Warrant Deliveries

In order to deliver metal into a warehouse, a trader must establish a short futures position. A short futures position can be created either by selling futures outright on the specific prompt date a trader is lining up their deliveries, or by lending from the required prompt date thereby creating a nearby short position and a long position further out. Metal cannot be delivered into the exchange system without creating this short futures position.

Futures contracts for base metals on the LME and CME are physically settled - this means that if you allow a short futures position to become prompt, you will be obligated to deliver metal in the form of warrants against that position. Most of the time short positions are carried prior to expiry but traders can use them to deliver physical warrants against should they wish.

Provided a trader can establish a large enough short futures position, there is no limit as to how many tons they can deliver into the exchange warehouse system. They are only limited by how much physical metal they can access (and afford to finance) while they transport it to a warehouse and prepare it for warranting.

Once 'lots' have been created by the warehouse, which will differ in tonnage depending on the metal being traded, the trader simply needs to instruct them to deliver the warrants to the broker they have established the short position with. Once they have been delivered, the trader will be paid for the metal by the broker at price their short futures position was established. Importantly, metal can be stored in warehouses for an indefinite period of time until the trader wishes to convert the metal into exchange warrants, based on when they establish their futures short and what prompt date it has.

So that's the how, but what about the why? 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.