Warrant Deliveries
Most people within the metals industry are aware that certain exchanges are physically settled. This means that should you allow a futures position to expire without squaring it, or carrying it to a different prompt date, it will become a physical obligation to either receive (if you are long futures) or deliver (if you are short futures) metal to the exchange. In base metals trading, these physical parcels of metal that guarantee every single lot of futures held to expiry are known as warrants. These warrants are stored in specific, exchange-approved warehouses globally and are of exchange-approved brands - producers of metal the exchange has deemed acceptable for delivery.
The exchanges themselves are known as lenders of last resort. If a consumer or trader finds themselves in a position where they have no other options to source metal, the exchange should always be a reliable source to provide said metal. Now, these warrants may not be in the ideal location, the freshest production, or the ideal brand. Still, given the exchanges’ vetting process for allowing producers to become exchange-approved, it provides a guarantee that the metal will meet a certain chemical specification, shape, and generally be acceptable by most that consume that particular metal.
Why a trader or consumer might look to the exchange as a source of material is fairly well understood - markets can get extremely tight, producers can go offline suddenly, and supply shocks are somewhat common - all of which might give a need for a quick source of metal. What is far less understood is why that same trader may want to deliver metal into a warehouse in the first place. How do sizeable amounts of material find their way onto the exchange in the form of warrants - what is in it for those that regularly deliver to the exchanges? It can be a confusing concept, particularly given the amount of rumors that often go along with significant deliveries to the exchanges and the somewhat secretive nature of these trades.
In general, there are a few main reasons that the holder of physical metal may wish to utilize an exchange for delivery, instead of selling it to the consumer market.
Backwardations
Backwardations can happen sporadically, often appearing quickly, and sometimes violently. They can be caused by organic changes to supply and demand, supply shocks or sudden bursts of demand. They can also occur from speculative positions in a market that influence the values of the forward curve. A large position build by one market participant for example can often shift a curve from a healthy contango into a backwardation, particularly the closer that position gets to expiry. If a company is holding an open short position and they are faced with borrowing that short through a costly backwardation, it may actually be more beneficial to them to use that short position to deliver physical metal to the exchange in the form of warrants.
Let’s say a company paid a $40/mt premium for metal and the sales premium they might be able to achieve in the spot market the following month is $80/mt. Their market is currently in a month over month backwardation of $120/mt. Selling the material to a consumer the following month would gross a $40/mt profit on the premium, but it would cost them $120/mt to carry that short position, a net loss of $80/mt. If they deliver metal to the exchange against their short position instead, they would only be sacrificing their purchase premium of $40/mt, in this case saving themselves an additional $40/mt by avoiding the cost of the backwardation.
Backwardations can also be profitable for traders. Let’s say in that same example, the trader had already borrowed their position past the point on the curve where the backwardation was occuring. In this instance, they could actually lend their position, thereby creating a nearby short futures position and squaring their short position further out on the curve. They would then deliver metal to the exchange against that nearby short position and they would pick up the entire value of the backwardation, a gross profit of $80/mt vs the profit of $40/mt they would obtain in the consumer market.
In periods of large backwardations, we often see inflows of metal to the exchange as traders look to capitalize on the value or avoid the cost of a backwardation.
Warehouse Incentives
While exchange-approved warehouses are not allowed to physically own warrants, they still play an important part in the levels of exchange stocks. The warehouse rent commanded for a warrant is pre-determined by the exchange at ~$16/mt/month. There is also a fixed cost that the warehouse will receive whenever a warrant is canceled, known as an FOT fee which is the warehouse charge for loading canceled warrants onto a truck for physical consumption. This is charged in local currency but typically is ~$45/mt. If a warehouse believes that fresh material delivered to their facility will remain on warrant for a certain period of time, they can estimate a guaranteed revenue from warehouse rent and load-out charges. Depending on the conditions in the physical consumption market, this warehouse revenue may be higher than the current physical premiums. A warehouse can pay this incentive to the producer or trader to encourage delivery to the warehouse.
Warehouses may also enter into a ‘rent-share’ agreement with a trader that agrees to deliver warrants to an exchange warehouse, typically this share will be 50/50 so a trader can expect to receive ~$8/mt/month in revenue for the life of a warrant. If a trader believes that metal is likely to remain in a warehouse for an extended period of time, they can calculate that rental income vs. the premium that would achieve in the physical market. This can be a risk as you can never be 100% confident that warrants will not be cancelled and removed from the warehouse, but it is a fairly well-calculated risk that traders are used to taking. Once warrants are delivered to the exchange, the trader no longer faces the cost of financing the material, but they are still receiving rental revenue. If this rent-share revenue is greater than what is achievable by physical consumption, you will often see metal flow into exchanges.
Financing Implications
If a company is holding a large amount of stock and wishes to immediately reduce their financing requirements, delivering warrants into an exchange warehouse is a very convenient way to reduce metal holdings. Provided you can establish the short position, there is no limit as to the amount of metal you can deliver into the exchange at any given point. As long as that metal meets the chemical specifications set by the exchange, and is of an allowed brand, in an acceptable warehouse, any amount of metal can be delivered as warrants. Particularly around certain financial quarter/half/full year ends, metal inflows to exchanges can increase as companies look to reduce the size of their balance sheets prior to printing their financial statements for the period.
This is not an exhaustive list of why companies might deliver warrants to the exchange, and sometimes it is a mix of multiple factors. However, knowing some of the main market conditions that make warrant deliveries into exchanges more common allows for better understanding and foresight into these markets.
