stranglehold on information. Metals are usually
carried by ‘bulk carrier’ ships, which are often referred to as ‘tramps’
because they do not necessarily ply fixed routes. Bulk carriers carry
homogeneous cargoes, like grain and oil, as well as metals, while
container ships are used more to transport consumer goods.
The biggest development in the transport of metals over the last 100
years has been in the size of the ships used. Even 70 years ago, a ship
with a capacity of between 1,000 and 2,000 tonnes was considered
large. Nowadays, bulk carriers can take up to 450,000 tonnes.
Today’s ships are not much faster than their predecessors, which is
understandable given they are carrying much heavier loads. Alastair
Fischbacher, senior manager at the shipping division of Rio Tinto,
estimates that most ships have an average speed of between 11 and 15
knots, compared to about 10 knots some 50 years ago.
“Cargo ships have not changed that much in terms of speed,” he says.
“But the flow of deliveries is more fluid than it used to be. There are more
ships moving more product, which helps develop the forward market.”
Alongside this is the growth in LME trading volumes. Last year alone,
these increased by 10 per cent, driven by a growing interest in
commodities as a recognised investment class.
With today’s modern fleet of bulk carriers, transporting metals is
more reliable and predictable than ever before. But the actual business
of freight is as risky as ever.
Earnings are cyclical and highly volatile because it is difficult to
anticipate future demand for the goods which need to be shipped
22
LME 130th ANNIVERSARY SUPPLEMENT
across the world. When the global economy is booming, demand for
goods increases, which drives up the cost of freight and leads to the
construction of more ships. But because it can take several years for
ships to be built, by the time they are in service, demand may not be as
strong, forcing freight rates down. As a result, in the 1990s major cargo
shippers such as the oil and metals industry started reducing the size of
their own fleets. Now most metals and other commodity goods are
shipped by chartered vessels.
Until the recent boom sparked by ballooning demand from China
and Asia, the trend in freight rates since World War II has been
downward. According to a report from Clarkson Research and
commissioned by the European Community Shipowners’ Association,
average transport costs fell by 80 per cent in real terms during the
second half of the 20th century.
Between 1960 and 1990, the average cost of freight increased from
$9/tonne to only $13/tonne. The highest spike in freight prices occurred
in 1956 when the Suez crisis led to the closure of the canal and
disrupted shipping. Obviously transport costs for metals shippers make
up a higher proportion of overall costs the less valuable the metal is.
But this steady downward curve in freight prices has been rudely
interrupted over the past five years or so. Soaring demand for raw
materials to fuel China and India’s industrialisation has pushed up
freight rates as ship builders struggle to keep pace with demand. Some
shipping companies report that rates have quadrupled since 2002.
Many of the world’s ports are also not large enough. Fischbacher from
Rio Tinto says: “There are some ports, such as Newcastle in New South
Wales, where waiting times are several weeks long because the supply
chain can’t cope with the demand. You could have 50 or more ships
waiting to load. That just makes the shortage of ships even worse.”
Clearly, the metals industry and the LME are dependent on a fully
functioning shipping industry to make sure cargoes get from A to B.
The Exchange constantly reviews its approved warehousing locations
to ensure that they reflect changes in consumption and trade flow
routes. Current coverage totals 400 warehouses in 35 approved
locations in 13 countries.
Even today, a massive one quarter of total seaborne trade (by
volume) is estimated to be made up of metals, which also include coal
and scrap. So it’s not just a case of money making the world go round –
but metals too.
Tim Webb is industrial editor at The Observer
Shipping and contracts
“
THE BIGGEST
DEVELOPMENT IN THE
TRANSPORT OF METALS OVER THE
LAST 100 YEARS HAS BEEN IN THE
SIZE OF THE SHIPS USED
”
LME 130th ANNIVERSARY SUPPLEMENT
23
Emerging markets
Onwards
and upwards
Commodities have been enjoying a
protracted bull run and prices have hit
historic highs. Phil Thornton argues that the
recent pattern may seem unprecedented,
but it stretches back for more than a century
24
LME 130th ANNIVERSARY SUPPLEMENT
Emerging markets
F
or anyone under the age of 30 the recent surge in both
demand and prices for metals must feel like an
unprecedented boom.
Prices of a host of industrial metals have hit record
highs as demand has ballooned following two sluggish decades in the
1980s and 1990s.
But viewed over a horizon of the past 100 or 150 years, the events of
the last seven are only a blip in a rollercoaster ride for both global metal
markets and industrial development.
The 130-year history of the LME provides the bookends for an era of
industrial development that began with the second Industrial
Revolution in the 1850s through to what today is increasingly seen as
the third revolution.
Over that period there have been four protracted bull runs in
industrial metals prices, running roughly from 1850-1875, 1890-1920,
1933-1953 and 1960-1975. This pattern can be seen clearly for copper and
aluminium and is also evident in the prices of nickel, zinc and steel.
Each bull run can be explained by monumental events in human
economic and political history, starting with the second Industrial
Revolution and followed by the urbanisation of the US, the period of
World War II rearmament and reconstruction, and lastly the Japanese
economic renaissance.
As Jim Rogers, the American financier, says in his book, Hot
Commodities: “They [commodities] are prime players in history, the
offspring of the basic economic principles of supply and demand.”
What each run has in common is that it marks a period when a
different part of the world went through a materials-intensive phase of
economic growth.
Whether or not the current Chinese-driven boom will last as long as
its predecessors will not be known for several years. Alan Heap, global
commodity analyst at Citigroup, says these ‘supercycles’ only come to
an end when the intensity of use declines and demand slows.
There have been two other noticeable trends during this period. The
first is that while prices have fallen and risen sharply, the general trend
has been downwards.
Towards the end of the 19th century copper prices fluctuated
between $3/pound and $4/pound in terms of 2004 money, and peaked
at $5 at the end of World War I. Since then the price declined to around
$1/pound in the late 1990s but is now back above $3.
This trend has been driven by increases in production, massive
technological change and a move towards recycling. According to one
estimate, copper production has risen from about 15,000 tonnes a year
at the start of the 1800s to around 45,000 tonnes a day now.
Meanwhile technical advances have reduced the cost of extracting
and processing metals, and lowered businesses’ dependence on them
by inventing substitutes such as plastics. Western economies have
matured, moving into services and ‘weightless’ economic activities.
Furthermore, metals are not destroyed when used and can be
recycled, prolonging their life. Technical innovation is increasing the
volume that can be economically recycled.
The other trend is a shift from West to East for both supply and
demand for industrial metals. The pre-World War II booms were
predominantly in the US and Europe, while later ones have been caused
by expansion in Asia.
LME 130th ANNIVERSARY SUPPLEMENT
25
Emerging markets
Before the LME was founded, Britain was broadly self-sufficient in
industrial ingredients such as coal and steel. The Industrial Revolutions
changed all that and forced entrepreneurs to seek supplies from what
were then far-flung areas such as Latin America and South-East Asia.
While North America had some 60 per cent of global copper mine
production and Europe 20 per cent at the start of the last century, their
relative shares have declined some fivefold over the last 100 years and
production in Latin America and Asia has grown exponentially.
The shift from the UK as net exporter to net importer led to the
creation of merchants who acted as selling agents offering a range of
grades of metal; and financiers, providing credit and hedging against
movements in prices.
The number of merchants rose as demand for commodities
expanded and it was the need for more standardised rules and
procedures that led to the creation of the LME in 1877.
The metals market is now driven by the urbanisation of Asian
countries such as China and India and deepening industrialisation in
Latin America, the Middle East and Asia.
Within that global picture, China has become the single most
important driver of price dynamics in the metals markets.
Figures from the International Monetary Fund show starkly the
impact that China has had on metals demand. Global consumption
of copper rose by 3.8 per cent a year between 2002 and 2005. Out of
that extra demand, China contributed 51 per cent. It also made up
almost the same share of the 7.6 per cent annual growth in
aluminium consumption.
For other metals the picture is even more startling. Chinese demand
for lead actually exceeded the 4.3 per cent annual global growth because
26
LME 130th ANNIVERSARY SUPPLEMENT
demand from some other economies fell. The same was true for zinc,
where Chinese demand rose by 4.2 per cent compared with overall
global consumption growth of 3.8 per cent.
It is hardly surprising to learn that China is now the largest consumer
of several key metals, making up around a quarter of world demand for
aluminium, copper and steel.
Figures from China’s National Bureau of Statistics in June 2007
show the country produced 1.27 million tonnes of refined copper in the
first five months of 2007, 11.5 per cent ahead of the same period last
year. Primary aluminium production surged 36.1 per cent to 4.68
million tons.
Meanwhile, the Economist Intelligence Unit’s industrial raw
materials price index rose 50 per cent in 2006 – the sharpest annual rise
since the index began in 1990. The base metals’ price index rose by over
62 per cent compared with 2005.
Globalisation has also changed the nature of investor demand,
leading to similar levels of financial innovation seen at the time of the
creation of the LME.
The Exchange continues to expand into new areas of contract
development, such as plastics and steel, and has also lengthened the
trading hours of its electronic trading platform, LME Select, in
response to trading demand from Asia.
Whatever the short-term outlook for prices, the history of the last
130 years shows that the ongoing processes of globalisation,
urbanisation and financial and technological innovation will underpin
the market for some time to come.
Phil Thornton is lead consultant at Clarity Economics