Aluminum Stocks: As Another Contango Begins, Here’s the Best Way to Play It
by Tony Daltorio, Investment U Research
Tuesday, February 23, 2010
Aluminum is the Earth’s most abundant metal. Over the decades, inventors have put the soft, durable, lightweight and malleable metal to good use in everything from airplanes to soda cans to baking accessories.
Not to be outdone, Wall Street found its own use for the metal, turning the industrial staple into a lucrative financial instrument. Right now, it has 75% – 90% of the world’s physical aluminum stocks tied up in financial arbitrage. In fact, according to Klaus Kleinfeld, the CEO of the world’s largest aluminum company, Alcoa (NYSE: AA), “almost all” of it is currently being held off the market. Why? To profit on the difference between the spot price – what it costs right now – and the forward price: What it costs at some later date.
Since aluminum comes in ingot form like gold, it’s relatively easy to store. That fact, combined with today’s cheap borrowing rates, has led people to buy up large quantities of the metal and store it in warehouses until the price rises significantly.
As my fellow Investment U writer Matt Weinschenk explained about oil back in January, when this happens it’s called a contango.
In this particular case, the price of aluminum three months out is roughly $30 per ton higher than the current price. And economists at Rio Tinto ADR (NYSE: RTP), the owner of aluminum giant Alcan, conducted a recent study that showed returns from aluminum financing deals hovering between 3% and 5% since 2009… Not a bad return with near-zero interest rates right now.
Aluminum speculation provides significant returns to financial investors… and it should continue doing just that for some time to come.
Aluminum as a ‘Hard Asset’
As evidenced by the flock to gold, investors are turning to hard assets as a safe alternative to traditional currencies. Though gold continues to claim the headlines, aluminum actually represents the most extreme example of the metal rush.
Of course, by doing that, investors risk pushing the prices too high and too far in an already notoriously volatile sector. Just consider how physical, aluminum stock levels on the London Metal Exchange have already quadrupled in the past 18 months to about 4.5 million tons. That’s 110 days worth of supply or enough to build about 68,000 Boeing 747s!
That indicates a gross oversupply, especially since manufacturing in developed economies remains slow. Yet prices continue to rise, largely because so much aluminum remains off the market.
Aluminum Stocks Tied Up in Financial Deals
If the reports and rumors are accurate, then 90% of aluminum stocks are tied up in financial deals. And China controls an estimated 1 to 1.2 million tons more of unreported stocks. In cyclical fashion, that kind of tight market helps to drive up prices even further, which in turn supports more financial deals.
That’s all well and good for the people making money hand over fist right now. But when interest rates begin to rise, that could all change.
Of course, the 1993-94 market saw similar financial deals taking place. Back then, even after conditions changed, excess stocks of aluminum remained off the market for another two or three years. They drip-fed back in as prices rose slowly and steadily on the back of increasing industrial demand.
So it could happen just like that again today. Some aluminum smelters are restarting on the back of higher prices, which is a good sign for their product. And just like seven years ago, that metal shouldn’t hit the market all at once – not with the stocks tied up in contracts of varying durations and terms, at least.
With that said, the future for aluminum looks okay, though not as exciting as it could be. Keep in mind that any increase in demand will be met with speculators unwinding their positions.
Two Ways to Play The Aluminum Stock Contango
However, investors who have the inclination and the financial backing to take on a bit of risk can get in one of two ways:
- Aluminum Play #1: iPath Dow Jones-UBS Aluminum Subindex Total Return (NYSE: JJU) is an ETN and represents a pure play based on aluminum futures.
- Aluminum Play #2: PowerShares DB Base Metals Fund (NYSE: DBB), an ETF based on a wider range of metals futures, focuses evenly on aluminum, copper and zinc.
Just keep in mind that either one – or any other plausible play on aluminum futures – puts you directly at the mercy of speculators. So be very careful if you do decide to pursue these trades.
Good investing,
Tony Daltorio
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