If King Midas were alive today, he would probably wish everything he touched turned to potash. With 75 million people added to the global population every year, food is a precious commodity, and the mythological monarch would understand that power resides with those that control the fertiliser.
Global capital markets certainly see the point, enthusiastically lavishing commodity producers over recent years with the funds to build global behemoths, employing millions and turning over billions of dollars annually.
Three out of the four world's biggest companies are commodity producers (the other is Apple). They are ExxonMobil of the US, with a market capitalisation of $315bn at the end of the third quarter; China's PetroChina, worth $270bn; and Brazil's Petrobras, valued at $220bn, according to the Financial Times.
With scale, however, comes enormous challenges, and for investors the numbers are dizzying. Commodity companies now resemble mini-states, their capital requirements no longer within reach of single institutions. Billions can be made, and, as shown by BP in the Gulf of Mexico this year, billions can be lost. The result for financiers is a difficult choice - commit, and shoulder the risks, or do not get involved at all.
"It is a very inconvenient question, which is made even more challenging for financial institutions because of the cyclical nature of the commodities market," says Doug Sherrod, group director of investment banking at commodities research firm CPM. "Complicating matters even further is that we are seeing new entrants through sovereign wealth funds and massive cross-fertilisation across market players, sources of production and financing."
The enormous costs of developing commodity projects and supporting industry consolidation are currently shared between a cabal of interested parties, from investment banks to hedge funds and asset managers, as well as trading firms and increasingly sovereign investment funds. All of the world's capitalists want a slice and the action is aggressive and messy.
It comes as no surprise that politicians are concerned about the dynamics of an industry that is growing exponentially and has a grip on the earth's finite resources.
A strategic decision
That concern was highlighted when the Canadian government last month threw out mining company BHP Billiton's $40m hostile bid for PotashCorp, the world's largest potash producer. The rejection will have caused consternation at the world's 10th biggest company, particularly after regulators in October shut down a deal to merge its Australian iron ore business with rival Rio Tinto.
The PotashCorp bid was rejected under the Investment Canada Act rather than anti-trust legislation, with the rationale that the takeover "would not be of net benefit" to the nation. It was only the second time in 25 years the Canadian government had used the act to shut down a deal, and the first time it had done so on the grounds of national interest.
The issue in Canada was foreign control of a strategic resource, echoing recent debates in India, the biggest importer of potash, where farmers railed against the effects of industry consolidation, and there were protests against rising food prices on the streets of Haiti, Egypt and Bangladesh.
A study of press reports around commodities shows habitual use of words such as 'oligopoly' and 'cartel', which is unsurprising given the structure of some sectors concerned. The world's eight largest potash companies, for example, control 80% of the market.
And the potash story is not unique. Across the commodity universe the story is the same, with mergers and acquisitions (M&A) fuelled by rising prices, leading to mega-companies turning over huge sums of cash and always looking for the next deal.
In the oil and gas sector, global upstream M&A transaction value hit a 10-year high last year, increasing 40% to just under $150bn, according to energy research firm IHS Herold.
The dramatic increase was propelled by multinational oil and gas corporation ExxonMobil's $41bn acquisition of US energy producing company XTO Energy and Canadian integrated energy company Suncor Energy's $21bn merger with Petro-Canada. It was also encouraged by Chinese companies that focused on the vast resources in Africa.
Trade finance rush
Alongside the need for M&A financing run the enormous operational costs of exploitation and trading. Trade finance remains a key source of capital, and the world's banks are falling over themselves to get involved.
Among deals reported in recent weeks by industry magazine Trade Finance, Russian oil producer TNK-BP signed a jumbo unsecured loan facility with a group of banks, its largest debt transaction, while Swiss energy trader Vitol agreed a $5.3bn European corporate revolving credit facility. The facility was launched at $4bn but typically was closed oversubscribed. Elsewhere, Ghana Cocoa Board raised a record sum for its annual pre-export finance, beating its initial target of $1.2bn.
A key risk management tool for banks is to syndicate across multiple lenders and it is common to see 30 or more institutions on a single deal. However, sometimes the capital need is so large that the role of the banks amounts to a moot point, for example in the recent $65bn share offering from Petrobras.
"The question is, what is the real bank role?" asks Julie Beatty, principal economist at consultant Wood Mackenzie. "Proportionally they probably have less relevance, in terms of net growth and where that growth is coming from. Companies have a lot more options than just the banks."
There is also a growing confidence in innovative solutions, such as structured finance. Brazil's Eco Securitizadora de Direitos Creditórios do Agronegócio (Ecoagro) recently placed a securitisation of agricultural receivables for soy producers, Trade Finance reported, with the promise of a further transaction denominated in dollars.
Commodities: derivatives notional outstanding for banks - 2009
Alternative solutions
As funding demands rise, some of the biggest names on Wall Street are looking outside capital solutions to get a slice of the commodity boom and have aggressively expanded into physical assets.
The leaders in the field are UBS, JPMorgan and Morgan Stanley, which have leveraged their substantial commodity derivatives businesses, now under pressure due to regulation of position limits under Dodd-Frank legislation, to buy into physical oil, gas and agri-business.
Despite selling off chunks of its commodities business, UBS's physical assets rose to $16.2bn by the end of 2009, compared with $9bn at the end of 2008, according to research firm Celent. In the same period, JPMorgan's physical holdings rose threefold to $10bn and Morgan Stanley's more than doubled to $5.3bn. Goldman Sachs has $3.7bn in physical assets.
Meanwhile, Merrill Lynch has announced plans to grow its commodities team by 25% by the end of 2012, and Société Générale said last year it will double its commodities business by the end of this year. JP Morgan has invested in storage facilities, and many large investment banks take physical gold as settlement on futures contracts.
The biggest bank in the business measured by notional outstanding of commodities derivatives is Barclays Capital, which has backed that with a decisive move into physical commodities and structured finance.
This year, Barclays created a shipping division called Pendle to support its growing physical oil trading operations, bought oil storage facilities in Cushing, Oklahoma, and in September hired seven former BP employees to join its US physical commodity sales teams.
A key growth area for the bank is providing structured finance, putting together highly complex debt and equity packages often with physical or derivative hedges running alongside.
Barclays also provides volumetric production payment loans, which are repaid in the physical, such as the deal arranged for US natural gas producer Chesapeake Energy in October, under which the bank paid $1.15bn for 11 billion cubic metres of natural gas reserves.
Still, this type of commitment to the physical market is restricted to the biggest players, says Craig Shapiro, global head of commodities distribution at Barclays Capital.
"When you are looking at physical buying of commodities over using derivatives, then it is certain you are going to see more capital out of the door," says Mr Shapiro. "We are living in very capital-constrained times, so each bank is going to take a different approach to doing these things."
Some banks, rather than building their commodities franchise, are said to be cutting team sizes, he said, as trading conditions outside precious metals become more difficult. Gas prices, for example, are at a one-year low, with futures contracts about one-third lower since the beginning of the year.
Meanwhile, all investments banks are struggling to gauge the impact of the Volcker rule on their proprietary commodity trading business, and under Basel III they face a fivefold increase on capital charges for trade finance contracts such as letters of credit.
"The increase in the capital charge for off-balance-sheet items will hit trade finance documentation and could have a severe impact for banks on the economics of doing this," says Robert Parson, a partner in the energy trading and commodities group at ReedSmith.
A new threat
As financial institutions face pressures from regulators, commodity trading companies are taking them on in their own back yards. Privately held Swiss commodity trading giant Glencore International is at the vanguard, leveraging its massive balance sheet to expand into financial services. Key to its strategy is an alliance with Credit Suisse, with which it has launched an actively traded commodity index fund and plans a physically backed exchange-traded fund.
Glencore's balance sheet shows it is well placed to compete with banks, reporting revenues of $70bn in the first half of 2010, producing a net income of $1.6bn. The company is also moving towards a public flotation, after it last year issued $2.2bn of convertible bonds.
Meanwhile, in a typical cross-asset play, it has built stakes in mining businesses, reaching a 34.4% interest in Swiss-based Xstrata at the end of the first half.
"In the project finance space it is true that banks are facing new competitors and new sources of capital," says Conor McCoole, head of project and export finance for Asia at Standard Chartered. "A lot of trading companies are cash rich and providing small mining projects with debt financing coupled with physical off-take. Still, senior debt is not their core business so expect them to recycle their capital as soon as possible."
Glencore is not alone in its effort to build capital and cross-fertilise. Trafigura, the second-largest independent trader in non-ferrous concentrates, owns fund manager Galena Asset Management, while the world's largest trader, Vitol, provides commodity finance, and sparked a regulator investigation in 2008 when it amassed 11% of oil contracts on the New York Mercantile Exchange.
Amsterdam-based Gunvor, the world's third largest crude oil trader, bought a Russian oil export terminal in 2009 and began executing trades in the energy markets. Meanwhile, US agribusiness giant Cargill, the largest privately held US company, holds a 64% share in Mosaic, a leading producer of phosphates and potash.
Commodities: average value at risk for leading banks - 2009
Government role
Watching carefully are global governments, concerned that the needs of the public are not undermined by the excesses of international business.
The solution for some has been to take a stake, leveraging the power of sovereign wealth funds, which held some $3800bn of assets under management at the end of 2009, according to International Financial Services London.
The funds are also tapping capital markets. China Mining United Fund, which owns shares in Brazil Potash, plans to raise 3 to 5 billion yuan, Bloomberg reported in August, to invest in gold, iron ore and metals projects.
"We are investing in whatever China is short of - potash, cobalt, uranium, chromium, copper, gold, silver, oil, coking coal and iron ore," the fund said in a statement.
Chinese companies, including the nation's sovereign wealth fund, spent more than $30bn last year buying assets in Nigeria, Australia and Canada, according to Bloomberg. China's sovereign wealth fund, China Investment Corp, has $300bn under management. Underscoring the consolidation trend, it emerged in recent weeks that Louis Dreyfus, the privately held French group, whose commodities arm generates some $35bn in revenue, is in merger talks with Olam International, 13% owned by Singaporean sovereign wealth fund Temasek.
The discussions reflect a trend for commodities firms and their sponsors to develop an industrial model, spanning every step in the production process from financing to mining, processing and distribution.
"In the absence of multi-lateral regulatory policy, firms are moving as quickly and as far as they can - pushing that power," says Wood Mackenzie's Beatty. "Until regulation has teeth they are going to play that to their advantage."
