Hedging with Jorge #Episode 52: Physical delivery on the LME – Explained with real-life scenarios

In this blog of Hedging with Jorge, we explore the third critical LME role delivery. Learn what happens when you opt for physical settlement instead of closing your futures contract. From broker interactions to warehousing costs, this 6-minute breakdown with Jorge and Ian unpacks it all. Watch now to understand how delivery premiums work and why consolidation and arbitrage matter in metals trading.

In this latest blog, we open a fresh video format and explore the third crucial function of the London Metal Exchange (LME), delivery. Through Ian’s conversations with Jorge, we unpack what it means to take physical delivery of aluminium via the LME system, with a focus on logistics, costs and arbitrage.

We begin with a recap of the previous step: taking a position in the futures market. Suppose you go long on 40 lots (1,000 metric tonnes) of aluminium for May 7 at USD 2,400 per tonne. This is done through your broker. Two days before the contract expires, you have a choice: close your position (via cash settlement) or opt for physical settlement.

If you decide to close the position, you enter an opposite transaction sell if you previously bought and vice versa. This may result in a profit or a loss depending on price fluctuations. You can also roll over your position, which we’ve covered in earlier episodes.

However, choosing physical delivery initiates a different process. You inform your broker of your intention and provide the funds. In return, you receive 40 warrants each representing one lot (25 tonnes) of aluminium. But here’s the twist: these warrants are linked to aluminium stored in LME-approved warehouses across the globe – Europe, Asia, North America and Australia, but not in Africa or South America.

Now comes the important part: consolidation. Since your warrants could be scattered across different warehouses say, 30 in Rotterdam and 10 in Tokyo you must consolidate them based on where you want the delivery. This consolidation can either cost you money or generate a small income, depending on location-based premiums.

But the costs don’t end there. From the day you take delivery, you start incurring:

Storage charges

Insurance costs

Cost of capital (money tied up in inventory)

If you want the material delivered to your own facility, you’ll need to engage a freight forwarding company to extract it from the warehouse and transport it to your desired port. The total cost, say USD 350,000 for 1,000 tonnes, would translate into an added premium of USD 350/tonnes over the LME base price.

This brings us to a key concept: arbitrage. The delivery system sets a natural ceiling on the premiums traders can charge. If a trader quotes a significantly higher price than the LME + delivery costs, it’s economically smarter to source the aluminium directly through the LME.

That’s how physical delivery not only supports market function but also protects buyers against excessive premiums. Jorge concludes that most deliveries are indeed handled by third parties but understanding the process helps in better negotiation and smarter trading.