Commodities are big news. Food prices have spiked by more than 60% in the past 18 months causing food riots in more than 30 countries, while crude oil prices have risen by 697% (at the last count) since 2001.
For banks with big commodities trading desks, this means good business; trading in US gas derivatives, for example, has more than doubled in the past year. Revenues are not broken out but analysts estimate that at the two biggest houses, Goldman Sachs and Morgan Stanley, commodities trading accounts for up to 10% of total revenues.
This potential has not been lost on competitors; and nowhere more so than in oil and power. While most banks may have dipped in and out of the oil and energy business in line with economic cycles since the oil crisis of the mid-1970s, since 2004 they have been aggressively building out in an attempt to catch up with the two Wall Street titans.
By the beginning of 2008, for example, Merrill Lynch, Citigroup, Fortis and Bear Stearns, had ramped up power and gas trading teams in Houston to about 200; Deutsche Bank’s had grown to 150 in a little less than a year.
But is the gold rush over for many new entrants? High prices also mean high running costs, and the credit crunch means capital is scarce: banks may want to build out their platforms, but many no longer have the capital to do so.
At the same time, the new power of commodity trading houses and industrial players means they can compete with banks to attract the most talented players. Even worse, they have developed such sophisticated in-house capabilities that they are often able to do for themselves the kind of structuring and complex risk management that the banks have long provided.
End of easy gains
Many believe that the cumulative effects of recent events will put an end to ambitious expansion plans. “New entrants have had a good run in the past couple of years because the market was conducive to growth. They got a big bang for their buck,” says Göran Trapp, head of commodities at Morgan Stanley. “In fact, it was harder for mature, incumbent players to generate those same kind of returns at the margin. But the credit crunch has put an end to any easy gains.”
And as the credit crunch continues to bite and there is less capital to go round, it will curtail the amount of business banks are able to do. In trading terms, the same transaction now ties up almost three times as much capital as it did just six months ago because of the huge rise in margin calls – the escrow deposit that clearing houses hold until a trade is settled. The margin on a single Brent Crude Oil futures contract (of 1000 barrels) required by ICE Futures in London was $5500 in January this year; by July 10, the margin required had risen to $13,500.
“To trade the same kind of volumes you need two or three times the amount of capital, so the cost has gone up at the same time as capital has become more constrained,” says Mr Trapp. “Some of the smaller country or regional specialists may even be squeezed out. It may be the best possible time to be in commodities but it is the worst possible time to need funding.”
Banks retrenching
Many banks are already reallocating scarce capital and resources to areas where they feel it will achieve the best returns. In January, Bank of America became one of the first casualties of the squeeze when it shut its commodities and energy trading desk in London; it says that it will focus on clients in the US. In the same month, UBS exited some European power and gas markets less than a year after it entered them.
Big trade finance houses also seem to be retrenching or consolidating. In June, BNP Paribas, a major oil trade financier in Asia, closed its Asian oil derivatives desk in Singapore having only launched the business about three years ago. Also in June, Fortis, announced that it had relocated to Houston the traders it hired last year to set up a trading business in Singapore – before the new desk was even up and running.
The credit crisis could not have come at a worse time for the many banks planning to expand their business beyond commodity derivatives into physical trading. It would be particularly bad news if there was a regulatory backlash against commodity derivatives trading – in which case a physical business would be a good hedge. Blaming derivatives for rocketing prices, some US politicians are already suggesting that restrictions should be imposed on futures and options trading.
But the move into ‘physical’ trading does not come easy; nor is it cheap. It demands a significant boost in capital, human and logistical expenses. Physical trading – actually taking ownership of the commodity itself – is risky for a bank, which would not want to take delivery of unwanted oil, for example. However, the informational and competitive advantages are huge.
Make or break
| “Physical trading in commodities can make or break a bank,“ says Dr Robert Brady, founder and chief technology officer of Brady, a provider of trading and risk management solutions to the commodities industry. |
“Done well, it gives you a huge informational advantage that enables you to read the market correctly and allows you to have an entirely different relationship with a counterparty. It also enables you to tailor a risk management solution to a client’s specific needs, so you can do more transactions and get more trades on your book.”
But it is not like any other asset that banks trade, and therein lies much of the risk. “Done badly, it can be disastrous. You have to understand the nature of the physical commodity itself, the way it is produced, the way it is consumed; you have to understand about different qualities, and how they matter to the buyer,” says Dr Brady. “Then there’s the logistics of shipping. And any problem, anywhere along the supply chain, has an economic consequence.”
Only a few banks have already managed to take the first steps. Barclays Capital has, so far, made the most inroads into Morgan Stanley’s and Goldman Sachs’ lead, and is now considered to be the third biggest commodities player globally. It already has a physical business, albeit relatively youthful, in metals, power and gas, and some agricultural products.
Platform in its infancy
Barclays Capital’s physical oil business, however, is in its infancy. According to Roger Jones, co-head of global commodities, the bank does not really have any choice but to go into the physical business if it wants to grow. “We already have a very big, diversified paper [derivatives] business, which leaves us only two ways to continue growing at the rate we have done over the past few years: put more risk on the books, which is not our way; or move into the physical space,” he says.
Mr Jones argues that neither the credit crunch nor rising costs will derail the bank’s commodities expansion, which will see staff numbers rising to 325 from 250 in the next two years. The physical oil build-out (referred to internally as Project Damascus) is at least a three-year plan, of which Barclays is in year one. “The build is going pretty much as planned. We have already started doing our first waterborne cargoes,” he says.
The key, Mr Jones stresses, is that the bank is building a business around Barclays’ existing strengths, not trying to emulate either of the two giants’ business models.
“We are not trying to build a large merchant oil business, such as Morgan Stanley’s, or to be all things to all people. We will start off only in those areas where there is a client need for risk management or for our own risk management. Physical capability will be enormously useful in some transactions: it will enable us to do a physical off-take instead of a financial hedge, for example. It will also support our principal investment business by allowing us to monetise any investment in oil infrastructure assets, such as tankage, ships or refineries.”
Royal Bank of Scotland is another latecomer to the physical business. In July 2007, it announced the acquisition of a majority stake in Sempra Energy, a company trading physical and financial energy products, including crude oil and refined products, natural gas, coal and metals. Following regulatory approval in April this year, the partners have formed a joint venture called RBS Sempra Commodities. Right now, that deal is looking very canny.
Andy Jameson, head of energy and natural resources at RBS’s project finance business, says that bank and clients are already reaping the benefits. “In Europe, we were recently financial advisor to a new-build power station and the client was interested in a very long-term physical coal supply; we can now offer that,” he says. “We were also talking to another client about project financing a new-build gas-fired power station, and RBS Sempra allows us to supply the gas and off-take the power in a long-term tolling deal.”
Crucial piece
If a bank has serious ambitions in oil and energy, the importance of physical cannot be underestimated, says Mr Jameson. “It is not just another bolt-on; it is a crucial piece of the puzzle. You can offer all the financial products you like, but without the physical there is a huge part of the supply chain – perhaps the most important part for the client – that you can’t offer. Physical closes that circle.”
One other new entrant is looking relatively well positioned, albeit as much by luck as by design. JPMorgan has displayed plenty of ambition in the oil and energy space in recent years, but has suffered from high staff turnover and an unstable platform. When it acquired Bear Stearns for a knockdown price earlier this year, JPMorgan landed a decent trading team through Bear Energy, and, more importantly, Bear’s physical business, which the bank had continued building aggressively right up until its collapse.
Bear’s private equity unit, Arroyo Energy Investors, acquired Delta Power in November 2006, and with it, stakes in 19 gas and coal power plants; then in May last year it acquired all the power assets from Williams, a US company largely focused on natural gas. It also has agreements with US power plants MMC Energy, BG Dighton Power and Project Orange Associates.
This may not propel JPMorgan into the physical oil or refined products space that it is keen to occupy – for which the build-out continues, the bank says – but it has gained a top-tier power and gas franchise, which will give JPMorgan’s entire commodities operation a much-needed boost.
Competitors who long for such a leg-up have looked on in envy. “JPMorgan’s Bear deal looks like a steal in more ways than one,” says an energy banker at a rival bank.
Lucky break
| This fact is not lost on JPMorgan. Catherine Flax, co-head of global energy and global commodities corporate marketing at JPMorgan, admits that the unexpected bonus of Bear Energy is enormously lucky. “It can be difficult in these [oil, power and gas] markets to build organically, so we were looking for acquisition targets; then Bear Energy fell in our lap. It has accelerated, by a number of years, a plan that we had already put in place,” she says. |
The bank has also benefited from a spectacularly speedy regulatory response. In a matter of weeks, it received the approval needed for a commercial bank to own power assets in the US – meaning it will not be forced to sell the crown jewels it has just managed to acquire. The same process took RBS Sempra almost 10 months.
But for those banks that have yet to build or acquire a foothold in physical, the credit crunch may signal the end of expansion plans, says Morgan Stanley’s Mr Trapp. The cost may prove to be too prohibitive right now, even if the synergies and returns are tempting.
Too late to build?
“I am not sure if any banks not already in physical will be able to get the capital allocation required to do the build, and it can be difficult to win the level of management support required,” says Mr Trapp. “This is not really a business that you can go into piecemeal. It is difficult to derive the benefits from a little bit of business. You have to have critical mass. The cost of doing a little is very high.”
Ms Flax agrees that winning management support to build this kind of business is critical. “Jamie Dimon’s support for this business is a key reason that we are able to dedicate the risk and credit capital required to build it,” she says. “It is definitely not for the faint hearted. You need to approach it systematically, and for that, you need long-term support.”
Banks are not only battling with high costs and scarce capital. They face growing competition from the dedicated trading houses, such as Glencore International, and non-financial players, such as power companies and utilities, which are increasingly giving them a good run for their money.
Recruitment has always been a challenge for investment banks because the pool of physical expertise is very small. Competition for this rare commodity is fierce and it is a major reason why banks find it difficult to build out organically. Historically, banks have pillaged the ranks of industrial players and smaller physical trading houses – but these players are increasingly cutting off investment banks’ talent pipeline.
Industry fights back
“Traditionally investment banks have had the upper hand in the recruitment game because they had the deepest pockets, but power companies and trading houses have been doing incredibly well in the past few years, and they now have the resources to compete more effectively,” says John Whitehead, oil and gas specialist at recruitment firm Commodity Appointments. “Their remuneration structures look increasingly similar to those at the major investment banks and, unlike investment banks, they offer much greater job security. Banks may exit the power markets; EON cannot.”
This could be a key point in current markets: the traffic in star traders can go both ways. Traders may not appreciate a lowering of their risk limits or being hampered by lack of access to market information if promised expansion plans into the physical business do not materialise. If traders that have been lured away from power companies or dedicated commodities houses feel that their wings – and their commission – will be clipped by a scale-back at a bank, they will be more susceptible to overtures from industry to return to their core business.
And it is not just salary packages that have changed. “Banks have traditionally claimed the intellectual capital on the financial side, in structuring and risk management and so on, but in the past few years physical players have significantly built their financial expertise; increasingly, power groups are putting together the sorts of sophisticated long-term structured deals that banks had previously done for them. Many are now a match for their investment banking counterparts,” says Jakob Bloch, managing director of Commodities Appointments.
For some firms, that may pose a more specific problem. In February 2006, Credit Suisse partnered with Glencore to provide risk management and structured products for both firms’ clients in the oil and petroleum sectors. Later, the relationship was extended to cover metals, in which Credit Suisse has built a decent platform. The deal was that Glencore would provide the physical information and access to the markets in which it operates in return for a share of Credit Suisse’s net profits. Crucially, it meant that Credit Suisse would be able to take physical products from clients and pay them for it, rather than give clients a benchmark hedge.
Partnership not paying?
However, many in the industry say that they have seen few results from the partnership. “I don’t think that the relationship ever became important enough for Glencore,” says one commodities banker. “Unluckily for Credit Suisse, their partnership was sealed just as Glencore was emerging as an industrial colossus. Credit Suisse needed Glencore more than they needed Credit Suisse.”
Adam Knight, co-head of commodities at Credit Suisse, maintains that the partnership, although young and still growing (it has tripled in size in the past year, he says) has definitely contributed to revenue growth. “If you look at growth in the alliance from the perspectives of both parties, it is on track or above expectations from both sides,” he says.
That said, he acknowledges that the alliance has worked better in some areas than in others. For example, it has taken the coal franchise “from nowhere less than a year ago, to one of the stronger franchises on the street”, he says. In the oil business, it has not had such a big impact. “But that’s largely due to the fact that, until recently, we were building our oils team,” adds Mr Knight.
Others point out that Glencore – now one of the largest privately held companies in the world – is offering the kind of deals that Credit Suisse should be doing. In October last year, in addition to a 10-year off-take agreement with Katanga Mining, it extended a $150m loan facility to finance the next phase of development of Katanga’s mining operations.
Dr Brady believes the deal demonstrates that the balance of power has tipped. “It used to be that banks would tie up a company – lending them money and winning other business in return, but now that power relationship is often being overturned,” he says. “Equally, with the popularity of commodities companies as an asset class, companies can go to the capital markets to raise money and cut banks out of the loop.”
Mr Knight argues that this is simply a function of both firms having balance sheets and established client bases: there will always be times when it is more efficient to do deals independently. But he is certain that the alliance will generate many more synergies as it matures. “We have a number of deals in the pipeline,” he says.
It seems counterintuitive that banks much in need of revenue opportunities would even consider scaling back their operations in today’s hottest sector. But, historically, the possession or not of critical mass has determined the long-term fortunes of commodity franchises: with it, a board or CEO will be more willing to continue funding growth through a difficult period; without it, the chances of the plug being pulled and the resources going elsewhere are much higher. For a handful of firms, the case for maintaining and expanding their commodities platform is proven, but the retrenching already obvious at many banks is a sign that the yo-yo effect which has characterised the commodities – and particularly the oil – business, has yet to disappear.
