Zinc spreads explode as tightness bites London shorts

Zinc bulls have been waiting a long time for this, but the slow-burning supply crunch has at last travelled all the way down the supply chain to bite holders of short positions on the London Metal Exchange (LME). LME time spreads exploded last week and they’ve grown wilder still this week.The benchmark cash to three-month spread closed on Monday at a backwardation of $66 a tonne. That’s the widest cash premium since January 2007. Contraction of the forward curve reflects acute tightness on the cash date itself as evidenced by continuing turbulence within even the shortest-dated of LME spreads.With exchange stocks falling and more metal being cancelled before physical load-out, those who have taken short positions look set for a torrid time. However, this sort of extreme tightness on the LME could yet prove a double-edged sword for bulls if it sucks “hidden” metal out of off-market storage.The whole front part of the LME zinc curve is now showing signs of extreme stress. “Tom-next”, that curiosity of the LME’s complex trading date system, has been trading in backwardation since the start of last week.The cost of rolling a short position from tomorrow to Thursday has this morning been as high as $15 a tonne.The cash-to-October spread flexed out to a $45 backwardation on Monday and around $40 this morning.The mechanics are pretty straightforward. The LME’s market positioning reports have shown one entity controlling 50-80% of available LME stocks over the past few days.It was briefly joined by another entity with a similar-sized cash position at one stage last week, though it had dropped out of sight by Friday’s close. However, the one that remained still controlled 50-80% of stocks.Factoring in cash-date positioning, its dominance was even greater, accounting for more than 90 % of non-cancelled stocks.Someone has all the LME stocks and they’re making the shorts pay, albeit within pre-set limits dictated by the exchange for such dominant positions. LME inventory is itself a moving target. Headline stocks have fallen by 39% this year to 260,325 tonnes, hovering around levels last seen in 2008. The key stocks metric at times of tightness, however, is not the headline figure but how much “live” tonnage is in the system.What the LME terms “on-warrant” tonnage is the real stocks liquidity base and those dominant position ratios are calculated against it. And on-warrant stocks have again dipped sharply lower. This morning’s LME stocks report showed 23,050 tonnes of metal stored at New Orleans moving to the cancelled category, leaving on-warrant stocks at 128,100 tonnes. What is already a tight market, in other words, could become even tighter. Or, if you hold short positions, even more financially painful.Those with LME short positions always have a third option beyond closing out the position or rolling it forwards.They could deliver against the position if they have access to physical metal.Which raises the question of how much more zinc is “out there” beyond the reach of the LME warehouse system.The zinc market has been wrong-footed in the past, most recently in 2015, by the sudden appearance of previously “hidden” stocks. Two years of a tightening physical supply chain should mean there is far less hidden material than in the past, but there are still good reasons for caution. Zinc is still occasionally entering the LME system in reasonable size volumes.* Andy Home is a columnist for Reuters. The views expressed are those of the author.