Eurozone troubles bring commodities market squeeze

Over the past year, something rather sinister has been happening: US investors have been reducing their exposure to the eurozone. Apparent across most types of investment institution, the trend is particularly marked in the money market fund community. In November 2010, eurozone assets accounted for almost a third of money market funds’ total holdings.

By October 2011, the percentage had fallen to just under 19%. Most of the decline took place between May and September, as the escalating crisis in the eurozone steadily reduced the appeal of assets from the region. In September alone, money market funds reduced their exposure to eurozone debt by $54bn, a good chunk of which included European financial institutions.

For European banks, the timing was unhelpful. Already under pressure from the eurozone crisis, they were suddenly confronted with a situation that made wholesale dollar funding more expensive and less accessible. And, as their ability to access dollars became more difficult, their ability to lend dollars became commensurately harder.

Dollar dominated market

“It boils down to a question of the haves and the have-nots. Some banks have dollars and some do not and most Europeans do not, or at least they have less than they used to,” says Andy Gooch, head of commodity sales and brokerage at Natixis.

Commodities – from coffee to copper – are traded in dollars so every participant in these markets uses the dollar as a base currency. Producers, processors, manufacturers and consumers all fund themselves with dollars and so do commodity trading houses, the firms that stand between producer and consumer, helping to finance the movement of raw materials around the world.

Trade finance is big business. Last year, the amount of money raised to finance global trade amounted to more than $150bn. For reasons of history and culture, most of the major players in this market are European banks, with the French banks, such as BNP Paribas, Crédit Agricole, Natixis and Société Générale particularly influential.

But when their ability to access dollars diminishes, providing liquidity to commodity traders is no longer as straightforward as it was. And it is a sensitive subject: few banks want to admit they are withdrawing financing from clients. “It is pretty obvious that, particularly in Europe, a number of banks are having to cut back on the lines extended to commodity traders, and in some cases finance has been withdrawn altogether,” says the head of metals trading at one prominent European bank.

Changing trends

The figures tell a compelling story. In the third quarter of 2010, $56.8bn was raised in trade finance. A year later, the figure was nearly 30% lower at $40.4bn. Some of this decline reflects a softening of demand, brought on by global economic instability. But changing trends in the trade finance arena play a pivotal role as well.

“During September in particular, an atmosphere akin to panic pervaded the markets. European banks started not rolling over loans and trading firms were selling rather than buying. In other words, they were de-stocking hard,” says Julien Garran, commodities analyst at UBS.

Commodity prices fell sharply in response. Copper, for example, moved from more than $900 a ton at the beginning of September to less than $700 a month later. In October, commodity players received some respite, when EU leaders agreed a bail-out package for Greece and appeared to avert total disaster in the eurozone. Raw material prices clawed back some, though not all, their losses and a measure of calm returned to the trade finance market. The underlying trends remain, however. “European banks are continuing to exit the business or reduce exposure to it. They are managing it in a more orderly fashion but over the next few months, it is likely that we will see a gradual diminution of lending to commodity trading houses,” says Mr Garran.

While some of the reduction in liquidity can be attributed to US investors’ disillusion with Europe, other factors clearly play a part as well. Regulators are imposing tougher capital ratios on banks in the wake of the financial crisis, Basel III is changing the way capital is allocated and economic uncertainty is breeding an aversion to risk.

The commodities risk

“Banks are backing away from riskier business and that includes financing commodities trading houses. Commodity prices are high and volatile so the risks associated with financing them have increased. On top of that, the regulatory environment remains unclear so banks are not sure how commodities-related lending will be accounted for. This has been an ongoing trend since the financial crisis but the eurozone crisis has made matters worse,” says Jeffrey Christian, managing director of commodities consultancy CPM Group

Privately, European banks admit they have been hit hard by the changing environment. As one senior commodities financier at a major French bank explains: “Our balance sheets are constrained. We are trying to boost regulatory capital ratios and Europe has been fairly closed to dollar funding for a while. It is difficult for us to raise dollars so we don’t have a lot of available resources for commodities trading clients.”

Commodities trading is a disparate industry. At the top of the tree are major players, such as Glencore, Vitol, Cargill or ED&F Man. Huge businesses, they source funds from tens, even hundreds of banks. At the other end of the scale, however, are numerous smaller businesses, many of whom have banking arrangements with just one or two lenders. “Big, well-established companies with multiple banking relationships are able to tap liquidity from many sources and move forward. Smaller companies with one or two lines are more worried and are actively looking for extra lines,” says Harris Antoniou, CEO of energy, commodities and transportation at ABN Amro.

The mechanics of commodities trading make the industry particularly sensitive to changes in the funding environment. Producers sell commodities to traders but if traders do not have the funds, they may not be able to buy or they may need to renegotiate the terms at which they buy. If the raw materials are not being shipped or the price of shipment is increasing, that will affect the consumer market, too. Manufacturers will buy less, their profit margins will suffer or they will need to raise the price of their end product.

Building relationships

The nature of trade finance exacerbates the situation. Most traders rely on letters of credit from their banks or relatively short-term revolving credit facilities. Long-dated deals are a rarity so trading houses need to know that they have ready access to capital. Such certainty is decidedly lacking at the moment and the position is made more acute because most trading houses are private entities. Swiss-based Glencore floated on the London Stock Exchange earlier this year, giving it access to equity capital but it is a rarity in the commodities trading environment.

“Many traders are privately owned and they tend to want to deal with as few banks as possible because they don’t want information about their activities to be widely disseminated,” says Mr Christian. The larger houses have developed deep relationships with their banks over the years, particularly the major French banks. Market participants suggest these links are likely to persist but others may be more vulnerable.

“What do you do when your liquidity is squeezed? You hang on to your key clients. That is what banks did in 2008 and that is what they will almost certainly do today,” says one senior banker. However, that does not help the legions of smaller trading firms.

“The CFOs of smaller trading houses are worried. They are concerned about the impact of the current eurozone situation on their European banking partners. Over the next year or so, their facilities will need replacing and they will either be more expensive or they will not exist,” says Rodney Malcolm, global head of commodities capital markets at Citi.

Changing landscape

Banks with more capital at their disposal are viewing the parlous eurozone situation as an opportunity. Having been unable to penetrate the commodities trading world for many years, they are now keen to gain access to a new source of business.

“European banks are pulling back and we will likely find out the full extent of that over the coming year. In the meantime, a number of folks, knowing the situation, are positioning themselves to take advantage of this new opportunity. In the past, it was very difficult to secure business in this sector but over the past few months, clients are reprioritising and signalling they are willing to sit down and talk. They are preparing themselves and trying to ensure they have sufficient flexibility to operate,” says Mr Malcolm.

Even the French houses admit new entrants are likely to step into the market. “European banks will almost certainly remain the dominant force in commodities trading. We have built up a lot of expertise in this area and it will probably stay that way but other banks are likely to come in, particularly Asian banks – they have a strong trading culture and they are used to shipping markets,” says one senior French banker.

The changing landscape is reflected in the pace and make-up of syndicated revolving credit facilities (RCFs). “Syndicated deals are taking longer and are less successful – and some banks are opting out of renewing facilities when they come up. In the past, too, European banks used to keep most RCFs on their own books. Now US banks, which used to have little or no role in this market, are creeping in,” says Mr Antoniou.

Clear evidence of this change can be seen from the rankings of trade finance loans for the first nine months of this year. Compiled by Dealogic, the rankings show BNP Paribas, Crédit Agricole and Société Générale are still in the top five but Citi is rising up the rankings, as are China Development Bank and Sumitomo Mitsui Financial Group.

Seeking consolidation

The pervasive picture is of instability, highly unsettling for all participants in the market. Even as certain traders explore new avenues of credit, others are said to be pursuing more radical solutions. A number of smaller and mid-sized players have been restructuring their businesses, some are putting themselves quietly up for sale and some are considering mergers.

“We will certainly see consolidation in this sector. There are lots of rumours about mergers, and trading firms are considering other options, too, such as opening up their equity base to outside shareholders or merging with shipping companies, for example,” says Mr Antoniou.

Some of those most closely involved with the trade finance market believe the liquidity squeeze affecting European banks will change the scope and structure of financing arrangements. Many trading houses have expanded into other areas along the supply chain, acquiring mines, farmland, crushing mills and other assets. Along the way, they have also been providing finance to producers and consumers, extending them credit for weeks and even months because the capital was available to them and it was an extra source of profit. Now, however, a retrenchment is expected.

“Global trade is primarily based on letters of credit but over the years, banks have become involved in paying for goods as well. Trading firms have been providing finance for producers and consumers. Now producers and consumers are more likely to be funded by their local banks and trade finance will revert to what it used to be,” says one commodities financier. “European banks are not best placed to fund working capital. But they are well placed to offer advice and to structure international trade transactions,” he adds.

Paying a higher price

The impact of all this change on the broader economy remains open to question. Even if new players come into the market, the price at which finance is provided will doubtless be higher than it was in the halcyon pre-crisis days. Liquidity is at a premium and trading firms, like almost every other business, will have to pay more to secure it. Some commodity watchers believe that, as the cost of transporting raw becomes more expensive, commodity prices will rise, ultimately affecting the end consumer. Others suggest that, if financing is too costly, trade will slow down, producers will be unable to shift their goods and prices will fall.

The true effect is likely to become clearer over the next 12 months. In the meantime, however, commodities markets are expected to remain unstable and unpredictable. “Times are extremely uncertain,” says Michael Overlander, chief executive of broking firm Sucden Financial. “Uncertainty is a contributory factor to volatility and we certainly have a lot of uncertainty around at the moment. “