The competitive landscape has been redrawn by the crisis, with collapsed firms being snapped up and others retrenching. Commercial banks are taking a larger piece of the pie, writes Suzanne Miller.

Over the past year, commercial banks have been ramping up their commodities desks as profits have poured in. Sceptics say they have seen this all before in prior times of plenty, and are wondering how long the banks will stick around this time when the going gets tough again.

"A number of commercial banks have a love-hate relationship with this sector because they've viewed commodities as a non-core business, so many have lacked a consistent strategy," says one industry veteran. "When times are tough, banks tend to get out of these non-core businesses."

In fact, there are signs that investor ardour for commodities may be cooling - if only for the moment. During the first quarter of 2009, investors poured $22bn into the sector, but invested only about half of this -$12bn - in the third quarter, according to Barclays Capital. Investors are chewing over a number of concerns, not least implications of stricter regulatory rules by the Commodity Trading Futures Commission (CFTC), which may impose tough position limits on futures holdings to clamp down on speculative price traders.

And returns for some baskets of commodities - rather than sharply outperforming equities, have fallen short of that; the Dow Jones-UBS Commodity Index has gained 17.12% year-to-date through October, roughly equal to the 17.5% gain by the S&P 500 stock index.

But if investors are worried, commercial banks have hardly had time to notice. Even as unemployment in the US hit double digits and capital-starved financial institutions slash costs and headcount, these same banks have been pouring resources into their commodities business - hiring across the board, from agriculture to base metals to physical trading and in any sector that could grow.

"In these past 12 months, I've never seen the rapidity in which large institutions such as pension funds have come into the market and the amount they are putting to work in portfolios," says Martin Woodhams, head of commodity structuring at Barclays Capital. "And our analysis says that the money coming in doesn't lead or second-guess the market. It's coming in for the benefit of gaining diversification."

Commodities as an asset class have come of age - commodity-backed notes, indices, inflation hedging, direct investments and derivatives trading - as the sector has proved it can survive boom and bust cycles and still attract new money. Bankers say a new generation of investors is emerging, hungry for the kind of portfolio diversification, inflation hedging and other risk management tools that commodities make possible - from large pension funds to wealthy individuals.

Expansion plans

Almost everyone is hiring: Bank of America Merrill Lynch plans to expand its commodities team by 25% over the next two to three years; Barclays plans to increase its commodities staff by 30% to 320 by the end of the fiscal year; Credit Suisse plans to add another 100 within the next two years; Société Générale plans to ramp up its commodities team by 35% and to double the size of its business; and Citigroup plans to add 30 professionals, bringing its global commodities team to 220. Most banks don't break out their commodities earnings, but some analysts estimate that the most successful - Morgan Stanley and Goldman Sachs - may have made between $2bn and $3bn in commodities-related revenue last year.

"The commodities market will need a huge amount of investment over the next several years," says Edouard Neviaski, global head of commodities at Société Générale. "We're talking about trillions of dollars that will need to be invested in infrastructure, cleaner energy and grains to support a rising demand for meat in developing economies such as India and China, where the middle class is growing. And most of this will be privately funded."

Morgan and Goldman

The number of competitors has fallen somewhat over the past year - with Merrill Lynch gone to Bank of America, US Lehman Brothers to Barclays and JPMorgan snapping up Bear Stearns. Those left standing are bruising for a fight over market share. Some commercial banks are already at the heels of Morgan Stanley and Goldman Sachs.

"The energy market has traditionally been an oligarchy with Morgan and Goldman at the top. That is clearly changing," says Andrew Awad, a consultant with Greenwich Associates. "Commercial banks are investing more and seeing the contribution to earnings in commodities grow significantly. There's still room to grow - and there's still room to take market share."

Earlier this year, Mr Awad and his team published a ranking of commercial and investment banks based on interviews with hundreds of corporate energy commodities users and found that commercial banks were gaining on long-time incumbents. Goldman Sachs and Morgan Stanley commanded 48% and 43%, respectively, of market penetration for global commodities over-the-counter (OTC) derivatives, while JPMorgan and Barclays had 34% and 31%, respectively. Mr Awad said banks are making good use of their credit relationships as an introduction to commodities business in a capital-starved market - something that Morgan and Goldman cannot do in the same way.

Barclays has perhaps grown the most aggressively. Over the past year, Barclays has taken the commodity trading businesses of Lehman, as well as UBS's operations in base metals, oil and US power and gas - giving it considerable new muscle.

Joe Gold, Barclays' global co-head of commodities, relishes the change in fortune. "Eight years ago, we were an also-ran. Today, we are in the top tier of the industry. We built our business by focusing on what was being underserved in the market and our growth has been client-driven ever since." And of course, the recent acquisitions haven't hurt.

Similarly, Bank of America's purchase of Merrill Lynch last year has given the combined group an important edge as it builds out the platform. "There's a lot of opportunity as we continue to leverage our equities distribution and lending platforms, with a goal to link our overall client-facing business in sales and origination," says Rob Jones, global co-head of commodities at Bank of America Merrill Lynch.

Citigroup, a relative newcomer to the business in the past four or so years, says it has an advantage through its considerable emerging markets franchise, where much of the industry's growth potential is focused. "One of the things that differentiates Citi from our competition is our presence in the emerging markets," says Citi's deputy co-head of global commodities, Stuart Staley. "Economic growth in many of these countries tends to revolve around commodities, whether it's producing raw materials or importing them to manufacture finished goods."

Energy markets

Morgan Stanley, meanwhile, is tapping into opportunities as well. Its co-head of global commodities, Simon Greenshields, says markets have started to develop in new ways over the past three to four years. For example, carbon, coal, liquified natural gas and dry and wet freight are all expanding geographically, and power markets are beginning to develop more liquidity. "We've seen this in western Europe and more recently it has spread to eastern Europe," he says. "We're following that trend, as well as the movement towards green energy and growing demand for biofuels." Three or four years ago, he adds, it was "barely on the radar screen". He says Morgan has "benefitted in part because it has been one of the largest importers of ethanol into the US to supply our system needs".

Morgan Stanley and Goldman Sach's ownership of operating assets in this industry gives them a distinct advantage because it is something that bank holding companies cannot do. For example, Morgan Stanley owns TransMontaigne, which has assets that include a pipeline system, tanks and barges for moving refined oil products around the US. The bank also has a big stake in Heidmar, an international tanker company - and owns six power plants in the US and Europe.

Other banks are also looking at the physical market as an important area of growth. Among the advantages, banks can use their physical trading capabilities to hedge risks in the futures markets with underlying commodities and to use first-hand information on commodity flows. Even as banks count up the advantages, they are keeping an eye on what regulators will do. More recently, JPMorgan acquired a set of power plants with its purchase of Bear Stearns last year. The Federal Reserve gave a temporary blessing to the ownership of the plants, for two years, with the possibility of three one-year extensions.

The physical side

Bank holding companies are restricted from owning operating assets and those that have a physical business must demonstrate that it complements their futures business. US banks are not allowed to engage in physical non-metals, even though banks outside the US can. The reserve has granted exceptions before, for instance it let Citigroup keep Phibro - the first US commercial bank to test the grey zone in what is permissible for owning a commodities trading firm - and it more recently stretched the rules for JPMorgan.

But Doug Landy, a banking partner and head of US bank regulatory practice at the New York law firm Allen & Overy, cautions that there may be bigger question marks hanging over Morgan Stanley and Goldman Sachs than was the case with Citi, now that they are bank holding companies.

"What Goldman and Morgan do is more central than what Phibro did for Citi. For instance, Morgan also makes investments in electric plants - something the [Federal] Reserve traditionally wouldn't be comfortable with," he says. However, Mr Landy also acknowledges that the Federal Reserve may be open to reason given how long it has been in this part of the business. "My view is that I do not think much will ultimately change in terms of their business line," says Mr Landy.

The bigger risk he sees ahead is the Federal Reserve's view on consolidated risk - whether the banks have enough capital not just in their trading arm, but in all other related parts of the business. "What's the risk and how do [the banks] add it up?" asks Mr Landy. It could be a potential problem if regulators determine that capital for trading books is too low and needs to go up and that risk is not being properly measured. "It has been a big education where these two banks have been explaining their business to the regulators, and how it works."

The physical business may have other limits too. For one thing, it tends to be a resource-intensive business. That means it can be problematic to own and transport large quantities of commodities such as grain, which is prone to rotting, and certain metals such as steel, which can erode - not to mention the tremendous storage facilities that are required to house goods other than precious metals. Kamal Naqvi, head of global commodity investor sales at Credit Suisse, says the bank's alliance with Swiss commodities trader Glencore gets around this kind of problem. "From our perspective, we get the information advantages of being in the physical market without any of the logistical difficulties," he says.

Proprietary trading

Some bankers also say that there are some question marks over the future of banks' proprietary trading, given that it is a capital-intensive business which thrives on risk-taking and huge pay packages for top traders. Some banks, such as JPMorgan, have already cut back, while Citi decided to sell Phibro. Banks are also capital-constrained, and if the CFTC imposes restrictions on trade positions, this could be problematic for proprietary desks which straddle their interests and those of their clients.

"Proprietary trading is going to become more difficult for banks," says one executive in the business. "Does it ultimately make more sense to use your position for a prop trade or do you reduce your client-facing business?"

The answers to such questions may be slow in coming. In the meantime, others say they will get on with business, which ever way the wind blows. "Against the backdrop of regulatory change, we're trying to stay nimble and take a proactive stance," says Citi's Mr Staley. "Our business is about managing risks and solving problems for our clients."

The faster banks can pull this off, the faster they may win more market share.

And that would be worth its weight in gold.

Greenwich share leaders 2009 - Commodities OTC derivatives / Share of relationships

Greenwich share leaders 2009 - Commodities OTC derivatives / Share of relationships

Greenwich quality leaders 2009 - Commodities OTC derivatives

Greenwich quality leaders 2009 - Commodities OTC derivatives

Methodology

Greenwich Associates conducted 362 interviews with corporate commodities users between September 2008 and March 2009. Interview topics included dealer use, product use, accounting treatment, sales coverage preference and strategic transactions.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter