Trade of thrones - filling the power vacuum at the heart of global trade

Feature | 25 January 2017
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Rollo Tomasi reflects on a year of political upheaval where noise drowned sense and reality when it came to responses to commodity price volatility, and where traders seem to be wearing the financing trousers

It feels rather a relief to have survived 2016. Let's face it, plenty didn't, although quite how you feel about Hillary Clinton not making it to the White House is probably as divisive an issue as which side of the fence (wall?) you sit over Brexit.

Perhaps even more staggering than the 2016 mortality rate among the senior cognoscenti of the commodity trade finance world (of which more later), is the fact that so many 'experts' - economists, political pundits, and credit analysts, got it all so far wrong in 2016. All stubbornly still with us, predicting skies are about to fall, rivers to boil, and boils to burst.

Commodities conundrums

So what happened to all those predictions? What about iron ore, which was US$37/t this time last year and was predicted by some forecasts to go down to US$25/t? This compounded an already challenging situation for the big Ukrainian producers and catapulted some into a prolonged restructuring which ran all year, or even a second year for some, although Australia's Fortescue Metals Group (FMG) put a certain amount of writing on the iron ore wall when they came out with surprisingly good results in February, which were widely reported for no better reason other than FMG is publicly quoted.

Being listed has turned out to be quite a double-edged sword for all those who went public during the commodity super-cycle, when the investment bankers suddenly 'discovered' commodities and realised how much they could rake in on fees by taking these companies to the equities markets.

What FMG's widely reported accounts achieved was to remind us of two key components of how we should analyse commodity producers:

  1. The speed at which they cut costs when prices fall. Way too often, the average credit analyst, sadly encouraged by the below-average credit manager, looks at sales prices coming down but assumes costs stay level, whereupon the company goes cash negative in a matter of months. If this were really the case (and its not to say some aren't rather too slow to do this) then we'd have stopped digging things out off the ground some hundreds of years ago. Of course, you have to look at how quickly such action is taken (just look at the survival of oil production in the US, despite all predictions that below US$50/bbl it was simply uneconomic) to see how absolutely critical it is to how companies perform in different price scenarios.

  2. Currency. A lot of the big commodity producers are based in countries where the currency closely mirrors the performance of the commodity sector - for example, Russia, Brazil, and for FMG, clearly Australia. The relevant commodity price collapses and the local currency goes south with it. What does this mean? Well, that old formula of local currency costs and hard currency revenue is why we all love commodity exporters (even if the analysts often haven't realised this correlation yet).

Iron ore

As it turned out, iron ore promptly climbed back up above US$50/t and by year end was kissing US$80/t, despite all predictions to the contrary, which apart from a lot of hard negotiations, may explain why the Ukrainians and the few banks who stuck with them are all looking a sight happier as we enter 2017. Of course the pundits are predicting iron ore will collapse again, and who knows, eventually they might be right - but there's also such a thing as being 'right too early'.


Oil prices had already dropped below US$100/bbl at the end of 2014 and, quick as a flash, the Federal Reserve Bank of New York went around all the banks active in the US a full year later saying "Guys - you realise oil has collapsed?"

Since then, the US regulators have revisited the banks every six months looking at their oil exposures, telling them they all had too much of it, bouncing them into loan loss provisions, prompting serial headlines about how many billions these banks are over-exposed to a collapsing oil industry, and generally intimidating everyone by saying they would be forced to raise more capital for supporting this industry.

Some European banks historically big in the oil sector, but bearing deep scars from earlier transgressions with US regulators, promptly pulled out their white flags and walked away from Houston altogether. Although to be strictly accurate, this was the second time BNP Paribas had exited the reserve-based lending (RBL) market, having previously sold their RBL business in 2012 to Wells Fargo, before returning in 2014 to rebuild it. And for a while, even North Sea RBL syndications struggled to pick up volume in the first half of 2016.

It didn't help when Goldman Sachs predicted the oil price could go as low as US$20/bbl although by now, forecasts from such a quarter are handled with a certain amount of caution, and eventually Lundin Petroleum's mega US$4.3bn RBL (for the even more mega Johan Sverdrup field offshore Norway) clawed it's way up to a very successful US$5bn (March 2016).

Nevertheless, the ratings agencies similarly piled in, and when they start downgrading Exxon and Chevron, you can imagine what's happening to ratings further down the food chain across the rest of the sector.

Of course it didn't end there, because a further pro-cyclical consequence of the current regulatory environment is that lower credit ratings push up the risk weightings used to calculate risk weighted assets (RWA). Thus with no change in anything except the credit rating, the RWA goes up, so the return of RWA (RORWA) goes down, whereupon when the bank's domestic regulator comes round and measures the bank's performance, they see the metrics on RORWA for the oil book heading south and this then triggers another round of regulatory retribution and scrutiny.

Meanwhile, what of oil? From a low of US$27/bbl this time last year, it has pretty much doubled to the mid US$50s, and while we cannot say there were no bankruptcies among some of the more highly leveraged US shale producers, most cut costs so rapidly that the real pain was in the service sector supplying the oil producers. When prices climbed back up, the producers were able to take all the upside.

King Coal?

And coal? Well a year ago we were told King Coal was dead, killed by low provinces and environmental pressures, with banks queuing up to say they would no longer support the sector, and again, thermal coal has meanwhile more than doubled and the metallurgical coal price has trebled, meaning all bets are back on again there as well.

There will always be a price

Perhaps underpinning the recalcitrant resilience of many commodity prices was the other major fallacy of the forecasting year. This was that the long-forecast 'Chinese slowdown' was finally upon us, and that this would depress all commodity prices. What went wrong with this? Let's just say everything is relative, and one country's "only 6% growth" is nevertheless still the equivalent of adding the total GDP of another two countries such as Switzerland and Singapore, so in the end even in a relatively 'poorer' year, the Chinese still both buy and produce an awful lot of commodities. It's the great thing about the commodity trade - the prices go up, the prices go down, as do the volumes, but they never go to absolute zero - there will always be trade, and there will always be a price.

Where does this leave us now? Actually, in a surprisingly good position. The cost control which producers brought in already from 2015 combined with this year's higher commodity prices, should see many produce remarkably strong full year results for 2016. These will probably start coming out in February to March 2017, with rating upgrades in the following weeks.

This will push RWA down so with nothing else changing, returns will, on this alone, look better. So much for producers. What about the traders, on whom so many of us increasingly rely for our daily bread? The traders of course always say they don't need a high price environment to be profitable and they should be able to make money irrespective the direction of underlying prices, yet it's always easier to make bigger profits off higher prices. Of course, the traders have also very much been the big beneficiaries of the widespread worldwide 'debanking', in the sense of banks pulling out of all sorts of sectors, be they coal, oil or correspondent banking, prompted by short-sighted regulatory pressures which seek to address individual issues, while inadvertently creating several others - let's come back to those.

Trader triumphs

The traders have, pretty much across the board, had a stonking year. You only have to look at Glencore. Towards the end of 2015, the analysts were all predicting crisis for the trader-cum-miner. Miners of course in general were on their knees amid widespread low commodity prices, with share prices hammered accordingly.

Glencore faced the additional challenge of speculative shorting of the stock amid claims that they were "way over-levered" when "compared to their other mining peers". I guess we save our brickbats this time for the equity analysts who don't know how to analyse a trading company (even one with a lot of mining assets). Anyway, where is the Glencore share price today? Let's just say it has outperformed coal in the number of multiples by which it has increased since. Glencore also pulled off one of the coups of the year by taking up a 19.5% share of Rosneft, also great with their Middle Eastern backers, in a move which puts them level with BP at the Russian major's top table just in time for a new hand at the helm of US sanctions against Russia, and arguably ahead of Rosneft's previously most favoured trader Trafigura.

That's not to say that Trafi hasn't also been taking advantage of depressed asset valuations to be hot on the same trail to improve its position, and they are Rosneft's partner in the acquisition of the well-seen Essar Oil refinery in India, where Rosneft's minority's stake on the one hand secures the refinery's crude supply but on the other, doesn't trip the sanctions trigger.

Similarly, Trafi made a well placed minority investment into Belgian zinc group Nystar, which got them a couple of crucial boardroom seats and a relatively chunky zinc prepayment financing syndicated in steps through the year, dovetailing neatly into the Nystar borrowing base financing which is run by the same agent bank, Deutsche, thus minimising the risk of any double counting of material.

Vitol of course kicked the structured year off with their jumbo US$3bn prepayment financing for Kazakhstan's KMG, which while not universally supported among the purists, was nevertheless successfully syndicated with big tickets put down by the Asian banks - Bank of China and ICBC for China, and Sumitomo and BTMU for Japan.

The oil trader also saw successful refinancing of their various refining joint ventures around the world and finished the year with a reported jumbo euro-denominated prepayment to Iran's oil products exporter NPC.

Other traditional big players like the ABCD Group (ADM, Bunge, Cargill and Louis Dreyfus, account for between 75% and 90% of the global grain trade) Gerald, Mercuria, ED&F Man kept busy. Perhaps a special mention should go to Castleton Commodities, who successfully crossed the seas this year from the US to make significant inroads into Europe and Asia, and were to be seen everywhere, fêted by their supporters.

Beyond Cocobod

That's not to say the banks have given up altogether on the big structured syndications, and the perennial deals such as Ghana's Cocobod seem to go on forever with gravity-defying success. But with Cocobod aside, the only traditional 'banks to producer' style jumbo pre-export financing (PXF) of the type so beloved of olden days was TCO's US$3bn Kazakh crude oil deal in the summer, and while there were a smattering of smaller Russian PXFs such as ING's deal for Russian fertiliser producer Uralkali, these were a shadow of the former Russian PXF self.

Nevertheless, the two big financing themes of the year were both very clearly trader-led: the continued march of the trader unsecured revolving credit facility (RCF), which is how they have so much liquidity available to take such advantage of the opportunities spawned by downward asset price valuations, and the trader-led prepayments, which seem to have become much easier for banks to finance than the traditional type of PXF offered directly to the producer.

It's almost as though the big commodity banks have rather lost their mojo and are much less confident about taking the lead on deals. Rather, they seem to prefer to let the trader make the running, so they can come in later once the commanding heights of the financing are already set.

The root cause lies in the very different regulatory environment in which banks today work. When Deutsche Bank's share price goes up because their latest regulatory fine, this time from the US Justice Department, is 'only' US$7.2bn and the German bank counts itself lucky to have agreed that amount, you have to say the world has changed, and the regulators really are masters of all they survey. The hard part is they are not yet experts in all they survey, and a recurring complaint from bankers is that they don't necessarily see all the consequences of all the bright ideas they have brought to the table in the name of making a better, safer world.

Unintended consequences of regulation

A prime example of these unintended consequences has been the Foreign Account Tax Compliance Act (FATCA) exhortation to identify 'all bank accounts held by US citizens'. The only way to do this has been to identify all bank account holders, and while it may seem a laudable objective to stamp out tax evasion, in practice it just means if you are a US passport holder, no-one outside the US wants to open an account for you because of all the additional reporting requirements which makes the traditional checking account a deeply uneconomic product.

FATCA also brings 'know your client's client' (KYCC) to banks. Now banks fear the traditional correspondent banking account because they have to be certain their client bank obeys all the same rules, so there has been a mass shutdown of thousands of bank accounts for other banks - most notably across Africa where outsiders have perhaps less faith that local banks apply the US rules with the requisite rigour now demanded by the US of the EU banks.

This now applies bank branch by bank branch. If Bank A in London is to make a transfer for a mutual client to Bank B in Amsterdam, never mind both banks needing to have current 'KYC' in place on the client, additionally Bank A must 'adopt', ie do full KYC on, Bank B in Amsterdam and in their turn, Bank B in Amsterdam must do full KYC on Bank A in London.

Both institutions (and indeed most others) have as a default setting that they will only 'adopt' the head office of the banks they deal with, to relieve burden of having to adopt all individual branches of the other firm. At the same time, of course, KYC as a process has simply got worse and worse.

Banks now have to classify all counterparties as low, medium or high risk, depending on profile, geography of activity (as well as incorporation, and shareholders/management). And products with trade finance are apparently seen as 'high risk' by US and UK regulators. Also, media 'noise' such as negative press commentary (however ill-informed) has to be taken into account, presumably on the presumption that there is no smoke without fire. While this may run contrary to the natural justice proposition that a person or entity is innocent until proven guilty, one must concede that in fact many of the banks (and for that matter) others have indeed been guilty as charged, and not just as a one-off, leading to the rather circular story heard this year that allegedly, one EU bank keen to polish its much criticised KYC credentials, ran a KYC assessment of its own subsidiary in South Africa and concluded it was 'high risk', not because it was in South Africa, but because of all the 'negative press commentary' about its European parent.

On the legal front, while the lawyers doubtless did very well from the lengthy restructurings prompted by the 2014/15 commodity downturn, with good success reported notably in December 2016 in Ukraine, probably the real landmark ruling of the year arose out of the equally long-running OW Bunker case - the bankrupt Malta-based marine fuel supplier. In May 2016 the Supreme Court in London overruled lesser courts to give final judgment on the Res Cogitans issues and effectively finding in favour of ING's claim to the pledged receivables as agent for the borrowing base syndicate, despite suppliers not having been paid. Just as the OW Bunker case challenged bank enthusiasm for borrowing bases when it first hit in November 2014, so this judgment should be very reassuring to creditor banks who outside the US, are never quite sure how good their collateralisation really is.

Endings and beginnings

The year 2016 was remarkable for the mass cull of the senior ranks of London commodity trade finance bankers, with many who have been around for decades finally checking out from mainstream banking.

Potentially the oldest man alive in structured trade finance, Neil McGugan, finally left banking for insurance broker Aon, from where he organised a well-received fact finding trip for assorted insurance and banking market worthies to Kiev which seems to have got him off to a good start. Fellow Japanese banker John Turnbull, a 16-year veteran of SMBC who set up structured trade and commodity finance there having first entered the market in the late 1970s, also left abruptly to run his own advisory business.

Another senior figure now suddenly in the advisory business is career-HSBC veteran Jean-François Lambert. Turnbull and Lambert are especially missed by those who remain since they carried a lot of the heavy lifting on commodity trade finance matters with regulators such as the Basel Committee, the European Banking Authority and the Financial Conduct Authority, with Turnbull also being prominent at the ICC Banking Commission where he is also credited with having been the leading author of UCP 600, the rules governing documentary letters of credit.

Another 'lifer' out was ING's Bernard Zonneveld, who in a 'poacher turned gamekeeper' move, which surprised many, has ended up as a non-executive director of Russian aluminium producer Rusal, with responsibility for compliance and audit…

Another abrupt move was the departure of big Bob ex-everywhere Angliss, veteran of Deutsche Bank, West LB, and Glencore to name but a few of his many former employers, but most recently ex-BTMU. Angliss, however seems to have had the last laugh, possibility benefitting from such wide experience of different employers, and promptly moved into a senior commodity trade finance slot at Bank of China's London branch. Some of the 'old and bold' are tight-lipped about the extent to which these moves were voluntary or not, although the moral seems to be that there is lamentably little loyalty to be had towards long-serving staff these days. Others are cautious as to whether this is good or bad for the market, as commentators struggle to balance the idea of making room for upcoming younger talent with the loss of so much experience and, also important in front of regulators, of such authoritative voices.

Top tips for 2017

Let's go out on a limb here and put out some markers for the year ahead on the basis that many forecasts will be wrong anyway.

  • The 'Trump bump' will be good for commodities in general, non ferrous will strengthen, although oil and iron ore may plateau.

  • President Trump will relax Russian sanctions but reinstate Iranian ones, although miraculously the Boeing contract will be exempted.

  • Consequently the Russians will be back and will remember who their friends were.

  • The Ukrainians will also be back, by year end.

  • China will be a strong market for syndicated structured deals, but African deals will be increasingly hard to do because of KYC.

  • While Trump may also be good for banks in general terms, banks will continue to struggle with reconciling their responses to regulatory requirements with the fundamental question of how to finance international trade. Expect more changes at banks.

  • Conversely, non-bank trade finance providers will thrive, especially in forfaiting and inventory finance. New trade finance entrants will use new technology such as blockchain and mobile apps to compensate for the lack of an international branch network along traditional banking lines.

  • The traders get another year as kings, but they will need to expand their trade finance teams to take up even more of the slack left by banks.


And that's it for another year!

Rollo Tomasi is TFR's tame structured trade
and commodity finance expert

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