Commodity finance experts discuss the impact that the global financial crisis, the rise of Africa and the discovery of shale gas reserves in the US have had on the sector.
Prowse: The availability of finance for international trade operations remains the most important issue in our market today. Over the past few years there have been many attempts to make trade finance available, in particular for the emerging markets. We have seen the government initiatives that resulted from the G-20 meeting in 2008/09, which led to greatly increased ECA involvement, but I am not sure to what extent that has actually filled the gap to the point that it was expected to. We have seen a lot more involvement from development banks such as the IFC World Bank, the EBRD, the African Development Bank and the Asian Development Bank.
We have also seen a lot of more involvement from insurance companies, the pension funds, the longevity providers, looking to fill the gap in the market. My first question is: has enough been done?
MacNamara: As structured commodity trade finance, we are in better shape now than we were before, in the sense that the crisis has actually been very good for us. On the one hand, it hit the debt capital markets and reduced the use of easy money, which in the past has prevented companies from exploring the trade finance route. On the other, it made the boards of banks, shareholders and regulators look at the basics and ask the question: ‘What are the fundamentals we want to hang on to in trade finance?’
The French hiatus I think has been no more than that. Plenty of us were still in business throughout the crisis, and we have gone up every year through the crisis. But we have rather under-served the small and medium-sized enterprises (SMEs). The reason is that we tend to deal with counterparty credit rating between B and BB. Above BB+, normally SMEs can borrow on unsecured, but below B-, it gets very hard to get them through our credit approval process. What happens during a crisis is that more and more customers fall into that category, and we lend to them. However smaller companies drop out of the bottom of that, and you cannot lend to them, because we would otherwise be very heavily penalised under Basel II and III for doing so. Collateral gets you so far, but it is not a complete solution.
Zonneveld: If you look at the current markets, where there is high uncertainty, you see that the volatility of commodity prices is high and will remain high for the time being.
Logically, the smaller companies are struggling to deal successfully with this high volatility and the sometimes quickly declining prices. The bigger trading companies and producers have more capabilities to swallow these kinds of price swings. Therefore as a bank, you tend to focus on the stronger players, especially in the current environment.
Turnbull: It is clear that the major companies did not suffer. With the French banks pulling back, it is interesting, looking not at the structured side but the bilateral business, it really had no impact at all on most of the major companies. Where it did have an impact was on much smaller ones because the French were very good at financing small companies. The ECAs and development agencies put forward the premise that they were filling the gap, I think they did try quite hard to do that.
Prowse: They also did a lot for the bank-to-bank flow, which would then feed into the SMEs.
Turnbull: That is right. Development agencies were very keen to finance and share financing. But if it is for a very poorly rated entity or company, even sharing with development agencies does not always make the deal doable for the banks.
MacNamara: We have to be clear that ECAs are looking to finance capital goods leaving the OECD. That is a very narrow focus.
Turnbull: Actually, there are some development agencies that have a much wider remit than that.
MacNamara: Some ECA programmes have been very good up to a point for the bank-to-bank business. They tried to adapt them for the commodities business, but that has been more of a challenge. Financing companies that are paying hard currency for a commodity which they then want to sell in the domestic currency of a country where very few of us have lines, and if they are going to sell it retail at a price set by the government, which then tries to change the price, resulting in civil unrest – is not a very attractive formula to a commercial bank.
Prowse: In the legal profession, we are seeing traders having difficulty in securing access to finance for their trading activities, and they are either resorting to general debt finance on a secured or unsecured basis, or to receivables-based financings, which are not terribly structured, without specific security being assigned. We have also lately seen a trend towards a return to the horrible ‘S’ word – securitisation – whereby traders are looking to use their own receivables to securitise them and to put them into a bond to be sold on the debt capital markets to try to attract slightly cheaper finance and a different, wider class of investors, particularly hedge funds, high net worth individuals and longevity providers as well as the banks. Do you see any of that across your tables at the moment?
MacNamara: Yes. Where traders have become very valuable again is that they have filled a significant gap by providing financing to smaller companies.
Many of the large players are more profitable – certainly on a per capita basis – than banks, which is a major difference compared to their predecessors 20 years ago. So, although Glencore’s results might be going down a bit, the company remains more profitable than most banks. Therefore, if they have a revolving credit facility, they have the flexibility to use it as they see fit and often do so in combination with insurance.
Zonneveld: The whole commodity market has been professionalised substantially over the last 10 years, which means that the bigger companies and the medium-sized companies have become really big. The big players like Vitol, Glencore and so on, were able to obtain a bigger piece of the global pie. For smaller companies, to be successful, there is hardly any room. The competition gets tougher and if you really want to play you have to work with increased amounts or you do not play at all. This obviously also influences the credit margins for the banks. And in addition to this, you see that ‘classical’ commodities financing is somewhat under pressure, due to the power of the big trading houses.
MacNamara: But they do offer a very attractive package to banks. If they take in the money from the banks and then recycle that to the smaller players with better risk management capability, maybe that is not a bad model.
Johnstone: The Loan Market Assoiation (LMA) has become much more involved in Sub-Saharan Africa in the last two or three years. When you go there, access to funding is key, but there is this underlying feeling that if you can unleash the agri and mineral potential, you will benefit from the boom. Does that mean it is going to be the major trading houses of the world that are going to have to unleash that?
Prowse: From what I have seen of Chinese investment in Africa, they do their trade finance alongside big structural project finance, which I think is a key way forward.
Tricks: Last summer, I was in Côte d’Ivoire talking to cocoa co-operatives. They have a serious problem in obtaining finance. Whereas Ghana next door has a fairly well-structured system under Cocobod, in Côte d’Ivoire the civil war and political upheavals in recent years have fragmented the cocoa industry.
MacNamara: In the 1980s, the International Monetary Fund (IMF) implemented structural adjustment reforms which called for the elimination of commodity marketing boards that were viewed as ‘restraint of trade’. I was in Nigeria in the 1980s when the Nigerian Cocoa Marketing Board was dissolved. What ensued was a tremendous spike in cocoa prices, because everyone thought it would take off. This was followed by a complete collapse in production, because nobody could get finance.
Prowse: There has been some talk in the press recently about alleged stockpiling commodities to establish so-called ‘contango markets’ to enable traders in particular to have a profit from spot prices to futures, particularly in metals. Do you see this kind of thing?
MacNamara: If analysts are saying that, they are missing the point. What you have in some metal production, with aluminium probably being the most extreme case, is a relatively high fixed cost base. An aluminium smelter costs a lot to build and maintain, so you have producers with a higher fixed cost. Once the cost of production is there, there is a limit to what you can do to reduce it. Then when the aluminium price comes down, at a certain point, production becomes a loss-making process. Historically, the aluminium industry was very cyclical and big banks used to look at it and say: ‘We make money for four years, we lose money four years.’ Therefore they opt for long-term debt to go right through these vicissitudes, because a refinancing in the middle of a cycle, when you have been losing money for two years, will not allow you to recoup your loss.
The point is in those periods, you do see stocks climb and you saw this back in 1991 and 1992 when we had the aluminium crisis, and we are seeing it again now. Traders and investment banks in particular have all come in to help in that situation. They are not doing it for free. However, it is not about speculation; but rather trying to help the industry survive.
Prowse: Mike, I wanted to ask you about the pre-export finance document that your organisation generated and issued a few months back. Without trying to be awkward, it seems to me to be an odd time for the LMA to be producing something of this vast size [200 pages]. Having used some of it, there has been some fantastic stuff in it that has been very useful. I have been taking out parts of it and putting them into smaller facilities rather than using the totality of it.
Johnstone: I think that was always anticipated. The core purpose of the LMA really is standardisation, so we historically have been involved in the corporate and leveraged loan worlds, and we have now moved into real estate, commodity finance and developing markets.
Every clause in there has a good reason for being there. It is also fair to say that in loan agreements generally, the boilerplate side is just getting bigger and bigger. We like to say we will deal with all of the boilerplate as standard and you guys can just focus on the commercial side but what we find is that the boilerplate side continues to expand. An example is that when Lehman’s went, suddenly you have to address a participant bank going bust rather than just the borrower.
So we always knew that users would take sections from it and use it that way, but we very much feel, and I think history backs us up, that standardisation really does help liquidity particularly in the secondary markets. So that is where we came from. LMA documents always will be comprehensive.
At some point in your career in the banking world, you have been in a dispute thinking: ‘I wish they had put that clause in.’ Most bankers have been there and a lot of our documents include the protection side. I find it particularly puzzling if you take the agent bank role; why would the agent bank in a commodity finance deal or the developing markets have fewer protections than an agent in a bog-standard investment grade or leveraged loan? I do not know why you would not offer the same protections and indemnities etc.
Prowse: There was a self-liquidating argument – that trade finance should be readily identifiable commodities, short-term, paid out from the proceeds, so you do not need all that corporate jargon that is associated with the LMA, corporate acquisition stuff.
Johnstone: That is a very fair comment. I don’t know at this stage if further commodity finance or trade finance documents will come forward if the market asks us to do them. There is a lot of focus right now on the developing markets side. A lot of that is tricky, with the combination of local currency and the US dollar tranche. That is something I wanted to ask you: do you fund in local currencies or US dollar?
Zonneveld: Mainly dollars.
MacNamara: We can now fund in local currencies, although are not doing so at present. We may do more going forward.
Prowse: There has been a lot of talk about the Chinese renminbi (Rmb)coming in and taking more of the play than the US dollar or euro in the commodities finance market. To what extent do you see that playing out, or again, is that more of a regional play? Is it hampered by the lack of convertibility and the lack of liquidity etc in the currency?
Johnstone: I can really only speak regionally, but I was in a conference in Cape Town last week. The Bank of China was there, and they have got a pretty sophisticated operation down there for Rmb financing, putting African borrowers and lenders in touch with their equivalents in China. Companies can set up Rmb accounts quite easily now. So I think in that sense, locally in South Africa, the Bank of China is really working.
Zonneveld: It is a local issue, so if you do a receivables financing structure in China, you have to do Rmb financing. It does not work otherwise, if you want to do dollar financing, you have to do it from abroad.
Prowse: So at the moment, the chance of internationalising to make it part of a global culture is not really there.
Zonneveld: Correct. You will see dollar lending in China but you only do so when there is an export flow involved, thereby getting as repayment dollars back again, so it is dollar against dollar. If you have an in-house in China financing, whereby the repayment does come from China, it has to be Rmb-denominated financing.
Tricks: One of the places you guys at ING are also looking into is Mongolia. I have been doing some work for one of the state-owned copper mines there and it is really interesting just looking at what is going on. The amount being produced is significant, as is the need for financing. It really is a very interesting market but at the same time it has a new government, which some people say is good; others say it is moving the goal posts.
MacNamara: From our perspective as trade finance and structured trade finance practitioners, this development is good. The question is: are they going to deliver and will the Chinese buy it? And the answer is yes.
Zonneveld: Some markets are bigger than others and for example Mongolia, in essence, has a lot of raw materials. You can find two or three sound deals per year there. It is interesting to compare Mongolia with countries such as Azerbaijan, Tajikistan and the likes. In terms of size and possibilities in natural resources Mongolia is quite big. But in all these countries the central government is strongly involved. Ergo you need to take that into account in your dealings with those countries. Sound links to the governments are key.
Prowse: Stephen, you do a lot of work for the ICC and other organisations that are involved in developing new instruments for open account trading or unstructured, if I can call it that, trade finance. In particular, you have done a lot of work on the BPO and looking at the new regulations for Swift. To what extent do you see those having an impact on facilitating trade finance? Are they just new legal forms that are not really utilised?
Tricks: People have been taking about having a ‘light’ letter of credit (LC) for many years and whether or not this really works, I think it is early days. Swift and the ICC are finally moving forward with the BPO. It is probably a good thing in terms of supply chain finance. To what extent people will really feel that they are getting extra value out of using the BPO as opposed to open account trading or letters of credit, one does not know. It is going to take time.
I was in Dubai a couple of weeks ago for a conference, and what was interesting was that people were really pushing the BPO there. I went to the launch of the ICC Regional Banking Commission in Dubai, for the Middle East North Africa region, and again there was a tremendous interest in the BPO. People want to see what it is and find out if it is going to work for them. It is very difficult to say what actually will fly.
Turnbull: I think it is probably a different sector of the market, not the traditional commodity sector. There may be some elements of trade that will use it but, as Stephen says, it is a bank-to-bank instrument, so you do not have the buyer and seller either side of the arrangement in the way you do with an LC. It is more supply chain-driven.
Prowse: The LC is not dead then, we assume, even though it suffered some criticism during the financial crisis, with a lack of bank-to-bank trust or maybe a lot of issuing banks perhaps not paying out or questioning further presentation of documents.
Turnbull: But that comes down to risk, not the instrument. What you have got then is a commercial issue as to whether certain banks would honour their obligations in a falling market or a non-commercial approach by particular banks. Some countries were much worse than others. China for example is generally quite good and has embraced the concept, integrity and autonomy of LCs and the ICC regulatory framework much more.
MacNamara: If you look at the oil business, the LC still provides a major function in world trade. You do not have to go very far down from the top in terms of credit rating to find people still paying via LC for huge volumes of business. All the major traders, who these days are very profitable and well-capitalised, are happy to pay by LC for billions of dollars every year.
Turnbull: I think the advantage with oil is that you have a very simple documentary process in that you usually only have two documents, the invoice and the payment letter of indemnity (LOI) which are both produced by the trader beneficiary. You do not have the documentary discrepancy issues that you have with steel, metals and agri. Oil works so well because of that. That is why the electronic commerce developments have been somewhat limited in that sector.
Zonneveld: It is important to mention that in the next five years there will be big game changers in our industry. One of course is the shale gas development. There are huge stocks available in America, which is going to become an important exporter of gas. China also has massive shale gas possibilities. I expect that the impact of these game-changers will be huge. For example, the volatility of the coal price will be substantial going forward. Another view we have is, that the worldwide demand for raw materials will continue to remain high and will grow in the long-term, and supply will be more difficult to find. Therefore I expect that oil prices going back to US$30 will most likely be a utopia. That also means that in our financial modelling and our way of financing commodities, banks will have to adapt going forward.
MacNamara: I think you are right that there are a number of game changers both on the commodity production side and the market side. However, I also think that political risk will not go away.
The last five years have taught a lesson that political risk will always remain with us.