Driving a soft bargain

Softs are among the few commodities left where banks can make a profit. Not surprisingly, many are making moves to enter this once clubby world. Amanda Greene reports.

When banks began to offer new or expanded commodity-finance services a few years back in order to ride rising commodity price trends, soft commodities were the last asset class on their list. Traditionally, softs have been viewed as more difficult and riskier because of crop and weather risk. Then there is the perception – fair or not – that more fraud and corruption accompanies a sugar deal than a metals deal. The complex subsidy regime of many agricultural crops in most world markets clinches the matter in most bankers’ minds: softs are not for the faint hearted and certainly not for an institution interested in making a quick profit.

But that was then. First, it became increasingly difficult to make a profit in oil. Banks then moved on to metals. But now these deals are much harder to close at healthy margins too. So guess which asset class is now in favour?

“In the past two years, the exponential growth in soft commodity prices and the consequent improvement in the credit profile of softs producers has increased their ‘respectability’ among bankers,” says John MacNamara, head of structured commodity finance at Deutsche Bank.

“Banks that turned to commodity finance over the past 18 months quickly realised oil and metals are not as lucrative as they once were. That’s because these companies are sitting on a huge war chest of cash. Banks, therefore, have had to go down the food chain, so to speak. Soft commodities are one of the few places where they can still make decent money,” he adds.

Expanding presence

The upshot is more banks are either entering this area for the first time, or expanding their presence in active soft commodity markets. They are competing directly with soft commodity specialists, such as Rabobank and Fortis.

Brazil is one country in which most banks eager to exploit soft commodity markets are increasing their presence. HSH Nordbank, for example, is deepening its presence in Brazil, according to David Lopez Menendez, senior vice president and head of commodity finance at the bank’s New York office.

Meanwhile, ABN Amro has just established a futures sugar desk in Brazil, concentrating initially on sugar suppliers. “In general we are going into more markets where we haven’t been before,” says Vandita Pant, executive director, head – commodity finance advisory for ABN in London. For instance, she says, the bank wants to leverage its network in markets such as Indonesia and Vietnam.

She estimates that 30% to 40% of its commodity deals are in the softs category. “It is one of the few areas where profits can be found. Most banks see increasing activity in this space as a given.”

Moving out

Besides new geographic markets, banks are also moving into new sub-sectors in softs. ING, for instance, has closed enviable fertiliser transactions in Russia [see TFR, ‘Deals of the Year’, February 2006, page 26] and hopes to build on this success in other markets as well.

ABN, as another example, would like to target palm oil and coconut oil in Southeast Asia, Pant says.

“Also, intra-region trade flows are important – going forward that is something we are looking to do more and more,” she adds.

In addition, ABN is looking at soft commodity finance deals structured on Islamic finance tenants, she adds. “This is an area we feel will increasingly be another distribution channel for commodity finance.”

Indeed, soft commodities are becoming 'fashionable' again among traders and bankers thanks to new consumers in the Middle East and Far East, according to Bernhard Lippuner, head of commodity and structured trade finance at Credit Suisse. He adds that Credit Suisse is very active in Southeast Asia. "China is a big importer of soft commodities," he says.

"We don't take positions but we support our soft commodity trading customers by giving them credit facilities." It is very active in pre-export finance for sugar in Brazil, for instance.

Other drivers

But there are other drivers behind the growth of soft commodity finance – factors that will support this asset class long after the run-up in commodity prices stabilise.

Increasingly, soft commodity products are serving as replacements for hard commodities, says MacNamara. “There has been exponential growth in ethanol and bio diesel fuel, which are oil substitutes.”

Ethanol in particular – with oil at $60 per barrel – looks quite good, especially when also viewed as a cleaner and renewable energy source. “There’s a lot of government and multilateral support for developing ethanol plants,” he says.

Consolidation among the major soft commodity players is also driving change.

There is little diversity any more in the soft commodity industry, says Lippuner, who used to work as a soft commodity trader before he joined the bank.

"When I joined the bank in the early 1990s there were a number of diverse players in the space, from large companies to many niche players. Many of these firms have disappeared and in many cases the large players have taken over the role of the niche companies."

The result of this consolidation, Pant says, is that “companies are vertically integrating and as a result the supply chain is extending out on both sides”. Banks are responding, she says, by bundling components of commodity finance and components of receivables finance into one solution. “Before, the standard practice was to pitch these solutions separately.”

ABN has structured such deals for sugar producers a few times, she says. The monetisation of commodities through ownership structures is increasingly used for softs. ABN has executed innovative structures supporting the export of orange concentrate out of Brazil. Currently the bank is closing a transaction in the sugar sector as well.

This bundled approach has increased the bank’s exposure to the soft commodity asset class, she says. “Increasingly, we are looking at it not on a product-by-product placement for a particular client, but as the sector as a whole, making sure we are optimising our relationship with a trader by offering financing through the chain.”

But it is the comparatively lower costs that, at bottom, are the key driver for banks wanting a piece of this market. Even if commodity prices were to radically readjust, the lower ratios of softs would still exist.

"The amount of credit facilities that you have to allocate to soft commodity traders is much smaller than the facilities provided to energy or metals traders,” Lippuner says. “A full cargo of grains may go up to $10m. A full cargo of crude is between $70m and $150m. If you concentrate only on soft commodities you can work from a smaller balance sheet,” he adds.

Challenges remain

The risks inherent to soft commodity finance that initially kept some banks from entering this space still exist, though. Overproduction, for instance, is a trait specific to softs, Lippuner says, and it is directly associated with government subsidies. "This obviously makes free trading more difficult than it is in metal or energy products, for instance."

Pant says that overall the soft market is more challenging than other commodity asset classes, such as metals. “Softs can be more difficult to sell to credit committees in addition to mitigation of risk. So it’s not that easy offering financing in the soft category. You need to have very detailed knowledge of the industry as well as local regulations, the influence of subsidies on pricing and demand mechanisms,” she says.

“There is more inherent risk, which is why ABN is quite selective in the deals we choose. We’re currently active in sugar, tobacco, grains and orange juice.”

Hedging strategies mitigate some risks

Soft commodity producers, for their part, have their own set of risks to manage. Like their oil and metals counterparts, they are taking advantage of derivatives technology to mitigate price fluctuations – perhaps their largest concern after crop risk.

“We are seeing a lot of innovation around the mechanism of embedding hedging into our financial structures,” Pant says. “We are looking at how to support the suppliers of our clients on hedging – this is increasingly important to offtakers because they are looking to lock in sustainable supplies in addition to wanting preferential treatment.”

Costless collar has become a popular structure in many commodity asset classes, including soft products. These solutions are fixed with a floor but still deliver upside to the client. Other structures are fixed to price, where the take-out is linked to a defined contract, she says. “And there are many structures around OTCs [over the counter] as well as future contracts. Our idea has been to offer holistic solutions to our clients that combine traditional financing [pre-export or otherwise] with hedging facilities.”