The sky’s the limit

Record high commodity prices are not only enticing new players to the commodity finance arena, but also inspiring global banks to tap new business and expand existing lines. Erika Morphy reports on a dazzling market that simply refuses to lose its shine.

Over the past twelve months global banks have been ratcheting up their commodity finance capabilities in response to a number of building trends in the market. Teams have been expanded and product lines such as variants of the cash and carry structures developed and then aggressively marketed in new countries. At the same time new entrants – from Citibank’s global trade services, which has been rumoured to be positioning itself to re-enter the soft commodities market, to banks that operate on Islamic trade finance principals, to US and European-based investment banks – are getting set to enter the fray.

The reasons are obvious and oft-cited: the record high level of commodity prices coupled with the pressures applied by Basel II on banks to change the manner in which they earn returns on capital as well as access capital.

“We are seeing more banks either entering this area or rebuilding their expertise,” John MacNamara, managing director of structured trade & export finance for Deutsche Bank says.” By now, with the implications of Basel II having sunk in, most of the global banks have sorted out what they want to do and how they want to approach the business. In commodities they see both an opportunity for Basel II-compliant collateralised business, and a market where a lot of the players are still chasing the banks for lines because the high commodity prices have put a lot of pressure on existing lines even if volumes by the tonne were static.” Such calculations, he says, has led many banks to start rebuilding teams they once redeployed or dismantled. “The British banks for instance – Barclays, HSBC, Lloyds and Royal Bank of Scotland have all come back to the commodity finance arena, while notably the Dutch and the French never really left.”

There have been other trends as well helping to reshape and revitalise structured commodity finance activities. These include the globalisation of supply chains and commodity producers themselves. Another driver is the liquidity provided by capital market exchanges, giving banks the ability to provide new structures and to take additional risks, knowing there are markets willing to absorb transactions banks no longer want to keep on the books.

Of course, these trends must be weighed against the less-than-desirable counter forces gathering in the market – less than desirable, at least, from Western perspectives. For starters, commodity prices in certain areas may well have peaked. Then there is China, which, as one banker says, is changing the world map of trade flows. Consider what is happening in Africa, for instance. In certain oil-rich countries such as Angola, the Chinese government is pumping billions of funding into development projects that are meant to be paid back with crude oil exports over a period of time. The end result will be far less exports to Europe and the United States within a few years time, and of course, less project and commodity finance provided by Western banks. Indeed, few global bankers are eager to see Chinese banks enter in the wake of their government’s strategic investments. “As of right now, China’s banks have not grown as fast as the industry has,” says one banker, and therefore are unable to support much of the government’s foreign market activity. That, of course, is subject to change.

A flight to returns

Underlying these developments – the rush to market by new players, the ongoing evolution of the commodity markets – is an even more fundamental trend at work: an increasing emphasis by banks on their return of capital.

Guillaume Leenhardt, head of Middle East and Africa for the energy commodities export project (ECEP) division, says banks are moving onto riskier propositions, inspired by what he calls a ‘flight to returns’. “In general, banks have become far less risk averse with regards to emerging markets in the last few years, in order to achieve reasonable lending returns.” As for BNP Paribas specifically, “we feel more comfortable with these risks, mainly as a result of our historical track record, the strength of our relationships in the Africa Middle East region, as well as the depth of experience of our teams.”

Indeed, this mentality is taking hold across all regions and is redefining the way banks look at their own businesses. The focus is no longer of revenues or lending strategies – rather banks have come to the realisation that corporate funding solutions have to be smarter in order to deliver the desired returns, not to mention customer base.

Super banks

The good news is that commodities as an asset class is one of the few areas in which banks – at least the smart ones – can be creative enough to develop such solutions. Banks are becoming more innovative in the use of hedges – at least for those companies that do not reject the possibility that, yes, prices may indeed fall. They are also reaching into new pockets of the commodity supply chain, structuring solutions for end users.

In fact, some observers are starting to talk of the emergence of a ‘super league’ of commodity-finance giants among the banks. These will be banks that never left this field. Banks that have been able to quantify their exact history of loss, product by product, across the commodity-finance spectrum going back decades, and which going forward under the Basel II advanced-internal-ratings basis can allocate new capital based on this actual history. Indeed it appears such patterns are already forming, with some of the most aggressive players in the current market able to price deals very low because of their Basel II modelling of their history of risk in this area.

However, for a bank to establish undisputed – and uniform – expertise across all commodity asset classes is a yet unachieved feat. It is difficult to imagine, say ABN Amro, which has been innovative in a number of areas, topping, for instance, Rabobank in its soft commodity expertise. Or vice versa.

If current trends continue, that point may well be reached by one or even more banks. Until then, it is worthwhile examining what the various banks are doing in their core strengths on a regional and product basis.

Region by region

Standard Americas has carved out a niche for itself in Latin America’s oil and gas markets by offering three product groups to companies outside the largest tier of players, says Roderick Fraser, head of energy finance – Americas, at Standard Bank Americas. These include reserve-based lending, financing around export flows and the monetisation of contracts.

“We are seeing a lot of activity in the region,” he says. “Our pipeline is pretty full now and the deals we do tend to fall into one of these three categories,” although, he adds, the bank also gets involved in M&A financing on occasion as well.

Some of the transactions – the reserve-based lending transactions for instance – are often supplemented with hedging products in order to maximise the borrowing base, he explains.

“In order to be able to lend the maximum against a particular asset, we will bring in a hedge. It is a way of putting some kind of floor on the commodity price associated with their production. This way we can get more borrowing capacity out of the asset.”

The hedge also supports the bank’s projections on the cash flows associated with future production, he says. “A hedging tool or component works well in these situations because we can establish the minimum level of cash flow that will be based on a floor or some kind of a swap that is put in place.”

Indeed, these structures have helped accelerate the use of hedges in such transactions, despite the high prices oil and gas have commanded over the past few years. “In the situation where commodity prices are high and may remain high for some time there is reluctance to hedge, because many producers still feel there is room for upside growth on prices,” Fraser says.

Also, he adds, another result of the commodity prices of the past few years has been the spinoff of several smaller companies. “Big multinationals in oil and gas tend to conduct their financial activities on a large scale – they might look to implement structures

where sales for crude go into an offshore trust and financing is issued around that trust, often in capital markets,” he says.

The smaller independent players, though, are not as cash rich and thus are looking for ways to accelerate their development. “Debt has become an interesting component of that activity.”

Standard is also seeing a surge of demand by smaller companies for export financing, the bank’s second area of concentration, he says. “These new companies are producing between 25,000 to 50,000 barrels a day, which is not insignificant. For these companies we are tailoring financing either in bank or capital markets arena around those export flows.”

The third area of focus, Fraser says, is the monetisation of contracts awarded by the largest of corporates such as the state oil companies like Pemex in Mexico and Petrobras in Brazil. “These firms have huge budgets and have pushed a lot of their operations onto the contractor universe,” Fraser explains. Typically these contracts call for a company to provide, say drilling services, or to lay a pipeline. Standard will monetise the contracts – which usually provide payment over a period of time – so the contractors receive payment upfront.

In Africa, BNP Paribas has become more active in oil and gas asset development financing in such countries as Mauritania, the Ivory Coast and Nigeria, Leenhardt reports. Not that the bank has abandoned its pre-export financing and financing of existing production activities, he adds.

But for various reasons banks in this region have had to start considering different levels of risk. The high commodity prices, Leenhardt says, mean most producers do not need as much financing as before. “So the next natural activity for banks is to lend to complete development of an asset, but this requires a much broader set of banking skills.”

Most banks are financing production that has an existing track record, he says. In a few transactions, though, BNP Paribas stepped beyond these parameters and completed a few deals where production was not complete – a greater risk on the development of oil reserves and the logistical infrastructure surrounding it.

Oil refining has also been attracting a lot of attention lately from once disinterested banks. “There is a lot of money coming from banks in financing upgrading programmes,” Leenhardt says. BNP Paribas has played major roles in Middle Eastern based projects such as in Bahrain, completing a $1bn comprehensive package early 2005 for the local refinery Bapco, which includes pre-export financing, project finance skills and a Japanese export credit tranche (see TFR, Deals of the Year, February 2005, page 36). “On a deal like Bapco, this is where we believe that our BNP Paribas ECEP business model, putting all these pieces together, brings a lot of value to our customers,” says Leenhardt.

Across country lines

Then there are those banks that specialise in certain products or structures for one asset class. Nigel Scott, global head commodity finance and hedging, works for Rabobank, one of the top global banks that specialise in structured commodity finance for soft commodities.

He runs two global units, both of which make use of derivatives but for different purposes. One unit, the structured commodity finance desk, offers such products as total return swaps, total return basis swaps, repo products and cash and carry products, that essentially monetise inventory flows for clients.

The second unit, the commodity price risk management unit, hedges commodity price risk for clients. This group might offer bespoke swaps based on the European price of fertilisers or cotton, for instance.

Structured commodity finance has exhibited good potential for growth, Scott says. Basel II, not surprisingly, has been a driver for both the bank to develop these structures and some clients to accept them.

“We originally developed them in order to maintain the competitive rates of funding we offer our clients, with the combined foresight of Bruce Tozer, the previous head of structured trade and commodity finance,” Scott says. In particular, those corporates that are smaller and are able to borrow unsecured at relatively cheap levels under Basel I may start to see much more expensive straight lending levels offered by some banks, once Basel II goes fully into effect. “The regulatory capital requirements that a bank might need to set aside in order to provide a straight loan for one of these clients could potentially require that the funding cost be substantially increased,” he explains.

This realisation set Rabobank on the path to developing new ways to monetise commodity flows for clients.

On to new markets

Prabhat Vira, head of global commodity finance at ABN Amro, says earlier this year the bank developed a new strategy that it is now implementing. “We decided to expand the geographic reach of our business through a paradigm shift in terms of the way commodity finance is being handled by most banks so far.”

In essence the bank is taking the traditional models of commodity finance – those that target the traditional producers and traders and expanding it to include solutions for corporate end users as well. “This is an area that I believe could be well served by us and we will access an expanded target market by leveraging the ABN Amro network,” he says.

Producers of, say, aluminium are targeted by normal corporate and commodity finance methodologies. But once the aluminium has been manufactured into other products – plates for an aircraft, cans for a soft drink distributor etc – it leaves the traditional realm of commodity finance. This area of the supply chain – the corporate end user – is what ABN Amro is targeting with new and innovative solutions.

Another area ABN is expanding is its market reach. Vira says the bank has appointed commodity finance ‘champions’ in 22 new markets – countries that range from Vietnam to Turkey to the United States. “These are countries where we believe we have the ability to deliver something new,” he says.