Let’s talk about spreads baby

If you got that reference I hope your back feels ok this morning.

As we finish the first few days of September, the London Metal Exchange zinc forward curve has flipped from a contango into a backwardation.

In simple terms: the price being quoted for cash (2 days from now) is higher than the price being quoted for 3-month, and actually all the way through to Dec-27. There is a deemed tightness in the zinc market that is convincing traders to pay more today than in the future, when the tightness may have disappeared.

So what is causing this? First, LME zinc stocks are low. There is currently only 55KMT of stock in LME exchange warehouses which is the lowest level in over 2 years. A low level of stock is indicative of a tight physical market, pressuring the nearby prices.

This stock level is also below the threshold to trigger the new lending guidance that would cap backwardations.

The other reason seems to be stemming from the banding reports. The LME publishes large position holders (both long and short) once they hold over a certain percentage of the nearby positions. Currently, on the September 3rd Wednesday there are two significant short position holders, one holding 20-29% of the shorts and one holding 5-9%. This means up to 38% of the remaining borrowing requirement falls on only 2 traders.

As we approach the 3rd Wednesday, they will either have to borrow that position, and hope that by then the spread has eased, or deliver in physical zinc warrants.

In a tight market the odds of being able to deliver thousands of tons to the warehouse are slim, and so the short holders will be forced to borrow. However, borrowing in a tight market when everyone knows you have no other options is easier said than done.

Backwardations can increase a lot quicker than contangos and once your position is exposed it can be very costly to get out of it.

Position management involves assessing all different components of the market: stocks, prices, position reports, volumes traded, trends, and understanding the underlying physical picture. Perfectly Hedged LLC is your guide to unlocking these nuances and making sure that you are not caught facing a costly roll...like a couple of traders are currently.