Corporate Darwinism for Commodity Trading Firms

By Nitin Gupta | 10 April 2014

With banks exiting commodity trading, Commodity Trading Firms are at the cusp of a fundamental business shift. Risks are very likely to shoot up, leaving Commodity Trading firms no choice but to evolve and adjust to these shifts.

Over the past decade, Physical Commodity trading business has been besieged with high price volatility. And it is not so with just the few top traded commodities like Crude Oil and Natural Gas. Not so long back in 2008, Sulphur prices crashed from a high of USD 800 / ton to nearly USD 50 / ton in a matter of a few months. More recently, Coffee (Arabica) prices have more than doubled in the last 2 months (Jan 2014 - Mar 2014). 

These significant instances of volatility peppered across various commodity segments have not been without its ill-effects. Between 2006 and 2013, nearly 33% of the companies vanished from the Fortune 500 list. That's 1/3rd of the companies in less than a decade. Of these 33% companies, another 1/3rd were companies with Significant Commodity Exposure (Power, Natural Gas, Agricultural, Metals).

Commodity cycles clearly seem to be supporting Corporate Darwinism - Only the ones with stronger Balance Sheets, Better Risk Controls and Differentiators in Supply-Chain or Product will survive. And the way I see it, the trend supporting Corporate Darwinism will only get stronger. It’s not just about survival of the fit, but also about evolution. One of the factors that is going to play a fairly big role in this evolution is the recent trend of world's biggest banks existing physical Commodity Trading businesses.

Banks and the Physical Commodity Trading Business

Commodity trading is largely a supply chain and logistics business, with Price, Credit and Operational risks strewn across each stage of the business. Each of these risks generated a demand for specialised market and product. A commodity producer needs to hedge his future produce / purchase. Sometimes the purchase / sales contracts are built with much customised pricing methods, which needs OTC or structured products for lesser basis risk. Trade Finance helps companies finance their purchases / sales during the time the commodity is being shipped from point A to point B. Sometimes the commodity needs to be stored in a warehouse / tank before it finds a buyer, thereby generating a need for owned / leased infrastructure to hold the commodity. 

Banks recognised these needs early on and created products to suit these requirements - OTC products, trade finance, structured products. Exchanges too started getting higher volumes with banks and hedge funds getting into the commodity trading business, which benefited physical commodity players as well as they could hedge more quantities. OTC products and Trade Finance were typically very lucrative businesses for Banks, before they expanded into physical storage infrastructure business. 

However, over time, banks were seen as manipulating commodity prices (Crude Oil, Copper and Silver among others) by hoarding them in their warehouses and creating short supply. Regulations were made tougher and the costs of being in Commodity Trading Business escalated, resulting in Banks exiting Commodity Trading Businesses. It started in December 2013 with Deutsche Bank's exit, followed by Morgan Stanley, Barclays, UBS, Goldman Sachs (Partial exit), Bank of America-Merrill Lynch and more recently, JP Morgan. Allegations aside, it cannot be denied that banks played a critical role in commodity trading business by providing cheap financing, increasingly competitive rates for storage infrastructure and by acting as counter-party to commodity businesses for OTC contracts. 

The Implications of Bank Exits

With most of the major banks now gone from the commodity trading business, larger Commodity players are taking their place. However, they don't have access to cheap capital like the banks did, which is going to raise costs of trade financing. Lesser letter-of-credits for high-risk counterparties and reduced hedging tools will further increase trade financing costs. The increased costs will put pressure on better deployment of capital - driving it towards better risk-return ratio. These changes will impact nearly every commodity trading firm, big and small. There are huge opportunities for growth, and bigger threats than ever before.

With such fundamental shifts happening in Commodity Trading Industry, the questions facing Energy & Commodity players today are:

  • How is the competitive landscape responding to the changes?
  • How should risk management evolve to become a strategic function in the company?
  • What steps need to be taken in the short and long term to reduce costs and strengthen balance sheet?
  • How should the company get better at deploying capital?

The prices of commodities will go up to some extent just due to higher costs of trade financing. Lesser quantity and access to hedging avenues means price and credit risks shoot up significantly. Lesser market making by banks implies higher liquidity risks. All of these upticks in risks are likely to be ironed out in medium term, since it is reasonable to expect that larger commodity traders will fill the void left by the banks. Exchanges and central clearing houses will do their bit by launching centrally cleared structured products that can be used for hedging.

However temporary the phenomenon might be, it still needs Energy and Commodity companies to significantly change the way they look at their businesses - since surely some of their peers are evolving to deal with the "New Normal". Higher price, credit and liquidity risks are going to play havoc at each stage of the supply chain.

So, what happens next?

To tackle these changes, companies need to integrate risk management in their daily routine. Given that Price, Credit and Liquidity Risks are going to get accentuated across the supply chain, it is only more logical to improve Risk Systems and processes. Everyone in the organisation will need to manage Risks from their perspectives – a logistics manager may need to reduce risks in the shorter end of the curve, a marketing manager will need to assess risks of offering / accepting a new structured deal with his counterparty or lose the opportunity altogether, a finance manager will need to manage cash flows from operations despite fluctuating currency and commodity prices, and so on.

Siloes of Risk Management will be the greatest risks for Commodity Trading Businesses in the near future. Just CFOs, CROs or CEOs can no longer be the sole bastions of Risk Management. Risk systems that exist but are rarely utilised outside the risk division and Risk processes that relegate Risk Management to obligatory reporting are huge risks in themselves. These are huge fundamental shifts indeed, and the companies that do not act on these shifts now, will see their survival in question - it is just simple Corporate Darwinism.

By Nitin Gupta - Risk Edge Solutions

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