Rising commodity prices mean an increased need for commodity finance, but does the bank market have enough capacity to support the ever-changing demand from trading houses and producers? Rebecca Spong reports.
The super cycle
It was thought by many that commodity trading giant Glencore’s IPO earlier this year might have heralded the end to the escalating commodity prices.
It raised US$10bn when it joined the London Stock Exchange at the end of May, making it the largest capital raised by an international company in London.
Ultimately the IPO didn’t change the long-term upward trajectory for commodity prices; but there is the possibility that the IPO and the resulting opening-up of information flow about Glencore’s business model might put the commodity finance market in good stead.
“The more people understand how top-end commodity traders operate and the strength of their model, the better it should be for getting our risk colleagues comfortable,” remarks ANZ’s Nick Williams, head of corporate sales, trade and supply chain, Europe.
Ian Henderson, director at Texel Capital adds: “From a banker’s perspective, having a listed company that has a share price to track, independent analysts reports and high levels of transparency, make it an easier credit to analyse.”
But he notes that Glencore’s IPO is unlikely to kick-start a slew of IPOs from other major trading houses which are not already listed.
Looking beyond the excitement surrounding Glencore as well as the challenges of supply chain shocks and inflation faced in the first half of 2011, demand for natural resources will escalate.
There is a widely held perception that the financial market is in the midst of a super-cycle that was only temporarily stalled by the crisis in 2008.
Post-crisis, the super-cycle is set to resume with even greater strength, pushing commodity prices higher.
This is due to rising demand from the rapidly urbanised middle classes in the emerging markets, coupled with a constraint on supply due to many of the projects, such as mining developments, not coming back online in 2011 as originally expected, but being postponed for a few more years.
“While the economic conditions have affected demand in Europe and to a lesser extend the Americas, this has been compensated by demand from Asia and of course, China in particular,” observes Federico Turegano, global head of natural resources and energy financing at Société Générale.
A report from Australia’s Export Finance and Insurance Corporation (EFIC) stated in late May: “Does last week’s correction spell the end of the commodity supercycle? Probably not. Underlying supply-demand conditions in many markets remain tight.”
Banks are looking to capitalise on this upward commodity price trend with a number of institutions setting up or expanding their commodity finance and structured commodity finance teams.
GTR reported in late May that Andrew Robison moved from Banco Espirito Santo to HSBC’s expanding structured commodity finance team, headed up by Jean-Francois Lambert in London. The West African-focused Ecobank has set up a London office to further enhance its position in trade and commodity finance.
Standard Chartered is also looking to expand its offering in the commodity finance market.
Ashutosh Kumar, newly-appointed to the role of global head of corporate cash and trade product management at Standard Chartered, tells GTR: “Demand for structured commodity finance has picked up, primarily for two reasons. The structure is low risk, so the bank is more comfortable with the product. It is better than a straight loan, especially in times of high volatility.
“What we are trying to do is offer more structured commodity transactions across the supply chain from the trader to the intermediary and the buyer.”
The Chinese banks are ramping up their activity in this market. ICBC for instance is an increasingly familiar mandated lead arranger on some of the high-profile syndicated commodity finance deals such as last year’s US$1.2bn pre-export facility for Cocobod. The Bank of China was a mandated lead arranger on steel trader Stemcor’s latest revolving credit facility.
“That’s the next big thing. The search for liquidity is moving east,” Peter Sargent, head of transaction banking, Europe, at ANZ tells GTR. “Look at the major commodity houses which have done revolving credit facilities (RCFs) recently. There are Chinese banks involved in most of these. And they have deep pockets.”
“Look at the major commodity houses which have done revolving credit facilities (RCFs) recently. There are Chinese banks involved in most of these. And they have deep pockets.”
The large top-tier trading houses have won many oversubscribed syndicated revolving credit facilities during the first half of 2011 with banks piling in to finance them.
“We see increased competitiveness. For the top-tier names in Brazil, Russia and Ukraine, liquidity pricing is being undercut,” comments Henderson at Texel Capital.
“It is fiercely competitive at the top and they are all fighting for mandates,” he adds.
Stemcor secured a dual-tranche oversubscribed US$1bn multicurrency RCF in early May. The MLAs included the usual big players such as BNP Paribas, ING, RBS, Société Générale and Standard Chartered as bookrunners. But joining as mandated lead arrangers were Bank of China and the Development Bank of Singapore.
Noble Group is also in the market looking to raise US$2.25bn in committed unsecured revolving loans. 16 banks have signed up as bookrunners, including Banco do Brasil, illustrating how liquidity for commodity finance is being sought from emerging markets in Latin America as well as those fast growing markets in Asia.
Trafigura and Vitol have also tapped the market in the first half of 2011.
“At the top end of the commodity finance market, the leading players still have access to finance and their RCFs are all oversubscribed. So there is strong appetite to bank that sector. The returns on those RCFs compared to the returns we used to get pre-crisis are much more attractive,” comments Williams at ANZ.
“All banks go into these RCF discussions with a very clear mandate that they will use them for more cross-sell and try to ensure that the client gives them classic trade finance, structured business,” he adds.
Risk appetite and capacity
Yet if commodity prices continue to soar, banks’ capacity to lend to these large RCFs for top-tier traders, let alone lend to the second or third-tier trading companies, could begin to erode.
As ANZ’s Sargent explains: “If oil prices go up 50%, in order for us to do the same amount of business we are going to have to double our lines. The new banking regulations, and the conservative nature of the compliance and risk teams are the real issues. Getting to double any of our commodity traders’ lines is a challenge.”
He adds: “If the WTO says world trade will double in the next decade then the question becomes is there a finite capacity in the commodities market?”
Michael Rolfe, global head of commodity trade finance at UniCredit agrees that getting increases to credit lines can sometimes be tough. “It does get more difficult for us here, as our credit committees prefer to see a file only once a year; when we do have to go back and get increases, it is easier for clients trading hedgable products.”
“Any increases (even those that are short term) at UniCredit means the preparation of a full credit proposal. But since these lends are collateralised by the underlying commodity, we tend to go with the increase, provided the client meets our stringent credit criteria. This doesn’t mean to say increases will be infinite; we will reach a stage when we may not want to go higher due to commodity product or sector concentration
Banks’ internal preoccupation with risk weighted assets (RWA) is the main hurdle for commodity finance teams.
“Capital allocation remains a key aspect of commodity trade finance business, as banks become more brutal in making sure that risk weighted assets are used in the most efficient manner,” remarks UniCredit’s Rolfe.
As Basel III looms, the focus on putting adequate capital aside will further constrain banks’ appetites.
“Banks generally have increasing costs to cover from a compliance and regulation point of view. There is always pressure to reduce margin and fees, but both banks and trading houses have to be realistic about each others’ costs of doing business,” Rolfe explains.
“UniCredit always looks at a blend of fees and margins that come from committed RCFs and uncommitted bilateral facilities. It is not in the banking or trading markets interest to reduce pricing to levels where business becomes negligible,” he adds.
He remarks that there is a realisation in the market that the banks cannot absorb all the costs that are being put on them by the regulators.
“Clients and their bankers have to be realistic; we cannot go back to pre-2008 levels,” he notes. “But most of the large traders look at their banks as stakeholders in their business, and both parties need to be realistic and transparent in their goals on this type of discussion,” he adds.
Yet the regulatory burden does seem to be slowing down some banks’ response times when dealing with their trading house clients.
A spokesperson from Trafigura tells GTR that although banks have been “very supportive during the volatile price period”, many have been slow to respond to price increases.
“On average it has taken banks in excess of three months to respond to price movements with line increases,” the spokesperson reports.
Trafigura also notes: “We are seeing new banks entering the market, but regulatory pressure is a potential concern for all banks.”
Some lenders are beginning to demand increased levels of security from their clients on structured commodity finance deals.
“I have seen an increased emphasis on taking security at the local level, for example, warehouses or stockpiled material pending delivery,” notes SNR Denton’s Solomon.
“However, the driver for these demands includes not only mitigating commodity finance risk but also in meeting stricter credit approvals for transactions on a general level,” he adds.
Some commodity finance lenders are also struggling with credit committees that don’t understand the nature of commodity finance transactions.
Solomon observes that a prevailing attitude of credit committees is to apply a “corporate lending type of analysis” to pending transactions. He believes that this strategy is “inconsistent with typical categories of borrowers and obligors in trade finance”.
A London-based banker involved in structured trade and commodity finance, who prefers to remain anonymous, has also encountered problems with credit committees that fail to grasp the nature of deal structures.
“More customers are seeking to tie their bankers into tripartite agreements with brokers to ensure liquidity is available to meet margin calls in a timely fashion,” he remarks. “From a bank’s point of view, entering such an agreement does carry obligations, but at the same time it provides transparency and security that would not otherwise be available to them.”
He argues that this structure provides the bank with the comfort that the customer is hedging the business it is financing with the bank.
“Sadly, many bank credit departments fail to understand how such structures might enhance the overall structure of the business they are transacting and are very reluctant to enter the agreement. “Price spikes are not headaches for the bank that understands the link between the margin call and the increasing value of the underlying physical commodity,” he adds.
Currency issues and the eurozone
A further concern for banks and trading companies is currency volatility.
When asked if there was enough liquidity in the market, Trafigura responded positively, although citing that the “cost of the US dollar continues to vary across the globe. It gets more expensive as one goes from east to west”.
From the bank perspective, UniCredit’s Rolfe points out. “Commodity finance business is driven by commodity prices and the US dollar. For Euro centric banks the dollar-Euro exchange rate has a strong impact; a weaker US dollar means lower Euro assets and liabilities on balance sheet which does help with higher client credit requirements, but also causes lower Euro revenue streams.”
Exposure to Greek risk is a problem for European banks too, making credit committees even more cautious and pushing up the cost of funding at some banks.
Williams at ANZ notes that the bank’s Asia focus has helped it avoid the fallout from the current financial problems, such as in Greece.
“We are fortunate because we are focused on Asia and can support the kind of business we’ve talked about without a credit committee being pre-occupied with problem files on Greek debt.”
New liquidity sources
Against the backdrop of a hamstrung European banking market, fresh sources of liquidity are being found in the emerging markets, particularly in Asia.
This trend reflects the growing regionalisation in the provision of commodity finance. “There are not many global banks doing this business globally,” remarks Sargent at ANZ.
“It is symptomatic of a move towards regionalisation. In Europe for instance, we only deal with the very big houses. But in Australia and Asia there are lots of medium-sized commodity traders we are happy to deal with.”
The market cannot just rely on the more liquid Asian-based banks, and some are arguing that other types of investors need to step up into the market to either finance or risk share on commodity finance deals.
“I think that there should be more done in the risk-sharing space. There are new investors coming into the market and we welcome that as it helps broaden the market. Hedge funds, pension funds, different kinds of funds want to invest in this asset class,” Standard Chartered’s Kumar tells GTR.
“There is an increasing realisation that this is an asset class that is quite low risk, the returns are good and the investors are there.”
UniCredit’s Rolfe echoes this: “With Basel III, and the increased costs for raising finance, perhaps it is time now for the financing banks and traders to think of the capital markets and maybe look towards interested investors that are willing to put money into commodity-backed lending.”
“Currently, I don’t think there is any institutional investor such as a pension fund that has really considered working with banks experienced in commodity lending to invest in commodity risks with non-public quoted companies. It could be time for those discussions to start.”
As commodities prices continue to rise and regulation continues to tighten, the market is waiting for someone to kick-start this debate.