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Looking for the commodity finance upside

So many negative stories have hit the commodity finance sector through the past year. But it is definitely not all doom and gloom, as the big traders get stronger and the commodity boom looks set to run fuelled by the green energy transition, EVs and infrastructural development.
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Just as you thought most of the dirty stuff had stopped hitting the fan in the world of commodity trading, something else crops up. Then we take the inevitable reality check that it’s a busy/wild/weird world out there and there is always going to be some shocking headline-grabbing piece of news that will scare some, be a wake-up call for many or water off a duck’s back for others.

Fraud on the scale that we saw it with some of the commodity trading scandals in Singapore in early 2020 is exceptional, and it is largely these particular cases which sent many banks reeling, investigating their losses and reconsidering their positions in the market. And for some, those cases and the losses incurred were simply too much – more about this later.

The latest sensational bit of news is the case of $36 million worth of copper blister shipped from a supplier in Turkey to China, which turned out to be painted stone slabs on arrival at the port in China where the fraud was discovered. Trading company Mercuria was the victim here. This trade happened mid-2020, but has only come to light publicly, and extensive legal investigations have apparently been taking place. Naturally, lots of questions are being asked - such as where was the proper collateral management?

And in another instance, following a court case in New York in early December last year, Vitol, the world’s biggest independent oil trader, agreed to pay $164 million to settle allegations that it conspired to pay bribes to secure oil trades in Brazil, Mexico and Ecuador. In a statement at the time, Vitol CEO Russell Hardy, stressed: “Vitol is committed to upholding the law and does not tolerate corruption or illegal business practices. As recognised by the authorities, Vitol has cooperated extensively throughout this process.” 

Such cases certainly don’t help the image of commodity trading, and for the commercial banking community – already taking a deep dive of self-analysis, and increasingly conscious of reputational risk – it puts commodity finance units under renewed intense scrutiny from anxious bank boards. So where does the sector go from here and how can we rebuild confidence and trust? Moreover, where is the upside for the commodity finance sector?

As noted above, the Singapore fallout partly led to the exit or partial exit of several banks from commodity trading. Most notably ABN Amro which declared it is pulling out of the commodity finance market altogether, BNP Paribas is closing its commodity operations in Geneva, SG is exiting commodities in Singapore and Rabobank is closing its trade and commodity operations in London, Shanghai and Sydney. These high-profile exits are in the main linked to the well-publicised commodity frauds and bank losses primarily in the Singaporean market with traders such as Hin Leong Trading, which primarily focused on crude oil products.

One element I am keen to point out here is the huge loss of personnel that will take place at many of these institutions in terms of highly experienced commodity financiers. Many are still involved in work outs, restructurings or winding down books. Many have already left. A few have moved elsewhere within their institutions, if they have been lucky enough to be offered a reasonable position. But, ultimately there is a wealth of talent that will be largely discarded by certain banks.

Banking impact

At the same time, a number of other global commodity trade finance banks have retrenched in the light of losses connected to frauds or collapses with traders in Singapore and Dubai. Not surprisingly many banks now refer to their ‘flight to quality’ with their client base – meaning they have or are in the process of trimming their portfolios to primarily finance top tier producers, traders and certain end users in the chain. 

Inevitably many of the losers here will be smaller or medium-sized traders. This is unfortunate as many such firms are usually privately owned, run by the owners with an inherent conservative approach to risk and have excellent track records over many years of trading. No one would have called Hin Leong a small trader though – in 2019 the company had revenues over $20 billion, and in October last year it was declared to have liabilities of $4.59 billion. And this perhaps was part of the problem – the company was big and financing facilities and procedures had become far too slack.

In the Singapore market, banks remaining in the sector are inevitably taking a much more cautious approach, particularly related to new lending or for requests related to extension of tenors for example. There is currently a lack of overall liquidity because of the pull back and de-risking taking place, but as one banker informed me: “providing we have four or five core banks on a deal we can still expect to build out the syndication successfully”. 

Traders report that regional banks have largely been very supportive, and there is a good appetite building as some take on business left behind by other banks that have moved out. Asian soft commodity traders report that there has been little impact for them from this bank fallout, and some report expanded bank facilities.  Traders also say that banks have become much more diligent and are asking more questions. Similarly, alternative lenders are selectively eyeing new lines of business and in some cases working with banks.

In addition, apart from a much more forensic approach to documentation, banks are also repairing the whole aspect of structuring. There is definitely a shift to more secured lending. Where structures had become somewhat slack, they are being tightened. But within this, there still needs to be a degree of flexibility so lenders and borrowers can work together efficiently and smoothly if any problems occur. 

Pricing? Yes, there are inevitably increases, but the level obviously depends on the borrower, the transaction fundamentals etc, and largely bankers are unsurprisingly keeping well and truly schtum on details. Pre-payment transactions are now required to have higher risk sharing undertaken by traders. And certain structures – such as borrowing base facilities and reserve based lending (within oil & gas sector) - can now expect to be seen being used in Asia going forward (albeit still limited for the time being).

The development of commodity finance business by global and Chinese banks in the Chinese market hit some ‘snags’ almost 17 months ago, and currently there are understood to be several workouts still taking place with certain smelters and refineries. Going forward, business in this area will remain difficult, but providing said workouts progress satisfactorily, there is no reason why there should not be a return for certain sectors and borrowers with structured deals and the right insurance cover in place.

But for now, it is not just the banking sector that has pulled back. The insurance sector has also taken a considerable hit – although full calculation of this is yet to be fully worked out. Consequently, insurance premiums have escalated for commodity traders – with “premium increases in the region of 20%-30% for smaller to mid-sized traders, if they can get it”, according to one underwriter in Singapore. Premiums for the top tier traders are said to be flat currently. For some insurance brokers, there is also a retreat from parts of the commodity sector.

Big traders take centre stage

Moving to the upside for the commodity sector, somewhat in contrast to the happenings that made much of the headlines through 2020 and into the early part of this year, the top traders are now largely reporting excellent financial results for 2020. This is important, not just because the commodity sector has had all the bad publicity, but because as demand and markets pick up, good strong well-disciplined and organised traders with their global reach are essential for global supply chains across the breadth of the commodity spectrum.

Trafigura was the first to report results for a partial 2020 (to September) and showed how it is changing successfully to meet market challenges and structuring its divisions accordingly, profiting immensely from working the oil and metals markets very successfully. The group recorded total revenues of $147 billion, compared to $171.5 billion in FY2019. But profits were up considerably, with net profit standing at $1.6 billion, up from $0.9 billion in FY2019. EBITDA reached $6.0 billion, up from $2.1 billion in FY2019.   

Commenting on the results, Trafigura’s executive chairman and CEO, Jeremy Weir, stated: “Amidst unprecedented market conditions, Trafigura’s expertise in physical commodity trading, risk management and logistics was called upon to an exceptional degree.” He added: “…this was a year that proved and improved the strength of our business. We emerge from it with a stronger balance sheet, an improving asset portfolio and an enhanced and increasingly diversified trading platform that we believe is well placed to adapt to and to assist the accelerated global transition to a lower-carbon world.” For more independent commentary see my commodity end of year review: https://www.txfnews.com/News/Article/7105/Commodity-trade-finance-2020-year-end-review

Glencore had something of a mixed bag through 2020 according to the preliminary financial report, but overall the solid financial performance allowed the company to reinstate dividends, despite the group loss of $1.9 billion. Overall revenues for 2020 amounted to $142 billion, which was down 34% on 2019. Metals trading profits were up by 53% and energy by 33% year-on-year. Importantly, the company managed to reduce net debt from $17.5 billion to $15.8 billion.

Glencore’s CEO, Ivan Glasenberg, commented: “Navigating from recessionary conditions in the first half to a strong price recovery for most commodities in the second, adjusted EBITDA finished the year flat at $11.6 billion. Strong second half cash flows repositioned net debt of $15.8 billion within our target range, allowing for the resumption of distributions.” 

He also remarked: “As the world focuses on the pathway to recovery from Covid-19, it is clear that meeting the goals of the Paris Agreement has taken on even greater urgency. While innovation and technological advances have transformed how we live and work, the commodities needed to enable this have not. Our commodities are essential in developing all facets of infrastructure needed to deliver the goals of energy and mobility transition.”

For energy trader Vitol, the trading house reportedly expects to show a net profit of around $3 billion in 2020, significantly higher than the previous record of $2.3 billion booked in 2019. The group made the bulk of these profits during the second quarter of 2020, when oil demand collapsed, allowing traders to buy cheap crude and store it, while locking in a profit by selling forward the oil on the futures market at higher prices.

The commodity price surge for specific minerals through 2020 also helped change the fortunes for the world’s biggest mining company BHP which revealed a record dividend of $5.1 billion. BHP’s half-year underlying profits actually hit a seven-year high of just over $6 billion due to a rally in the market price for iron ore.

The commodities boom

Sticking with the commodity upside, it is clear that we are presently at the beginning of a commodities boom. And there is much hype about this possibly being the start of another commodity supercycle. However, it is far too early to tell as supercycles take a long time to build and also need to be in play for a good number of years before they can be truly termed a supercycle. The last supercycle was between 2004 and 2011, but it actually started building in 2001, and demand from China played a huge part in this. 

Driving this commodity surge at the present time is the green energy transition, the move to renewables and the electric vehicle revolution. It should be noted that electric vehicle manufacturing consumes four times more base metals than conventional vehicle production. Couple with all these factors the eventual emergence out of the current global pandemic – restocking and increased demand – together with the need for infrastructural and construction development throughout the world, and the growth in commodities trade is clear. 

Most parts of the commodity complex have seen a boost in speculative interest, including softs, energy and metals – particularly with iron ore, nickel, aluminium and copper. But it will not all be plain sailing going forward as questions remain over the supply and demand for certain commodities. For instance, there are many questions as to whether there is sufficient supply of rare earths, and perhaps more importantly who controls those deposits. 

And for crude oil, which will eventually become a declining commodity, the price of crude will very much depend on the OPEC+ group keeping a tight reign on production to avoid a market glut. US shale oil production could also be a limiting factor on prices. Currently crude oil (Brent) is trading around $62 per barrel. Predictions for the second half of the year are that Brent will average $65 per barrel.

The commodity boom is also shown through the recent jump in the Baltic Dry Index (BDI) which tracks rates for capesize, panamax and supramax vessels ferrying dry bulk commodities. By last week the BDI had risen to 2,105, the highest since September 2019. And for panamax vessels – which usually carry grain or coal cargoes of about 60,000 tonnes to 70,000 tonnes – it was at its highest rate since September 2010. Analysts report that the dry bulk shipping market is currently in a perfect storm with not enough vessels in the right place at the present time and fleet companies holding back on orders for new builds until it is clear which fuel source is the best to use on new vessels. 

Looking ahead in the commodity markets, Dan Smith, MD at Commodity Market Analytics, told the TXF APAC Trade and Commodity Finance Virtual Conference last week that in 10 and 15-years time aluminium, nickel and steel would be the really strong commodities and significantly higher priced relative to today. He also indicated that the copper price would be more modest, but depending on industrial demand it could certainly bring an upside bullish surprise. “Currently, we aren’t in a supercycle, but a lot of commodities are moving up,” he noted.

Where will the banks be?

With the odds stacked for a boom time in commodities, the question is where will the banks be? Will there just be more business for those that have remained in the market, how much of that business will be picked up by alternative lenders and funds, or will some of the banks that have exited or pulled back eventually dip back in? For the latter point, if they do come back in, where will the experienced staff come from.

Writing on Linkedin in late February, my long time friend Paul Lodwick, a highly experienced commodity banker currently at Rabobank in London, stated: Those banks that remain committed to trade commodity finance have a golden opportunity to capitalise on the departure / downscaling of their peers. The commodities boom will ensure that there is high demand for their money, which they will be able to price accordingly. Investment funds, that had stepped back from the market are now stepping back in, incentivised by the prospect of higher returns.” 

He added: “The exodus of TCF banks, which has been most prevalent in London, often leaves behind a worthy talent pool of bankers that are very familiar with their customers and their trade flows. Banks/funds therefore also have a great opportunity to pick talented individuals or whole teams which they can use to service their new portfolios.”

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