denotes premium content | Sep 3 2010 
Feature
posted 30 Jun 2009 in Volume 12 Issue 8
Global commodities review
Hard times?
This time last year, the only way was up. Since then, prices in most commodity sectors have crashed, before recovering. Trade & Forfaiting Review has talked to a range of top professionals in the market to find out what is going on.
The panel:
John Turnbull, Global Head of Structured Trade & Commodity Finance, SMBC (JT)
Jean-Francois Lambert, Head of Structured Trade Finance, HSBC (JFL)
John MacNamara, Global Head of Structured Commodity Trade Finance, Deutsche Bank (JM)
Sandra Nolasco, Head of Commodity Trade Finance, BBVA (SN)
Bernard Zonneveld, Global Head of Structured Metals & Energy Finance, ING Bank (BZ)
Q1 – In the Global Commodities Review this time last year, there was much talk of a commodities supercycle. Is this still on or have events proved such talk false?
BZ, ING – In my view, whether it’s a commodity supercycle or not, we will see prices for commodities in general rise in the years to come. At present, due to the crisis, supply and demand are unbalanced, leading to temporary downward correction in prices for commodities. The crisis has created a substantial lack of demand, and the producing companies have had to react swiftly to ‘right size’ their operations and cut costs.
Structurally, however, we will continue to see an upward trend for commodities. On the one hand, commodities in general are getting scarcer and, on the other, the key developing countries – particularly China and India, which account for roughly 40% of the world population – have only just started an economic development that will continue for years to come, and display a permanent ‘hunger’ for raw materials. Commodity prices will therefore remain on a structurally higher level than the averages we saw before the boom.
SN, BBVA – Supercycle or not, the commodities boom of 2003-2008 is notable for its magnitude, and scope. Commodity prices in real terms increased by 130% from the previous low in 1999 to a peak in March 2008. This compares with a 47% rise in the 1950-57 post-war boom and a 59% rise in the oil shock of 1973-74.
Furthermore, previous surges were all concentrated in one or two commodity segments: metals and agri-commodities in 1950-57, and oil and agri in 1973-74. The 2003-2008 boom saw a surge across all three segments and included not only the ‘usual suspects’ (such as oil and wheat), but also more exotic materials (such as super alloys).
JFL, HSBC - This time last year, prices were reaching the sky and the comfortable explanation was that financial speculation had invaded the commodity realm. But what was the foam and what was the wave? Clearly, the tide has receded and this was caused by both recession and the speculative positions that needed to be unwound fast: the surfers got caught and sank. We now navigate in much shallower seas...
“There is no way prices will bounce back to pre-crisis levels in just two years. If they did, we should run for cover as a second bubble would burst and create even more disruption than the first.”
Jean-Francois Lambert, HSBC
Q2 – Were commodities too expensive in June last year or are they a bargain now?
JT, SMBC - Prices are always a combination of the forces of supply and demand, plus the expectations and speculation of the markets. Commodity prices have always been cyclical. It was only a matter of time before there was a re-adjustment of pricing.
BZ – A very interesting question! Prices are reasonably low now – but only temporarily. If you look at what happened with crude oil recently, it has almost doubled in price from early-year lows to roughly $75 per barrel. So many traders and producers are re-stocking at the moment – look at the fully loaded storage tanks on shore and the high number of tankers criss-crossing the oceans, stuffed with oil at the moment – that the expectation for a further rise is foreseen. In general, other commodities follow the oil price trend, and are therefore also on the rise.
In some commodities, ‘basic commodity rules’ do not seem to apply any more. The aluminium price has been on the rise and is now above the $1600 level. However, LME stocks have continued to rise as well. As a rule of thumb, if there is more than 1.5 million metric tonnes stored at the London Metals Exchange (LME) then the price will start to go down, but already there is in excess of four million tonnes at the LME. Maybe this can be explained away by the purchase of ‘fresh’ aluminium – just produced ‘alu’, straight from the factory/producer – as demand is restarted. But if prices continue to rise, as I expect, one could indeed say that it is a bargain right now.
But it will not be a straight upward line. We will see temporary price spikes and very sudden drops. Therefore, for my banker friends, who like to play safe: stick for the time being to the ‘worst case scenario’ cash flow in analysing commodity companies and their resilience to the crisis.
“Due to the capital constraints imposed by IFRS and Basel II, many banks had to cut back lending, including lending to the commodities industry… due to the scarcity of financing, the return to growth of many companies will be hampered.”
Bernard Zonneveld, ING Bank
SN – The issue is more whether the prices adequately reflect supply and demand. While there was much talk during last year, blaming hedge funds and speculators for the price boom, there were strong fundamentals sustaining commodity prices, not least the fast growth of
JFL – Commodity prices are, by and large, driven by supply and demand. Too high a price or too low is irrelevant. What we need to assess is the adequacy between supply and demand. Demand is depressed and supply is receding to adapt. Do we see demand picking up fast? The positives include
JM, DB – The supercycle hasn’t necessarily been debunked, it just came to an end. As with most market volatility, the correction was as overdone as the original bubble, and now we’re back on a curve that wouldn’t look out of place if we were in 2005/6. For commodity lenders, the old adage of ‘what goes up must come down’ and vice versa has proven to be exactly right.
Q3 – What have been the knock-on effects of the fall in commodity prices – in the real world or in various markets and economies?
JT – Last year, we were all concerned about the impact of rapidly increasing prices and high levels of volatility. Would commodity traders’ hedging strategies be able to cope with sustained one-way movements in prices, or with sharp fluctuations? Could they all meet their margin calls in such cases? This was a severe kind of stress-test for them and, in general terms, they have weathered it well and proven their managerial robustness.
Regarding producers, it is clear that in some sectors, such as metals and mining, producers did use expectations of continued high prices to increase debt to finance acquisitions or major capital expenditure plans. As we are seeing now, many such acquisitions are either having to be abandoned or, if already done, the debt burden thus incurred is proving onerous.
For commodity producer economies, the challenge is always the same: how to ensure that windfall income from high prices are used wisely for diversification and investment in overall productivity, so that when prices drop the economies are stronger and more resilient.
“We think that financing to good-quality borrowers, especially those with unpledged security capacity, and to those with a positive cashflow and moderate debt, will continue to be available for general maintenance and exploration.”
John Turnbull, SMBC
BZ – This clearly depends on which commodities you are talking about, which companies, and in which countries. Let me give you a few examples. Clearly, the base metal and steel markets are in a difficult position at the moment. However, in oil & gas, fertilizers and coal have been much less affected. Besides, it depends on what companies have done in the recent years. Companies with ‘fat on the bone’ will weather this storm reasonably well, but companies with aggressive growth and acquisition strategies based, in many cases on ambitious leverage, will clearly suffer. These are the companies talking to their bankers on a regular basis about restructuring of their debt positions. The knock-on effects can clearly be seen in
SN – The fall in commodity prices has had a big impact on the profitability of some producers and, in particular, some investment and expansion projects. However, there is always another side to the coin… An important knock-on effect is the relief of inflationary pressure. Just a year-and-half ago,
Second, one must not forget that in the first half of 2008, commodity companies (and customers!) were struggling for liquidity, faced with both increased prices and a severe dry up of credit availability. The fall of commodity prices has – for many – eased the pressure, providing the very necessary breathing space for re-organisation and restructuring.
JFL – Many producing countries are on their knees when they were used to be running. Those with huge foreign-currency reserves are resisting better than others. Local currencies taking a hit with devaluation have compounded the effect, for them, of a drop in commodity prices. Suddenly, debt is overwhelming, production is too expansive and demand is limited. Hence defaults, restructuring and contract renegotiations are becoming the norm. All service providers along the chain are suffering and, notably, in the shipping industry it is only thanks to serious mothballing that it has been able to adapt to lower demand and get the freight price to rise, somehow, after they dived.
Regions affected?
JM – I’m not an economist so maybe shouldn’t comment on economies, but as a historian I can tell you that history suggests we’ll get over all this – life goes on(!). In the real world of bank lending, of course, almost all commodity-backed deals went through some very real stress testing in the commodity price correction, and there is a hangover of waivers crunching their way through the systems and mechanisms of the banks, which for many is inhibiting new credit approvals. When was the last time you saw a steel-backed facility? Severstal? However, since the 2008 year-end low point there has been significant price recovery across many commodities with the knock-on effect, for example, that Russian Central Bank reserves have actually gone up for the past three months running.
“Producers have suspended or postponed investment projects, traders have reduced volumes due to lack of working capital and processors in destination markets reduced inventory levels.”
Sandra Nolasco, BBVA
Q4 – Have you seen an emergence of economic nationalism?
JT – Economic nationalism is always there - it does not suddenly emerge. But times of stress make it more apparent. For commodity producers, the tension is often between the need for foreign involvement of technology, capital and managerial expertise to enable them to extract and sell their mineral endowments, and the desire to ensure adequate flow of revenues into national treasuries for spending on the domestic economy. In some cases, private or foreign ownership will be targeted by governments simply because it is an easy source of additional revenues or simply because it high profile. In the long term, however, I think that rational governments will always strike a balance between the need to attract the necessary resources to be able to extract and sell the commodities, and the need to ensure sufficient revenues for their own treasuries and to assuage public sentiment. Rational investors will also recognise this when negotiating production rights and so on.
While there were some extreme cases, such as the embargo on rice exports in certain countries, generally I believe that governments recognise the vital importance of trade to their economies and generally seek to ensure that such trade flows proceed smoothly. In times of financial constraint they will tend to give priority to ensuring that vital import obligations are met.
BZ – Apart from what we already know - what is already happening in some Latin American countries - we have not seen these trends in other parts of the world yet. Some expected that
JFL – In the commodity business, not specifically, although it is never far from the unwritten political agenda.
JM – Well, traditionally this was applied to the Kremlin and maybe some of the left-wing leaders in Latin America, but in recent years it has been rife in Western Europe and the
Q5 – How will the curtailment of finance over the past year affect the production of commodities over the next year or two?
JT – Producers’ investment in additional capacity is driven by two things: their expectation of future prices and their access to finance. Both have declined dramatically over the past eight to 12 months, though prices only to more historically average levels. Producers have sought finance for capital investment in their existing production facilities, but what drove the market much more was the wave of acquisitions on the back of high prices. We think that financing to good-quality borrowers, especially those with unpledged security capacity, and to those with a positive cashflow and moderate debt, will continue to be available for general maintenance and exploration. Producers are still coming to the market, though for smaller size deals at shorter tenors.
BZ – First, we have to look at what curtailment of financing means and how the financial crisis has affected the banks. There were a lot of factors at play in the events of mid-2008. However, I would like to emphasise the severe impact of the International Financial Reporting Standards (IFRS) on the banking system and the capital of the banks, as well as Basel II. Both regulations, in my view, need serious reconsideration, mainly due to the unforeseen high impact on the capital base of the banks and, therefore, on the availability of assets for lending.
Due to the capital constraints imposed by IFRS and Basel II, many banks had to cut back lending, including lending to the commodities industry. In general, due to the scarcity of financing, the return to growth of many companies will be hampered. They therefore have to rely on their own realised cash flow for growth. Furthermore, investment plans have been postponed, amended or even stopped in previously planned development projects. This all means that the road to recovery will follow a reasonably slow path, and will take more time than people anticipate at the moment.
SN – The lack of credit availability has certainly affected commodity players – not only producers, but across the whole value-chain. Producers have suspended or postponed investment projects, traders have reduced volumes due to lack of working capital and processors in destination markets reduced inventory levels. The issue for producers is that, depending on the sector, reactivating dormant capacity and/or resuming investments may not be as easy as turning it off. In particular, metals and mining might need longer to bring production capacity back on track.
JFL – The main issue is demand, not financing. If there is demand then prices will go up: producers’ profitability and cash flow will improve, risk will look more attractive and, hence, financing will rise. This is the virtuous circle. Financing conditions are arguably getting more stringent and will remain so (this means better structures, duration linked to the business cycles, more thorough assessment of the relationship between suppliers and buyers, and pricing more reflective of the true risks). But is this a bad news?
JM – Oil seems to be the last man standing with several new deals grinding through, but there has been a very noticeable reduction in metals activity (not a complete stop, but certainly much reduced), while the softs side in certain countries, notably Brazil, is really suffering. The particular issue there is that many prepagamento lenders have been very disappointed about the level of security and subsequent recovery provided by certain instruments, such as CPRs, with the result that it is now very difficult for farmers to attract new agricultural credits except from the big traders. The Brazilian banks are in noticeably good shape, yet they also seem to be unenthusiastic about the agri sector and a lot of that can probably be put down to the poor performance of the security instruments.
“This really ought to be our time. We have precisely the structures for this market and can give commodity corporates access to bank debt on a collateralised basis that should not frighten either the credit department or the regulators..”
John MacNamara, Deutsche Bank
JT – Demand for metals has fallen sharply due to the sudden halt in construction projects and difficulties in manufacturing sectors. Many producers have sharply curtailed production. As inventories get used up prices have stabilised. Demand for oil has eased only moderately, but will move in line with general economic activity.
BZ – Maybe this can be best phrased by a comment of one of our customers, who mentioned : “It’s business as usual; however, on a lower basis.”
We all know that production levels of commodity producers will remain lower for the time being, waiting again to grow in line with economic recovery. Recovery means a real pick-up of demand again. Clearly, some commodity segments are facing a greater impact from the fall out of demand than others. The food sector and, hence, agri commodities, continue to flourish and so does the oil and gas sector, fertilizers and coal for the power sector.
Metals, however, is heavily affected and is struggling. However, this also sector feels that a slight recovery is nearby, which is more reflected by price increases for metals since the beginning of April. We do not yet know whether this slight recovery means an ongoing real improvement in this sector, although I have to say that it looks promising for the second half of this year.
SN – Demand for metals and minerals has decreased significantly in the past year. The demand for metals and steel is very pro-cyclical, and vulnerable to changes in sectors that have been strongly hit by the global economy, such as automotive, aviation and construction. As for softs, naturally there is a change in the composition of the food basket as incomes rise (or decrease), but as a sector food demand is much less elastic. There we tend to look at supply for clues.
JFL – There are no crystal balls in the good bankers’ toolkit. But energy prices will rise (from oil to cook), then steel, then non-ferrous metals. Soft prices have already stabilised and are picking up. But there is no way prices will bounce back to pre-crisis levels in just two years. If they did, we should run for cover as a second bubble would burst and create even more disruption than the first as players will have been already weakened.
JM – Probably same answer as above. There were a large number of steel-based facilities in 2008 – more than we’ve ever seen before and also larger: the billion-dollar-plus deal became the norm. This has come to an abrupt halt and many of those borrowers are in intense discussions over their covenants. However, I don’t think this discredits the original deals. We have seen very few payment defaults, and most breaches have been ‘technical’ in the sense that they are breaches of covenant, but that doesn’t mean they are not servicing their debts.
The fortunes of those of us employed in commodities always, to some extent, follows the commodity prices, so when these are low that makes life more difficult. Yet particularly in the steel sector, borrowers have been quick to cut input costs to restore profitability – yes at a lower level, and maybe too low for EBITDA covenants set in 2008, but this shouldn’t be cause to panic just yet.
Two key items should give us some comfort: one, most of these guys entered this current downturn in much better shape than they had ever been in before and, two, certainly for all the deals we were in, these were and remain genuine trade finance structures, with real contracts for real goods assigned to lenders, so that export proceeds do indeed wash through the agent’s accounts, which themselves are pledged and ringfenced from third party creditors.
That puts us structured commodity trade finance lenders in a much stronger position than say bondholders. That said, the current wave of waivers probably has to work through the market and physical commodity has to pick up before we see another big steel PXF.
Q7 – How long do you expect current conditions to last - and what will happen when global growth increases, once again?
JT – Everyone is looking for green shoots, but for every piece of good news there is some bad news somewhere else. We need to differentiate between different sectors and between borrowers. In metals we expect prices to remain quite low for a while, while in oil we are seeing quite a strong increase once again. Volatility remains high across the various key commodities.
BZ – As already mentioned the commodity prices will strengthen again, due to the underlying strong fundamentals. I expect a real pick up to begin in 2010, which also means that those who will benefit most are the companies which have cut their costs drastically. They will be prepared for the upswing. As soon as global growth picks up again, it will be the developing world that will benefit most, more than the mature countries of the OECD. This means that some of the current financial restructurings taking place with companies in those countries will benefit and soon show a ‘business as usual’ profile again. Compared with 1998, many bankers thought they would lose money. As far as I know most of these difficult financial structures were all repaid two years later, without substantial losses for the banks (if any).
“The value added of commodity trade finance lies to a large extent on its risk mitigating capabilities and customisation. It is a proven technique and has an enviable track-record in times of economic stress.”
Sandra Nolasco, BBVA
SN – The ongoing debate among market specialists is whether the decrease in commodity prices is a blip in an otherwise upward trend or the end of the boom. There is an argument that the underlying fundamentals supporting growing demand (not to mention supply constraints) are not only intact, but even enhanced by the crisis – with the decrease in investments and production capacity planting the seed for a strong price recovery, once demand takes off. The weak dollar policy and low interest rates may enhance this effect, raising the danger of inflation.
On the other hand, there are those who argue that population will expand more slowly and that incomes will rise more weakly, halting the strong global economic growth of recent years and putting a ceiling on commodity prices for the years to come. In this scenario, a (slow) increase in demand would first be absorbed by the reactivation of dormant capacity.
JFL – Current conditions will prevail into the second quarter of 2010; with certain markets taking longer to recover than others. For example, the
JM – This is the ‘how long is a piece of string’ question isn’t it? Short answer is ‘don’t know’. I’m already seeing downward pressure on debt prices, driven by a recovery of nerve among the corporate bond brigade. On the other hand, we said what goes up must come down and we’ve been watching commodity prices all going up all year, so some sort of further downwards correction on commodity prices before year-end is also a distinct possibility. As a company, we hope for the best but are prepared for 2010 to be another tough year.
Q8 - What opportunities do you foresee for structured commodity trade finance in the current and predicted market conditions?
JT – Structured trade finance works well as long as producers keep producing. Although a lot has been written about difficulties in the steel and aluminium sectors, oil, other metals and softs have generally not had such difficulties. I expect that good quality producers with unpledged contracts for supply to offtakers will continue to come to the market, especially now that corporate and project financing is in short supply. There may not be the megadeals of the past two years, but there will be a steady flow of deals as there was four or five years ago. Structures will go back to being tighter.
BZ – A niche product like structured commodity finance (SCF) will always follow the market swings. We saw it erode as the economies of the developing countries improved from 2002 until mid-2008. But, at present, the typical classical SCF structures are in full swing again. There is hardly any room for clean financing, hardly any capital markets products available; ergo, the only way in which companies can attract financing is by using SCF (that means pre-export finance structures, based on strong collateral features, shorter tenors and higher pricing). I personally expect the market to remain strong for our product until the end of 2010. By then we will see how we have to adapt to the circumstances. For the time being, we enjoy these good times for our product.
SN – The value added of commodity trade finance lies to a large extent on its risk mitigating capabilities and customisation. It is a proven technique and has an enviable track-record in times of economic stress. In the face of the international financial-market turmoil, lenders have re-focused on structures and borrowers increasingly capitalise on their commodity export flows as a means of raising finance.
Commodity trade finance provides banks with the opportunity to strengthen their relationships with customers, while improving the risk profile of their portfolios. Some are better able to seize the opportunity. BBVA is in a very strong position throughout its geographic footprint, with sound risk capabilities and an appetite to maintain and establish long and meaningful relationships with customers.
Furthermore, we believe that many companies are preparing for the recovery of the global economy by re-organising, focusing on cost-cutting and improving their efficiency ratios. They will come out of the crisis stronger, better prepared and will be looking for opportunities. Banks that have taken the opportunity to continue broadening their structuring capabilities and risk management systems, like we have at BBVA, and that are strongly focused on their customer relationships, will be well prepared to capture the potential of the recovery.
JFL – There are many lessons to be learnt from the current situation. Such as financing established supply chains, where dynamics between producers and offtakers are well understood and strong enough. The structure is important (and, as said, will tighten) but nothing beats a good understanding between buyers and sellers. The supplier-buyer relationship will require more financing as suppliers are going to struggle to access affordable funding locally without their good buyers support. As commodity prices stabilise, banks will be keener to finance such requirements through adequate structures. We are therefore positive. But even in structured trade finance, the golden rule about banking remains that what matters is: first, the relationship; second, the relationship; then security. Not the other way round.
JM – This really ought to be our time. We have precisely the structures for this market and can give commodity corporates access to bank debt on a collateralised basis that should not frighten either the credit department or the regulators. There are all sorts of global initiatives sponsored by government and the multilaterals to get world trade going again and they are pouring money into banks. Yet the commodity business is the real economy at its most visceral level, and those of us still standing have a duty to take the SCTF products to the next level in the current environment. We can save the World! (We just need to get that next credit approval...)
