May/June 2002
The LME’s new North American Special Aluminum Alloy Contract—NASAAC—could improve price transparency, reduce price risk throughout the industry, and more. The question is: Will it?
By Kent Kiser
March 4, 2002, marked a milestone for the London Metal Exchange and the North American secondary aluminum industry. On that date, the LME launched its North American Special Aluminum Alloy Contract, or NASAAC.
Not just any metal contract, NASAAC lives up to the “special” in its name because it’s the LME’s first regionally focused contract, designed specifically for the North American secondary aluminum industry.
Notably, NASAAC is not the LME’s first aluminum alloy contract. The exchange introduced its standard aluminum alloy contract in 1992. While that contract has carved out a respectable niche for itself in the European market, it hasn’t been used widely in the North American market for several reasons: the contract’s metallurgical specification doesn’t match the requirements of North American users; prices tend to be basis Italy since most of the contract’s stocks are warehoused there; and the contract lacks sufficient transaction volume, or liquidity. For these reasons, the contract isn’t an effective hedge for North American consumers.
In October 2000, major North American secondary aluminum producers and consumers contacted the LME to consider solutions to these problems. From these discussions, the LME decided to offer a regional contract to meet the needs of the North American secondary aluminum market.
This new contract would resolve the specification problem by having a spec that truly reflected the aluminum alloy used by North American consumers—particularly automakers such as General Motors Corp. This specification—denoted as LME NA380.1—would be a modification of the Aluminum Association’s A380.1 specification.
The new contract would address the warehousing problem by having delivery points only in locations relevant to North American users, including Baltimore, Chicago, Detroit, and St. Louis.
It was less certain whether the new contract could resolve the problems of liquidity and hedge effectiveness. That would only be decided by the market, after the contract was introduced.
In November 2001, the LME took the bold step of approving the creation of NASAAC, giving the new contract a launch date of March 4, 2002, with a first prompt date of June 5, 2002. It also set July 2002 as the first prompt month for traded options as well as traded average price options, or TAPOs, contracts.
Thus was NASAAC born and introduced to the North American market.
The Liquidity Question
Naturally, the LME has high hopes for its new contract. The exchange’s dream would be for NASAAC to become the price reference and price risk management tool for the North American secondary aluminum industry.
The industry could certainly benefit from the targeted exchange-based pricing approach offered by NASAAC, says Martin Abbott, a former LME executive who now serves as vice president of American Metal Market. As he explains, such exchange-based pricing offers three principal benefits:
• price discovery that is subject to regulatory and third-party supervision, which gives exchange pricing an advantage over other pricing methods such as published prices;
• risk management. Other pricing methods don’t allow any degree of risk management or any kind of forward pricing structure; and
• physical delivery. Participants can use the exchange as a delivery point of last resort, accepting metal from or shipping metal to warehouses approved—but not owned—by the LME.
NASAAC is, in essence, a new playing field for the North American industry, says LME Chief Executive Simon Heale, who likens the new contract to a baseball diamond. A diamond is just a diamond, however, unless it has players who use it, he acknowledges.
“We provide the umpires, we provide the balls, we provide all the tools for the game—but you are the players,” Heale says. “Only you can decide if you actually want to turn up at the LME baseball diamond and use the facilities we provide.”
That gets to the heart of the matter: Will NASAAC attract participation from all sectors of the North American secondary aluminum market—scrap processors, smelters, and consumers—to build adequate liquidity? After all, without liquidity, the contract can’t accurately reflect the market or serve as an effective hedging tool.
This need for broad participation is the main weakness of exchange-based pricing, asserts Abbott. In his view, the LME’s system of credit-driven customer accounts could limit participation in the market and, thus, hinder NASAAC’s success.
“At a time when LME membership is becoming more and more bank-like and its requirements of counterparties becomes more conservative, it is unlikely that many of the smaller players in the secondary aluminum market will be able to open trading accounts,” Abbott says. “Even the cash-margin account may be difficult for many of the industry’s players given the cash-flow constraints. Meanwhile, individual brokers may find it difficult to devote much time and attention to a relatively small product like the secondary aluminum contract when they can be distracted by the primary aluminum and copper markets.”
In its favor, NASAAC is beginning life bolstered by goodwill from North American producers and consumers since they helped create the contract. The challenge is to convert that goodwill into “regular, active use of the contract,” Heale says.
In its first day of trading on March 4, there were 392 NASAAC lots purchased in 21 trades—a “pretty reasonable” debut, says one LME official. From March 4-29, there were 1,678 lots purchased in 134 trades. “We’re seeing a lot of good liquidity there so far,” remarks one scrap processor. “The contract seems to be of interest to everybody.” One consumer notes that the bid/offer spreads are fairly narrow and that the LME prices reflect the Midwest price for the physical metal.
A Better Hedge?
OK, so let’s assume that NASAAC achieves the necessary liquidity. The next big question then is: Will NASAAC become a useful price risk management tool for North American secondary aluminum players?
The consensus seems to be yes.
To understand why, you have to look back at the problems that North American secondary aluminum processors, producers, and consumers faced before NASAAC.
One problem was that they couldn’t effectively hedge their North American alloy purchases using either the LME’s standard alloy or high-grade primary aluminum contracts. In simple terms, it was a case of hedging apples to oranges rather than apples to apples.
This lack of an effective hedging tool had a direct, negative effect on the earnings of North American secondary aluminum participants. That’s because of the Federal Accounting Standard Rule 133, or FAS 133.
That rule, which took effect Jan. 1, 2001, requires companies that have audited financial statements (predominantly publicly traded firms) to have a formal risk management program that, in simple terms, provides an effective hedge for what they buy. An effective hedge is one in which there’s a high correlation between the prices of the purchased physical commodity and the hedging instrument. Under FAS 133, the ineffective portion of a hedge—the percentage of noncorrelation between the two prices—must be immediately reported to earnings rather than deferred. If, for instance, the correlation is only 83 percent, then the ineffective 17 percent would have to be reported immediately to earnings. The result was unacceptable earnings volatility for North American players.
Obviously, a better hedging tool was needed. That’s where NASAAC comes in. By giving North American firms a better match between the material they buy and the hedging instrument, NASAAC can offer higher price correlation between the two and, hence, higher hedging effectiveness. That, in theory, will translate to lower earnings volatility.
NASAAC could offer a correlation of 98 percent in the near term and 100 percent in the long term, says aluminum industry expert Mary Lou Southwood of Commodity Metals Management Co. (Wexford, Pa.). In other words, North American market participants would finally have a way to hedge apples to apples.
Speaking from a scrap processor’s perspective, Cindy Brooks, a nonferrous trader with OmniSource Corp. (Fort Wayne, Ind.), says, “We believe that secondary scrap prices have a strong correlation with the 380 ingot prices, and we believe that the 380 ingot prices will begin to show a strong correlation with the new alloy contract. Given that, we believe that the new alloy contract will provide an effective and useful tool for hedging secondary aluminum scrap.”
To reiterate, though, NASAAC must achieve and maintain liquidity to become such an effective and useful tool. As Southwood stresses, “The activity level will determine if this becomes a good hedge instrument for the market.”
The Pros and the Cons
If NASAAC does indeed become an effective price risk management tool, companies up and down the North American secondary aluminum chain could enjoy less-volatile earnings, which could help them become more stable and financially stronger.
Scrap processors, for instance, could use the NASAAC contract to hedge the changes in their scrap inventory, offers Charles Hatton, senior vice president of the metals group of Man Financial Inc. (New York City). As he explains, when scrap processors buy more scrap than they’re selling, they’re exposed to risk if prices decline. When processors sell more scrap than they buy, they’re exposed to risk if prices rise. To protect against such price risk, Hatton notes that processors could establish a baseline inventory level, then hedge the changes.
“If you drop below your baseline level, you replace the shortfall by buying NASAAC futures,” he says. “If you exceed your baseline level, you sell forward NASAAC futures.” In this way, processors could offset their net scrap position and minimize their price risk.
Aside from reducing price risk, NASAAC could give the North American market an accurate, transparent price on which participants could base their buying and selling. For example, processors could decide to buy scrap from their suppliers and sell scrap to smelters referenced to the NASAAC price, thus locking in a consistent margin. As OmniSource’s Brooks states, NASAAC “allows us to manage risk better than we have been able to before and provides price transparency that is better than anything that existed prior to the launch of this contract.” For those reasons, Abbott emphasizes, “everybody from the mom-and-pop companies to the established merchants needs to be persuaded that the LME price is the way for them to price their scrap.”
For smelters, buying scrap on a NASAAC basis and hedging their metal sales with NASAAC could give them greater control over their own costs and margins. “The pricing mechanisms we use expose us to a great deal of price risk in terms of when we price our products for our customers and when we buy our raw material,” says Bruce Warshauer, president of Wabash Alloys L.L.C. (Wabash, Ind.). “To the extent that we can purchase NASAAC contracts when we’re pricing our product and unwind those as we’re buying our scrap, that minimizes our price risk and allows us to stabilize our margins.”
According to Abbott, “It’s time for the smelters to abandon all hope for the system that takes scrap prices and seems to add a percentage for margin—and they must clearly separate the commodity cost for raw material from the conversion cost of processing.” By acknowledging that secondary aluminum is a commodity—rather than a product—with an exchange-based price that’s beyond negotiation, a smelter leaves itself “vulnerable only on the relative efficiency of its capacity to convert raw material,” Abbott says. As Brooks adds, “The secondaries now have a pricing mechanism that tracks with their sale price, and they will almost certainly use the same mechanism to price raw materials and lock in their scrap.”
For automakers and other consumers, greater price reliability in the market could enable them to forge longer-term contracts with their alloy suppliers. “To grow secondary aluminum usage in future auto applications, we need fair, effective, exchange-traded pricing indicators through which we can manage our price risk,” says Dan Bealko, GM’s global commodity manager, light weight materials. “We believe that NASAAC will fill that need.”
Automakers could also sell their production scrap basis NASAAC prices. “If that can be achieved,” says Abbott, “then the greatest fear of the alloy makers—the fear of a dislocation between scrap and alloy prices—can be at least partially allayed.”
While NASAAC has its share of supporters, it also has its detractors, many of whom complain that the contract was created by General Motors for General Motors and doesn’t truly benefit smelters or scrap processors. These skeptics assert that NASAAC won’t adequately address the so-called basis risk faced by the smelting and processing sectors. Others fear that the limited number of North American players using the contract could expose the NASAAC market to manipulation by speculators. (Such fears persist even though the LME has—in the words of one exchange official—“a raft of policies that make manipulation very difficult,” including special lending policies for and reports of large-position holders.) These and other concerns are why some smelters and processors are taking a wait-and-see attitude toward NASAAC. Only time will tell if their claims have merit.
Success From the Top Down
Time will also tell if NASAAC ultimately succeeds or fails. The answer, of course, depends on its acceptance by the North American market.
That acceptance—if it occurs—will likely be a top-down process, beginning with the major consumers and trickling down to the smelters and then to the smelters’ scrap suppliers. If big players such as General Motors adopt NASAAC, it’s a good bet that smelters and at least the larger scrap companies will follow suit. As Abbott asserts, “You won’t do it by persuasion. You may do it by example. But ultimately you’ll probably do it by coercion, which means that when the big players say ‘We’re going to do it this way,’ then the smaller players will fall in line.”
And indeed it looks as if General Motors is putting its weight behind the contract—the company will switch the pricing for all of its purchased aluminum alloy parts to NASAAC beginning in January 2003, says Bealko.
Such an announcement bodes well for NASAAC’s future. This kind of “good consumer forward buying on the NASAAC should attract larger, good credit producers into the alloy business, together with the financial market-makers needed to make the new contract succeed,” notes Rohan Ziegelaar, associate director of structured commodity products for Scotia Mocatta (London).
While the LME is confident about NASAAC’s prospects, it isn’t unrealistic. “New contracts are not easy to launch,” admits the LME’s Heale. “They need widespread support, and users are bound to be tentative at the beginning.” Also, he notes, the North American secondary aluminum market is “respectable in size, but it’s not enormous.” Plus, “producers and consumers are not necessarily going to be in the market every day. So we’re all going to have to work at this.”
The biggest danger to NASAAC’s future, Abbott suggests, “is that the exchange and its members might lose interest before the contract has been assimilated by its users.” Heale begs to differ, asserting that the LME is “totally committed to this contract.” As he affirms, “some exchanges around the world launch contracts with a sink-or-swim attitude. We don’t. We like to plan them as carefully as possible and support them in the long term.”
As part of its support efforts, the LME plans to meet with industry stakeholders this fall to gauge NASAAC’s progress in its first six months.
Until then, the market will march onward and NASAAC’s fate will hang in the balance. If it doesn’t succeed, the North American secondary aluminum market will be back where it started—which would be unfortunate, says Abbott. In his view, “the ability to manage risk, participate in the price discovery process, and create some predictability is too good to miss.”
NASAAC Futures Contract Particulars
Contract: Aluminum alloy conforming to the LME NA380.1 specification.
Lot Size: 20 mt (with a tolerance of +/- 2%).
Form and Weight: Ingots (8 to 31 pounds), small low-profile sows (900 to 1,300 pounds), and large four-way-entry sows (1,250 to 1,600 pounds).
Delivery Dates: Daily from cash to three months (first prompt date two working days from cash). Then every Wednesday from three months to six months. Then every third Wednesday from seven months out to 27 months forward.
Quotation: U.S. dollars per mt.
Minimum Price Movement: 25 U.S. cents per mt.
Clearable Currencies: U.S. dollar, Japanese yen, British sterling, and euro.
Contract Maturity: The contract maturity has been extended to 27 months.
Warranting Period: The warranting period has been extended from eight to 16 weeks from the original melt date, which will allow sufficient time for North American producers to ship material to the U.S. warehouses. The extended warranting deadline will also facilitate the shipment of East European material into the U.S. East Coast.
Removal and Rewarranting: Warranted NASAAC metal can be removed from the approved delivery points and subsequently rewarranted, which could pull down high warehouse rents and allow stock financing to develop.
Condition of Metal: Under NASAAC, the LME is for the first time imposing requirements on the condition of the aluminum alloy being warranted. Metal must arrive at the warehouse in covered transport and must be unloaded in covered or dry conditions. Surfaces must be smooth and free of open shrinkage, porosity, layers, and/or seams. The visible presence of foreign substances such as white/gray residue on the surface, imbedded inclusions, skim/dross, salt cake, iron oxide flakes, or dirt is unacceptable. The product’s edges and surfaces must be free of sharp edges, spurs, and/or flash that might present hazards in handling.
Approved NASAAC Brands
As of April 10, the LME had approved 41 brands of secondary aluminum alloy for NASAAC delivery. Following are the approved producers by country.
Australia—Sims Aluminium Pty Ltd.
Belgium—Alumet
China—Shanghai Sigma Metals Inc.
Finland—Kuusakoski Oy
France—Aldevienne SA
Indonesia—P.T.H.P. Metals Indonesia
Italy—Premoli Luigi & Figli S.p.A., Raffineria Metalli Capra S.p.A., Sacal Societa Alluminio Carisio S.p.A., Vedani, Carlo Metalli S.p.A.
JapanvAsahi Seiren Co. Ltd., Fuji Alumi Industry Corp.
Malaysia—Ye Chiu Metal Smelting Berhad
Poland—Alumetal Sp.Z.o.o. (two brands)
Russia—JSC “Podolsk Non-Ferrous, Metals Plant”—Permtsvetmet
Spain—Aluminio Catalan SA, Refinara Diaz SA
Taiwan—Chen Jung Metal Materials Co., Sigma Brothers Inc.
United Arab Emirates—Lucky Alloys Ltd.
United Kingdom—Alenoy Ltd., Bernhard Metals (UK) Ltd., Coleshill Aluminium Ltd., Mil-Ver Metal Co. Ltd., F.E., Mottram (Non-Ferrous) Ltd., Norton Aluminium Products Ltd.
United States—Allied Metal Co. (two brands), Behr Nonferrous Metals Inc., Bermco Aluminum, Custom Alloy Light Metals Inc., Custom Alloys Scrap Sales Inc., Leggett & Platt Inc., Culp, Aluminum Alloys, Liston Aluminum Brick Co. of Corona, Spectro Alloys Corp., State Metal Industries Inc., TST Inc., Thorock Metals Inc., Vista Metals Corp.
For more information on NASAAC, contact the London Metal Exchange, 56 Leadenhall St., London EC3A 2DX England. Tel.: 44/20-7264-5555. Fax: 44/20-7680-0505. Web: www.lme.co.uk.
Kent Kiser is editor and associate publisher of Scrap.•