A Novelis production facility in South Korea. Novelis and other consumers are concerned warehouse owners will buy up large amounts of metal. Bloomberg News

The world's metal is slipping into the shadows.

Banks, hedge funds, commodity merchants and others are stashing tens of millions of tons of aluminum, copper, nickel and zinc in a hidden system of warehouses that span the globe.

These facilities are known to some in the industry as "shadow warehouses" because they are unregulated and don't disclose their holdings.

They operate outside the London Metal Exchange system of warehouses, the traditional home for these metals.

As of October, a record seven million to 10 million tons of aluminum were being housed in these facilities, in countries as far apart as Malaysia and the Netherlands, according to estimates from several analysts.

Eva Vazquez

The amount dwarfs the 5.5 million tons of aluminum in the LME-licensed warehouses, based on LME figures as of Tuesday. Just 12 months ago, the figures were about equal.

A similar shift is taking place with other industrial metals, analysts say.

As a result, producers and consumers are bracing for potentially wild swings in metals prices as market participants have difficulty accurately gauging supplies of these metals. With no clear insight into how much metal is in the shadow system, setting prices will become increasingly difficult, they say.

Analysts and traders say the flow of metal into shadow warehouses already is making prices move in unpredictable ways—such as when a large amount of unaccounted-for metal suddenly makes its way onto the market.

"It's a real concern for anyone in the industry that metal can be sucked away into a nonreporting location with no expectation or date as to when it's going to be available again," said Nick Madden, senior vice president and chief supply-chain officer with Atlanta-based Novelis Inc., an aluminum-products maker that is among the world's biggest buyers of the metal.

"The risk here is that the metal gets controlled by fewer and fewer hands, whose interests and business model is probably conflicting with that of end users," he said.

Industrial metals end up in all sorts of everyday goods—from aluminum soda cans to copper wires inside refrigerators to zinc-plated steel in roofs. Turbulent raw-materials prices can make it more expensive to produce such goods when prices spike or limit output from mines and smelters when prices drop below their cost of production.

The lack of transparency is making this shadow system increasingly attractive to institutions seeking to profit from information that other buyers and sellers don't have. Some companies also are seeking a cheaper alternative to the LME warehouses, which can be 10 times as expensive as the unregulated storage, analysts and traders say.

However, metal owners can face higher interest rates from banks if they wish to use metal stored in shadow warehouses as collateral for loans, because banks see the LME system as less risky, analysts say.

Five companies operate 75% of the LME's 778 licensed warehouses. All own shadow facilities as well, people familiar with the companies said.

In some instances, a single firm runs licensed and unlicensed warehouses in the same building, with the metal counted by the LME separated from hidden stockpiles by a chain-link fence, said David Wilson, a commodities analyst with Citigroup.

Until 2010, most warehouses were owned by logistics firms like Netherlands-based C. Steinweg Group. But as metal-financing trades became more popular, C. Steinweg was joined by units of Goldman Sachs Group Inc. and J.P. Morgan Chase JPM  & Co. as well as commodity traders Glencore Xstrata PLC of the U.K. and Switzerland and Trafigura Beheer BV of the Netherlands.

All five companies declined to comment.

Metal consumers like Novelis say that prices could increase sharply if warehouse owners buy up large amounts of metal, creating a shortage.

Alcoa Inc., the largest U.S. aluminum maker, has the opposite worry. The company fears aluminum prices are vulnerable to a shock if a large amount of metal suddenly gets moved from shadow warehouses back to the LME's facilities, said Tim Reyes, president of materials management at Alcoa.

"If one day, 2 million tons of aluminum show up and it just went from one pocket to another pocket, it has an impact on price that it shouldn't, and that's a concern for us," Mr. Reyes said.

Such volatility makes it harder to make production plans, he said.

Many metal buyers and producers say they are worried that new rules approved by the LME in November will speed up the flow of metal into shadow warehouses.

Starting April 1, LME warehouses with wait times exceeding 50 days must deliver out more metal than they take in. The delays help boost income from rent and increase the fees paid for faster service, so warehouse owners are expected to increase LME rent charges to offset any reduction in profits.

The rules strike at a trade that has grown sharply since 2010, where investors buy the cheap physical metal and sell a futures contract on the LME at a higher price.

Meantime, the metal sits in an LME-licensed warehouse until the futures contract expires. Higher warehouse costs make this trade less profitable.

If applied today, the rules would flush aluminum out of LME-licensed warehouses holding 3.5 million tons of the metal, equal to 7% of annual global demand.

Warehouses holding copper and zinc also would be required to speed up the release of their stockpiles.
In a Nov. 7 report, the exchange said one potential negative side effect of the new regulations is that more metal could end up in shadow warehouses.

The LME in a statement said it has a duty to run a fair and orderly market and that the warehouse bottlenecks posed a range of issues in terms of price discovery.

The rule changes were made following a consultation process that included an examination of all concerns raised about the possible unintended consequences of any changes, it said.

"We believe that the package of measures contained in the proposal is, on balance, the best solution for all market users," the exchange said. 

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