Swiss Re Corporate Solutions gathered trade finance banks and insurers in New York to discuss key issues in commodity trade finance: the main risks, banks’ strategies and opportunities for new business.
- Christophe Bourges, head of solutions structuring and commodities, North America, HSBC
- Helena Radzyminski, managing director, loan syndications, Natixis
- Juan Martin, managing director, head of structured commodity trade finance and trade finance load syndication and trading, Americas, Deutsche Bank
- Erich Michel, managing director and group head, commodity and structured trade finance, MUFG
- Andreas Seubert, head structured trade finance, Swiss Re Corporate Solutions
- Filipe Bonetti Alves, head credit/BTI Americas, senior vice-president, Swiss Re Corporate Solutions (chair)
Bonetti Alves: To start us off: what are the key issues that you are seeing in the commodity markets today?
Martin: Obviously, commodity prices have gone down dramatically over the last year. We have seen a slight recovery in some of the commodities, which is very positive, and it gives a little more certainty to credit committees about what is going to happen going forward. The reduction in prices is coupled with the current political and economic financial situation in Brazil, which is a market where most of us in Latin America originate a substantial part of our business. When you put those two together, it creates a major constraint on what you can do, although it also brings opportunities for doing more business.
The credit committees are being a little bit more cautious with respect to the overall exposures to commodities themselves and to Brazilian risk, and that has slowed down the use of the excess liquidity which is in the market. I think the market is still very liquid, but it is just that people are being more cautious in general as to where they put their money and under which structures they do it. It works on both sides: from the borrower side too there are not as many needs as there used to be in the past, and the borrowers are also cautious as to where they would be investing in the coming months or years, given the overall environment.
Michel: I think the wholesale commodity business has been going through a downturn. Banks are not acting the same way as they have in the past. They clearly have become more cautious. Overall, it has triggered a different approach in the manner in which banks engage the market.
We have always had a very prudent approach as to how we engage in the commodity sector. Some years ago, when other players dropped off or were reducing their exposure and activities, we stepped up in a very strategic and responsible way. Clients and prospects noticed, and it’s been one of the key reasons we’ve been able to build a solid franchise across the western hemisphere.
Bourges: Mainly the longer term, capex-based, cashflow structures have suffered when not secured by long-term price hedging or protections. Likewise, some unsecured cashflow-based deals have proved weaker – even with the bigger names. Financing infrastructure is a more difficult market with unstable prices. By contrast, what I would call traditional, shorter-term working capital lending has weathered well. These structures are very often current assets based or secured and thus more self-liquidating than longer-term fixed assets cashflow-based lending.
Another flaw in the market has been the fact that more recent longer-term lending structures may have seen weaker covenants or conditions. These were seen when some banks had to absolutely enter the market or continue to keep on growing. It is not specific to commodities lending. It may be the last phase of a lending growth cycle.
More prudent or experienced commodities banks may have been more selective to avoid troubles.
Banks exiting the market implies reduced liquidity in the commodities market.
Bonetti Alves: Going a little bit deeper on the liquidity issue that we see in the market, do you see this as a combination of constraints that the banks face themselves such as high funding costs? Or more of a kind of sector, region, country-specific issue such as in the case of Brazil, where we see that banks are pulling out given the macroeconomic political situation?
Bourges: I don’t want to be specific for any country but when things go bad, ratings go down. Then the need for more capital goes up and that is where banks and the market see not only liquidity reduction but relatively even more regulatory capital put aside. This mechanically and generally reduces the liquidity dedicated by some banks and lenders to producers, merchants and processors of raw material. There was, let us call it, easy money and then it got more complicated.
At a time where the world fundamentally continues to grow and basic materials remain essential for the population, if liquidity dedicated for commodities production reduces, then the world may create its next price boom.
To be provocative, my biggest concern at this stage, is maybe what happens if and when prices rise again? We have recently seen crude oil going up 100% from US$25 to US$50, so that is a good thing. It doesn’t clean up the mess that is in the oil industry but it’s a bit better. But what about if agricultural products shoot up? They are cyclical, they are weather-related, and what if they go up 25 or 50 or 100%? They are very volatile. With banks scared about what happened, and all the capital that they have put aside, and some of the banks who have disappeared, the liquidity is not going to be there. I don’t want to be overly pessimistic, but I think we are not out of the woods yet.
Michel: In general, I would agree with you that some banks may have rushed in and others are leaving, but I think overall that will always happen. I think that’s a strategic decision being taken by certain organisations. They may be driven by favourable market conditions and opportunities, low funding costs and capital they may be willing to deploy to certain commodity sectors.
When commodity prices are up, it usually creates a lot of liquidity in the market and as investors rush in, they sometimes overlook business fundamentals. At that point, you want to make sure proper risk mitigation or protection is in place, while ensuring that clients adhere to a sound hedging policy. We have been very diligent and cautious in the manner in which we select our clients while maintaining a strict discipline in our credit underwriting process. Overall, the key to building your business over the long-term is prudent client selection. If you go for the quick win, you will burn your fingers.
Commodity markets are volatile, but the problems we saw were more severe than what many expected. Andreas Seubert, Swiss Re Corporate Solutions
Seubert: It is true that commodity markets are volatile, but in the last two or three years I think the problems we saw were more severe than what many expected. That is to some extent a result of the long boom period we saw, more than 10 years of high commodity prices, and today I believe the oversupply in some commodities is really significant and will change how the market works. I think we were taken by surprise, in that we faced claims in areas we did not expect.
We were concerned about the low oil prices, for instance, we saw the sugar prices going down significantly last year, so we expected sugar in Brazil, and all of our long-term oil exposure in the Atlantic specifically would be very much in danger. So far, knock on wood, not that much has happened in oil. We have a problem with a North African refinery but that has nothing to do with the oil prices. And in Brazil, there is a number of claims, but not in sugar. It is the problems in grain and soybeans that we are seeing now that we didn’t expect. I think that different things come together. Low commodity prices, strong devaluation, and I believe, banks and those of us covering them are too optimistic possibly and are not looking sufficiently at the leverage of some of the companies.
Going forward, I would say the lesson learnt is that we really have to be more selective, and the good experience we have had in the past in some regions like Russia, we cannot apply in different countries like Brazil, because this is a different scenario with smaller, privately-owned, family-owned enterprises which tend to behave differently than the companies in Russia.
Michel: One thing I would add to proper client selection is understanding the importance of investing in different asset classes. A healthy balance between short and long-term exposures will enable you to react quickly to rapid changes in the marketplace while protecting your own portfolio. This is very important to us.
Bonetti Alves: One follow-up question in terms of structures. We have felt as though we are very much at the back end of the chain providing insurance cover to some of you. Along with what has been mentioned on client selection, we’ve felt there is a flight to quality, so banks looking for better names and stronger counterparties. To what extent have you seen the possibility to enforce stronger structures to these counterparties, which are stronger in the market because even more banks are pitching them?
Michel: In general, banks will go back to basics during tough times, and in MUFG’s case it’s our commitment to supporting core clients. For instance, as we endure a liquidity squeeze due to the drop in commodity prices, companies in these sectors will now be looking for additional liquidity support. In the past, however, banks were subjected to stiff competition and limited structural protection, the situation has changed and even top-tier companies are open to discussing structural components to the financing.
We’re at a point where you can demand tighter structures, especially in Latin America, where availability to the capital markets are somewhat limited these days. For example, some companies will agree on structured solutions to secure their capex and operational expense needs, especially if the bank market is limited in terms of capacity. Having said that, you must also have a healthy risk appetite to take advantage of these types of opportunities.
Martin: I think the top names will always find the liquidity. No matter where you are in the cycle, no matter what the surrounding conditions are, they will always be able to get the liquidity because that is where everybody wants to put the liquidity. And then maybe the first thing you see is a slight price increase and then you start seeing the structure and I fully agree with Erich. The only thing I would add on that is in some cases it also works not only because they want the liquidity but because this liquidity provides some other benefits in terms of the kind of debt that they are raising now. So they are willing to structure if it is going to provide them some other kind of relief in other aspects. And I think that is where many opportunities lie as well.
Bonetti Alves: On our side we are more cautious and I have the perception that we are reducing quite a lot the support that we can give on the hard commodities sector. Do you, in your organisations, have specific fronts that you are cautious on or that you are pulling out of?
Radzyminski: In general, I would say most of the banks are much more cautious on the oil and gas sector. The majority of banks have a global exposure limit by industry. Today, an oil and gas transaction in the Americas is competing with oil and gas in Africa or in Europe, whereas before you didn’t have those types of conversations.
It doesn’t mean that banks have stopped doing business, but it means that they are much more cautious, driven by relationship, credit quality, structure, returns and also by the fact there is a global limit.
Seubert: To be fair, some problems came up that simply we could not predict. If you look at Ukraine, we have had some hard commodity exposure in Ukraine. If you had asked someone four years ago: ‘Can I take a risk on company X in the east of the country?’ and they had said: ‘If it’s very much to the east of the country, you shouldn’t touch it,’ you would think this was a ridiculous answer. Today we know that yes, there is military aggression coming from Russia that nobody had predicted.
It is similar to the energy sector. The change in strategic concept of Saudi Arabia was not that easy to predict, and now it has a strong impact on the level of oil prices. Going forward, I would expect for the next few years we won’t see US$120 a barrel again.
Bonetti Alves: If we look on the flipside, we are getting more cautious but in a way we still have to make the numbers. Where are you looking for opportunities to make up a little bit the pull-out from the energy sector, for example? Where are you trying to spot new opportunities to look for new business?
Bourges: More in the short-term working capital as opposed to the long-term project type of exposure, and anything related to it. Again, because short-term working capital is essential. The commodities are still flowing from one continent to another, so there is a need to provide that liquidity, so focusing on the shorter-term asset base is obviously an easier sell to credit then going for a three or five-year cashflow-based type of activity. As far as the sectors are concerned, oil and gas is difficult, but there is life outside oil and gas in the industrial metals, in the agricultural sector, so life goes on.
Radzyminski: In Argentina, we expect the biggest growth in agriculture during 2017 due to the fact the government lifted the export tax and established a single foreign rate. This will result in more financing needs from the companies to finance future investments. We expect to see more pre-export financing in the market coming from this evolution in Argentina.
Michel: In general, we feel pretty comfortable dealing with independent traders that are engaged in the energy sector. Usually, they have limited exposure to price risk, and even if they are exposed, they are usually properly hedged. Further, I think there are opportunities with energy products in certain industries that do not necessarily have an impact on the bank’s oil and gas exposure, such as utilities or transportation; both of those depend on the supply of energy products.
In the agri sector overall we’ve done pretty well in Brazil, which is one of the most dominant agricultural market in the world. In fact, we’ve built up a sizeable agri business there over the last few years. Elsewhere in Latin America, our ambition is to develop a regional agri business, reaching into Mexico, Colombia, Chile, and, hopefully soon into Argentina. While we remain cautious, we still believe there is upside in the region, although probably not to the extent of what can be produced in Brazil.
In metals and mining, it’s case by case. That’s a sector that has been experiencing challenging times, and some of the producers in Latin America have been dramatically affected. So we’ll selectively entertain some of the metals opportunities that emerge from our core clients.
Bonetti Alves: We have the perception that banks are making more and more use of insurance. How has your organisation adjusted or changed the distribution strategy that you have in the current environment?
Bourges: Banks in general use insurance for the country risk, credit risk mitigation, so as a risk reduction strategy on and off. Where now banks need help is probably in the balance sheet management, in the fact that regulatory capital requirement is more and more constrained and therefore the key is in how we can better use insurance and any of those risk mitigation factors to reduce the balance sheet and what’s the benefit country by country, regulator by regulator, of the insurance. Either you sell completely, so it’s off; some banks have a very strong dynamic selling purely off the balance sheet, but whether they decide to put it on the balance sheet and mitigate the risk with the insurance, what’s the benefit from a capital requirement? And it’s still a work in progress. I think it depends on the countries, the regions where you are and how the regulators see the insurance and understand it as a real distribution opportunity and not only a risk mitigation.
Michel: The key is risk substitution. For us, it becomes really attractive if we can lower the RWA and utilise the insurance within our own rating model as a risk substitution. Then it becomes an asset that is highly valued within the bank.
Seubert: Are traders becoming more competitive to banks in arranging prepayment facilities, large-scale facilities sometimes, hiring teams of directors to arrange transactions?
Bourges: They have always provided financial help to their suppliers.
Martin: The difference is that producers who would not even entertain entering into long-term or medium-term supply agreements with the traders are nowadays considering it because it provides some other benefits to their financing. We haven’t seen that many deals close, but there have been deals in places where you would never have expected those deals to happen.
Bourges: It really comes down to the liquidity and the access to the debt capital market that some of the producers enjoyed in the boom times: now that they don’t have access to the debt capital market they still need the liquidity and the trader can provide that liquidity by way of prepayments.
Radzyminski: Six months ago, some companies would not consider a structured prepayment transaction as the market would easily absorb clean financing. Today they are more open. Although we see more requests from clients to provide them with pre-payment financing proposals, very few transactions have materialised.
Martin: And there is a difference between a bilateral loan to one of the producers and money that they receive in advance for future exports. So it’s still debt for them but it’s a different type of debt.
Bourges: It is often an advance within a commercial contract as opposed to a bank debt, so on the balance sheet as a liability, it is treated differently.
Seubert: What we see is more requests on insurance of such prepayments. It seems the banks have less capacity on providing limited recourse finance, because the traders usually try to pass on the credit to third parties, so banks normally would reduce traders’ risk exposures. Instead of limited recourse financing, insurance is the alternative from the traders’ perspective.
Bourges: Talking about alternatives, I’d be interested to see what everybody sees in respect to alternative funding coming from private equity?
Martin: There are a few funds which have been set up with the sole purpose of investing in trade finance. And they are very much focussed on a certain type of asset which is, from my point of view high-yielding. And then there are other institutional investors who have discovered the benefits of trade finance and they are very much interested in the asset or the asset class. However, I also see that there is still a price disconnect between where you price trade finance assets and where you can place them with institutional investors, not to mention in which format you are able to do it. On the other hand, they are involved in successful repackaging or securitisations. We know that some banks did MAPs, for example. At Deutsche Bank we have also done a couple of CLOs, which are different and they have different objectives than MAPs, and those are usually placed with institutional investors. So there is an increased appetite for trade finance assets, which in many cases are related to commodities, but there is still a disconnect with the price because of the format of how you do it.