(The opinions expressed here are those of the author, a columnist for Reuters)
* Shanghai Lead Market: https://tmsnrt.rs/2JdLOCe
* ILZSG Lead Market Balance: https://tmsnrt.rs/2JibhdE
LONDON, May 30 (Reuters) - It looked as if that was it for the lead rally.
After hitting a six-and-a-half year high of $2,685 per tonne on Feb. 2, the London Metal Exchange (LME) price beat a steady retreat all the way back to $2,241 in early May.
The bull flames were damped by the late-February delivery of 22,125 tonnes of metal onto LME warrant at warehouses in Antwerp.
It was a physical reality check for a market that was riding high on expectations of acute supply shortfall.
There has been a steady trickle of lead arrivals ever since and headline LME stocks are now down by just 8,000 tonnes on the start of the year at 134,200 tonnes.
Last week, however, the London market was forced to sit up and pay attention to what was happening in Shanghai, where bulls have been surging into the Shanghai Futures Exchange (ShFE) lead contract.
Based on past "flash" squeezes in Shanghai, this one may not last long. But by reopening the arbitrage window with London, it may tighten physical supply outside of China.
Graphic on Shanghai Futures Exchange lead contract: price, market open interest and stocks:
Open interest on the ShFE lead contract grew from 80,000 contracts to 133,000 between the middle of April and May.
The most active contract surged by 13 percent to 20,225 yuan per tonne and time-spreads tightened over the same period.
Underpinning this bull charge is the low level of stocks registered with the exchange. They have fallen by 29,322 tonnes since the start of January to just 12,676 tonnes, the lowest level since February 2016.
Physical availability in China is being disrupted by Beijing's rolling environmental inspections on the secondary lead processing sector.
Smelters producing refined metal from scrap have been closed in Guizhou, Jiangxi and Guangdong provinces, according to Shanghai Metal Market.
Some are already reopening but others are still awaiting clearance. The clean air bandwagon, meanwhile, has moved on to Shandong province with one lead smelter closing ahead of the June 9 Shanghai Cooperation Organisation (SCO) summit in Qingdao.
It is logical that these outages would have tightened the local market with stocks being tapped to fill supply gaps.
However, we've been here before, both in November 2016 and September 2017.
And in both cases the rallies lasted barely a couple of weeks before bulls booked their profits and stocks were replenished.
Will this time be any different?
Unlikely, according to Oliver Nugent, commodities analyst at ING.
"Whilst respecting the physical tightness ..., we dont think such a quick pace of Shanghai open interest is sustainable," he says.
"If the exit is as quick as before then Shanghai lead prices are sure to drop which will, in turn, knock on to LME levels," he warns. ("Lead is not dead: Chinese go long, big time": May 21, 2018)
Nugent points to subdued physical premiums in Shanghai as a warning sign that the physical market may not be as tight as the paper market suggests.
Holders of physical metal may simply be biding their time before delivering into ShFE warehouses.
However, even if the Shanghai squall blows over, it may already have made its impact by reopening an import-friendly arbitrage window with the international market.
This was the outcome of the 2016 Shanghai squeeze. China's imports of refined lead jumped from just 1,075 tonnes that year to 78,000 tonnes in 2017.
It was the first time China had been a major net importer of lead in refined form since 2009.
How much of what was "imported" made it beyond China's bonded warehouses is a moot point.
Only Chinese-brand metal is deliverable against the ShFE lead contract and what was imported last year may still be trickling into the mainland market.
So far this year, the trade pendulum has swung back in favour of small net exports, but that was before the arbitrage window flexed open.
LME STOCKS HIT, PRICE JUMPS
And last week saw Shanghai's bullish mood infect the London market.
The trigger was Wednesday's cancellation of 21,250 tonnes of lead in LME warehouses in the Dutch ports of Rotterdam and Vlissingen.
Neither is an obvious shipping point for China but then again most of the LME lead stocks, 69 percent, are located in Europe.
These cancellations, moreover, have lifted the amount of metal awaiting physical load-out in the system to 45 percent. "Live" tonnage totals 73,750 tonnes. The last time it was this low was back in 2013.
It was therefore no surprise to see a reaction in LME time-spreads, which had been drifting into a state of ever-more relaxed contango.
The benchmark cash-to-three-months period <CMPB0-3> was valued at a $12.00 contango at the Tuesday close. A week ago it was as wide as $18.75.
The outright price also received a Shanghai fillip, jumping eight percent last week to $2,515 before easing again this week to a current $2,450.
Graphic on lead market balance, according to ILZSG:
NOT OVER YET?
Quite evidently no-one's getting too carried away.
The history of "flash" squeezes in Shanghai and the suspicion, fed by the February stocks increases, that there is more metal "out there" is keeping would-be bulls in check.
Yet the underlying drivers of lead's recent rally haven't disappeared.
The raw materials part of the supply chain remains stressed. China's imports of mined concentrates fell 22 percent in the first quarter of this year.
A key supplier, North Korea, has dropped out of the picture after China closed off imports as part of international pressure on the regime.
As with sister metal zinc, a supply reaction to higher prices is building with the International Lead and Zinc Study Group (ILZSG) forecasting global mine supply growth to accelerate from last year's anaemic 0.4 percent to 4.2 percent this year.
But the Group is still expecting a second year of refined metal shortfall to the tune of 17,000 tonnes after last year's deficit of 141,000 tonnes.
The Shanghai squeeze will not affect that fundamental picture but if it generates a renewed flow of metal towards China, it will determine where the shortfall becomes manifest.
Every tonne that heads to China is a tonne that's not coming back.
The London market has been assuming there is sufficient slack in the supply chain to cap the lead rally.
After last week's cancellations, it doesn't seem so sure.
(1$ = 6.4223 yuan renminbi) (Editing by Edmund Blair)