Executive summary

In his most recent report, given the increasing presence of aluminum in auto production, Rich Excell explores how contract renegotiations at major auto companies could be a possible market catalyst.

One of the biggest stories of 2023 has been the negotiation for higher wages by unions. The airlines have seen this across all workers – pilots, flight attendants, and mechanics. We have seen it in rail and trucking. We have seen it with the West Coast dock workers. The latest, and arguably biggest, negotiation to take place is between the United Automobile, Aerospace, and Agricultural Workers of America (UAW) and the Big Three auto manufacturer companies – Ford Motor Company, General Motors, and Stellantis (formerly Chrysler). 

Contracts are coming to an end and the UAW wants to renegotiate these deals having seen the success of other unions in getting higher wages for their workers. The first of the Big Three contracts are set to expire on September 14 and a shutdown across all automobile manufacturers has been suggested as a possibility and a negotiating tactic. 

Image 1: Amount of aluminum per vehicle

If there is a shutdown among automobile manufacturers, what markets might be the most affected? Traditionally, one might suggest that steel makers would be, or semiconductor chips, given the large number of chips that now go into an automobile or light trucks. However, quietly, one of the bigger inputs for light vehicles in the U.S. has become aluminum, making up 12% or more of a car. When Ford switched to making the F-150 out of aluminum in 2015, it was clear that this metal had become a critical input to even the most popular trucks on the market. 

Given the need for all automobile manufacturers to drive higher their corporate average fuel economy (I) standards, producing cars, and light trucks out of the lighter aluminum has become a critical factor to success. Thus, I believe traders in the aluminum market should pay close attention to the impending UAW contract negotiations. 

Aluminum Association headline on electric vehicles

In The Aluminum Association’s article “New Survey of Automakers Confirms Aluminum Use Expected to Grow in New Electric Vehicles” published in April, they highlight the growing importance of aluminum as the industry shifts its production to more electric vehicles. 

In the article, the AA quoted Abey Abraham, Principal of Automotive and Materials at Ducker Carlisle, saying:  “Electrification positively affects aluminum content and compensates for the transition away from powertrain and transmission components, which are primarily aluminum.” She went onto state that “as electrified powertrains create significant growth opportunities for aluminum, more stringent fuel economy standards also continue to promote mass reduction in ICE vehicles.”

The success of the aluminum industry appears to be tied ever-more-closely to the success of the automobile industry overall. 

Image 2: Overlay of the generic front month aluminum future and the U.S. auto sales total

I can see from the overlay of U.S. automobile sales total demand and the generic front month aluminum contract that the relationship has gotten tighter over the last several years than it was previously. I can also tell that the automobile demand leads Aluminum futures on the upside as well as the downside. For now, automobile sales have held up relatively well; perhaps as automobile makers are churning out newer product ahead of any potential shutdown. However, if this automobile sales number (line in white) were to fall precipitously from an automobile strike the way we saw it fall in 2008 and in 2020 for other reasons, do we think there is a risk that Aluminum futures might face the same fate?

Image 3: Chart of generic front month Aluminum futures and generic front month Natural Gas futures

One of the major inputs in the manufacturing of aluminum is the energy source, typically natural gas. If I plot the front month futures of natural gas and aluminum the last five years, I can see that the two tend to move in tandem. Lately, there has been a decoupling with natural gas prices having fallen more than aluminum. Could this be the natural gas market sensing the potential oversupply of natural gas since a key market like automobiles, and therefore aluminum, may be facing a possible manufacturing shutdown? There are other factors, but we shouldn’t ignore that a key input to the process is giving a signal that demand may not be as strong as the other economic data could suggest.

Image 4: Daily Ichimoku Cloud chart for the generic front month Aluminum futures

Turning to the charts, there is the daily chart for aluminum. There are several times this year that futures have tried to rally but have ran into resistance on the Ichimoku Cloud – the area that approximates the level where the average buyers and sellers have their positions put on. This suggests the bears are still solidly in control of this futures market. There is no other strong signal from the RSI or MACD that would indicate otherwise. In fact, not only has the cloud been strong resistance – as seen from rejected rallies in April and July – but the cloud is moving lower. Futures recently failed at the cloud level again.

Image 5: CME Group’s CVOL chart for all markets

I also want to look to the CVOL tool to get a sense if implied volatility in the markets is relatively expensive or inexpensive. As I look at the Aggregate chart of all products at CME Group, I can see that not only aluminum, but all metals, are relatively inexpensive in implied volatility terms. This isn’t surprising to me as I can see that implied volatility is inexpensive across all asset classes at the moment. This tells me that long volatility ideas might be preferred.

Image 6: QuikStrike’s skew measure from Vol Tools

I also want to get a sense if the calls or puts are preferred by traders. This tells me if there is a heavy bias in positioning toward a big move in either direction. It tells me where the more nervous side of the market is because buyers of options as insurance would drive those prices higher on a relative basis. If anything, I can see the prices for upside options are relatively inflated in relation to the puts, but overall, the out of the money options are not that elevated relative to the at-the-money options. This is not surprising given the low level of volatility. Traders are often looking to take risk premia out of the market wherever it exists.

Image 7: Term structure of implied volatility for aluminum

It is also important to get a sense of the term structure of implied volatility. Are there certain dates that are favored over other dates? Given I am speaking about a catalyst in the near term, are traders worried about that catalyst and pricing contracts that are most affected at a premium to other contracts? It doesn’t appear that way. I can see that the implied volatility term structure is upward sloping with the near dates being the cheapest. This shows that there is no premium whatsoever in the front month contract, which would be the contract that is most driven by an impending strike. This tells me that this is the contract I want to look into for possible ideas.

Image 8: Commitment of Traders report for aluminum

One last stop before I structure my idea is the Commitment of Traders report for aluminum. I have looked to the options market to get a sense of positioning, but how are futures traders positioned? I suggested before that I thought bears were in charge of the market. Does this mean that positioning has gotten too short? No, it’s looking like the opposite. Positioning among managed money accounts is the longest it has been over the last year, having gotten much longer just in the last few months. Is managed money possibly at risk from a surprise hit to aluminum demand if there is a UAW/automobile maker strike?

Image 9: Aluminum Spread

My goal in building this spread was threefold. First, find a way to get net short deltas to express both the risks to aluminum price from a potential UAW strike but also the technical rejection at cloud resistance.  Second, be net long options because implied volatility is relatively inexpensive. Lastly, if possible, sell upside skew because the calls look incrementally more expensive than puts. 

The spread I have chosen to do is to sell an October 2300-2350 call spread and use the proceeds to reduce the net premium outlay for the 2100 puts that I bought. You may ask why I don’t just buy the 2100 puts outright. This is a fair question. The cost for the 2100 put is almost 10 ticks whereas I was able to do this spread for an outlay of four ticks. If I wanted to spend the same four ticks of premium, I would need to buy a 2050 put so my breakeven starts even lower.  

Why am I doing an options spread instead of just selling the futures? You can see from the breakeven diagram that I essentially only lose a little bit of money between 2100 and 2300 with the futures at 2200. For small moves in either direction, I basically breakeven (lose four ticks). If I were short futures, I would make money on small moves lower, but I could also lose money on small moves higher. Thus, this spread may be better than short futures. Importantly, on big moves lower, I have potentially larger exposure to possible profits relative to the cash outlay because I own the downside puts.  Yes, I am at risk if futures move above 2300, but my risk is capped at 2350. A short futures position would not have risk to the upside capped off. 

Putting it all together, I believe the options market has given me a somewhat equivalent short position, with better reward to risk characteristics that takes advantage of pricing, positioning, and catalysts. My loss is limited and my potential gains unlimited. I won’t make (or lose) as much money on small moves, but on large moves, I have a better position that has more staying power. 

By using options, I feel I can comfortably position for the potential news events and moves. The tools at CME Group help me discern the best way to set up a trade around a possible catalyst. 

Stay vigilant and good luck trading!

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