The boom in commodities over the past two years has drained equity from manufacturers and processors in developed markets and placed it in the hands of their emerging market suppliers. Kris Van Broekhoven, director of structured commodity trade finance at Deutsche Bank in London, explains how this is turning trade and commodity finance on its head.

While the commodities price boom has left many producers cash-rich – undermining demand for traditional trade finance in emerging markets – trade financiers are filling the overhanging capacity with new instruments aimed at cash-constrained developed market processors.

Certainly, a major shift is starting to occur in the dynamics of banking for the leading commodity trade financiers operating in emerging markets. The traditional route – based on funding emerging market producers by removing the payment risk offshore – is becoming less relevant in an environment where high prices have rendered the producers cash-rich while leaving the OECD-based processors cash constrained and therefore less creditworthy.

Also, traditional trade finance had the two-fold effect of guaranteeing supply for the buyer, while strengthening trading relationships with emerging market suppliers – both of which are undermined by a high-price environment that transfers power from the purchaser to the producer.

Commodity trading environment changes

The result of these changing dynamics has been a fall in emerging market trade finance mandates as producers have adequate cash to cover production costs well into the future. Of course, the dearth of mandates has been felt hardest by participant banks that do not focus on primary origination of transactions.

However, even banks that pitch at the mandated lead arranger level have been finding the environment more and more difficult as cash-rich commodity producers have switched off or downsized their bank-funding requirements.

The upside to this is that the commodity producers themselves are enjoying some of the most benign credit conditions in their history. Producers are benefiting from the lack of correlation between their cost of production and the market-driven price of their produce. Indeed, margins reached an all time high for commodity producers this year – with gold, oil and copper repeatedly breaking records. And while most commodities have come off from their record highs, long-term prices remain historically high (see LME copper price chart).

Yet for the manufacturers and processors in the importer markets the scenario is not so sweet. While emerging market commodity producers have struggled to accommodate the influx of funds, OECD buyers have struggled to cope with the strain that spiralling input costs are having on their working capital requirements. For instance the price of copper cathodes appreciated from below $2,000 per tonne in 2003 to more than $8,000 per tonne in mid-2006, eroding the working capital of the processors and boosting profit margins for the producers.

Perhaps inevitably, as these asymmetric fund-flows developed between emerging market suppliers and developed market buyers, downstream integration in the value chain by the producers became obvious. Kazakhstan’s copper producer Kazakhmys bought Mansfelder Kupfer & Messing of Germany in December 2004 – a trend strengthened by other notable acquisitions that have been concluded over the past 18 months. These include Russian steel company Severstal’s purchase of the Italian manufacturer Lucchini and Evraz group’s purchase of Italian steel plant Palini e Bertoli.

Bankers need to be nimble

Of course, nimble bankers can step in to this situation and tailor solutions that acknowledge the new environment. Firstly, to the processors – as trade finance mandates from producers have waned, so the working capital needs of the processors have increased.

Interestingly, many of these working-capital deals to developed market processors have been structured by the leading trade finance banks. Indeed, by combining a developed market subsidiary with a less than stellar credit history and a below investment grade emerging market producer, structured trade finance teams have created a new generation of high-yield instruments.

The result has been a series of ‘borrowing base financings’ (BBFs). A BBF is a loan that links the credit facility to the market value of inventory and receivables in each target company. The value of inventory and receivables is closely monitored by the bank and priced at their current mark-to-market value. Therefore, as the value of inventory and receivables decrease, the credit facility will decrease (and vice versa, of course) – ensuring that the customer links the level of debt to the value of collateral.

Previously, such deals would have likely been structured on a bi-lateral basis. However, many trade finance banks that traditionally focused on performance risk-based structures are showing a growing appetite for BBF structures – with appetite increasing to the point where syndication is now the rule rather than the exception.

Indeed, a number of syndications are being put together that explicitly give major processors breathing space in the heat of the commodities bull run. This is manifested in bigger deal sizes. And, going forward, the market is more likely to see deals like the recent German-based KME’s €850m ($1.07bn) borrowing base financing.

Furthermore, the beauty of this instrument is that the deals are classed as collateralised performance risk deals in developed markets. And by offering a product so closely aligned with performance risk, it will attract demand from many tier-two trade finance banks that are struggling to find suitable assets to fill their trade finance lines.

Moreover, the product boosts risk-adjusted return on capital and is particularly attractive for banks that are prepared or preparing for Basel II. Certainly, the structure wins favourable treatment under Basel II.

Deutsche Bank has witnessed a growing appetite for these deals over the past two years both in the size of originated deals and the re-structuring terms of current deals. For instance, the Duferco deal in Belgium originally closed by Deutsche Bank in December 2004 with a revolving facility of €80m has been re-negotiated twice – once in 2005 (extended for a tenor of three years) and then again in May 2006, when it was increased to €150m. And it has come as no surprise that every time the deal has been re-negotiated the original lenders stayed committed to it and even increased their participations.

RBL financing also on the increase

But what of emerging market clients? While generating an asset base of high-yield instruments from the developed market may be an interesting diversification for trade finance banks, they also need to focus on utilising their asset-based lending capacity to emerging market borrowers. And because of the dip in demand for traditional trade finance, banks are searching for new ways to use up this capacity. This coincides with emerging market producers looking for funding for widespread exploration programmes. Consequently, this has led to a resurgence in reserve-based lending (RBL).

RBL offers the borrower a facility whereby credit is made available based on expected production capacity. For instance, with an oil company it may hinge on expected extraction based on proven reserves, versus realised extraction levels. However, the technique is robust enough – and the offer of RBL financing is now strong enough – for many banks to begin moving down the credit league table at second and even third-tier emerging market producers, and to products beyond oil.

A further offshoot of the commodity boom is that emerging market commodity producers are quickly being turned into domestic buyout houses. The level of equity being dumped on producers’ balance sheets is turning previously hand-to-mouth operations into aggressive suitors for smaller companies in their market.

This is driving acquisition finance deals within the emerging markets. Indeed, banks have started to structure deals to accommodate an aggressive acquisitions programme, using trade finance type collateral to support the security structures. For the producer’s part, this may involve maintaining an adequate balance of unencumbered reserves as a collateral base for future acquisitions.

Naturally, this will provide the necessary security for an aggressive acquisitions programme that involves the purchase of weaker balance sheets. And, of course, in the longer term this may encourage banks to restructure in such a way that trade finance becomes an origination machine for lucrative acquisitions programmes.