On the future of commodity finance and funding the trade

Published on March 28, 2022

Energex guest writer, Kevin O’Reilly offers here a unique take on the financing woes of commodities trading.

The 11th Annual FT commodity summit in Lausanne attracted more attention than usual. A European war, persistent Covid-19 related supply-chain issues, and hesitant central bankers contributed to soaring commodity prices, extreme volatility, and unease amongst commodity traders, despite record profits across the board in 2021. Those with business models that rely heavily on commodity finance to exploit arbitrage opportunities or guarantee future cashflows through hedging their production and inventory on Commodity Exchanges sounded the alarms. Numerous CEOs and CFOs warned of ‘stress’ in the system, bemoaning liquidity crunches, insufficient bank packages, and expressing legitimate fears for smaller ‘commodity merchants and traders’. There was even talk of Central Bank action and bailouts (although the moral hazard associated with bailing out those who choose to ‘live and die by the sword’ has damped down such suggestions).

Almost daily, there are stories of concern for the finance of commodity traders. It is reported that their funding facilities are being used to make margin calls on their futures positions (that have hedged a forward trade of a physical commodity) and will be insufficient if the current levels of market volatility persist. Those reports portend of financial calamity and even the dreaded ‘too-big-to-fail’ scenario (somewhat ironic as most commodity traders moved their operations to jurisdictions that would allow them to circumvent the capital requirement rules put in place in 2010’s Dodd-Frank act to protect the global financial system, which included commodity trading on Exchanges!).

After a decade of poor returns, low prices, and little volatility, most banks reduced their interest in commodity trading and commodity trade finance. The retrenchment saw financial talent move from banks to commodity merchant traders who have filled the void left by those banks. These trading firms have grown from niche commodity players to become globally integrated commodity companies with a range of physical and financial operations and exponential growth in trading backed by tangible assets. Furthermore, a decade of incredibly cheap money allowed significant leverage to be employed to capture marginal arbitrage profits, perfect the art of physical trading, and develop deep banking relationships. The recent explosion of commodity prices has allowed these traders (and their finance teams) to exploit more significant opportunities: All this comes with a cost and poses new risks, so the industry must engage in thoughtful cost-benefit analysis.

Commodity trade finance funds the underlying exchange of commodities from supplier to buyer and is tied to the underlying asset conversion cycle. Banks provide liquidity to physical traders to trade, fund inventory, and post variation margins to Exchanges where arbitrage profits are locked in. Facilities have many participant lenders and have often been oversubscribed as banks (and investors) hunt for yield in a zero-interest rate world. Moreover, the banks have become very familiar with managing the risk associated with these clients: they understand the underlying business very well. Many publicized financial issues with commodity-type clients are often due to fraud instead of lax risk management or errant speculative behaviours. What has kept the industry operating smoothly is the ability of the traders to draw down extra cash in times of need through their Debt Accordions.

A Debt Accordion is a provision allowing a borrower to expand the maximum amount allowed on a line of credit (LOC) or to add a term loan to an existing credit agreement. The extended credit interest rates remain the same as the original credit line (but might incur additional fees). Furthermore, Debt Accordions will limit the total amount that can be borrowed, and any new borrowing will be contingent on the company complying with its existing financial covenants. Companies typically purchase an Accordion agreement if they anticipate capital needs in the future but are unsure when those funds will be required. Banks willing to extend such features usually have strong relationships with the borrowers and understand their businesses to guarantee a healthy collateral package. Collateral packages typically consist of cash, liens on verifiable inventories, and accounts receivables.

Last September, rumours surfaced about huge margin calls Gunvor had to make to finance their TTF hedges for their LNG deliveries. The TTF futures prices rose dramatically, and variation margins grew daily. Futures Exchange exists to help producers, consumers, and arbitragers of commodities fix prices and guarantee certainty of cashflows. However, there are cashflow mismatches with Exchanges requiring daily variation margin calls to be met until the underlying physical entity is liquidated and the associated cash flows are received (usually later). Higher commodity prices, in general, mean more capital is required to do the same types of trades as last year without necessarily leading to more profits—a more expensive underlying means a more significant export or trade finance capital draw. Greater volatility means a more substantial need for money to meet all margin calls. In the last few weeks, the well-publicized issues surrounding the Nickel trading on the LME have given an even more extreme example to commodity traders.

Gunvor made that margin call and announced new funding with a $1 billion+ facility from lenders, including Rabobank and SocGen. Financing variation margin strains balance sheets, reducing working capital, violating loan covenants, and shrinking expected profits. In January, the German energy behemoth Uniper needed an $11 billion injection from its Finnish parent for their margin calls as gas prices recorded their wildest days. Again, those calls were met as the funding was provided.

Mercuria and Trafigura have announced additional funding lines with partner banks. These companies had record performances last year and look set to do so again. Trafigura also revealed they were looking at attracting PE investment to fund trading operations further but have not been successful. PE money is costly, and while it may come with other commercial benefits, it will become a drag on overall performance and operating ratios.

Just before the FT conference, the withdrawal of Sabadell bank from Trafigura’s lending facility was reported as the proverbial canary in the coal mine for the commodity trading industry. However, the Spanish bank is exiting many lending businesses, and their commitment of $40 Mio accounts for about 1% of the total commitment of the lenders to Trafigura. Rumours of someone else’s demise continue to be greatly exaggerated!

When commodity markets present opportunities, but commodity traders feel financial strain, what is the best way forward?

At the FT conference, Torbjorn Tornqvist, the CEO and principal shareholder of Gunvor commented that he might be open to new outside capital. Additional equity would provide added security for their lending banks, strengthening the overall balance sheet and allowing trading operations to continue. It is unknown what his actual appetite might be. While fresh equity brings stability, it also brings ownership dilution, a drag on equity-related performance metrics, possible changes at the Board level, and is far more costly than debt. Notwithstanding, it should also be noted a lack of investor interest currently in the secretive world of commodity trading. Investors prefer stable earnings and real tangible assets rather than the opaqueness and volatility of revenues associated with more speculative pursuits. Past performance is not indicative of future results, as we are often warned.

Raising further debt has already been undertaken by most major market participants, and there may yet be further appetite by lenders to satisfy their needs. The banks understand their businesses and believe in the validity of commodity trades. Even in highly stressed times, the borrowing bases they have provided are rarely drawn over 50% of the agreed collateral packages. The largest gas trader in the USA, Tenaska, recently decided on a 4-year $1.5 billion facility that was $600 million oversubscribed! Demand remains very firm.

Is it possible to eliminate the additional expense of margin financing by changing the business model to wholly or partially self-hedge the inherent exposures of these trades?

Vertical integration allows a company to streamline its operations by taking direct ownership of various stages of the commodity supply chain rather than relying on other counterparties or suppliers. A commodity trading company may achieve vertical integration by acquiring or establishing its production, transport, refining, and sales and marketing operations, even going as far as retail in some cases, such as supplying transport fuel at the rack. Inherent in this construct is removing export and trade finance legs that depend heavily on financial hedges. Possible commercial synergies are neither new nor original. Still, oil and gas producers again aligned with refineries, midstream and petrochemical businesses, mines with smelting operations (tolling), and power generation linked to multiple feedstocks, salt caverns, heating, and energy storage could eliminate the need for hedging required for contracts between such standalone enterprises. The inherent self-hedge and the change of risk profiles from outright price risk (most volatile) to basis/spread risks (less volatility) might reduce financial stresses and free up capital for more productive uses.

The advantages can include greater efficiencies, more market information to monetize, and reduced Exchange costs. The disadvantages include steep initial investment as assets cost money and time to acquire and integrate. Furthermore, the potential countercyclical deadweight of a portfolio of assets and the opening of other avenues of market risk consequent on the exposure of a manufacturing margin can also weigh upon performance. In short: when markets change fundamentally, a trading asset then becomes a liability!

Suppose markets are to remain elevated and volatile for the foreseeable future. Should these commodity titans consider investing in a new operating model (one from the old days) that will reduce exposure to daily futures price swings and allow for more stability while preserving the ability to exploit market opportunities as they arise?

It will be interesting to make critical strategic judgments ex-post as quarterly results for firms with different operating models and various degrees of integration are revealed alongside their urgency in sourcing new funding avenues: We will return to this subject then!

Kevin O’Reilly is a freelance expert energy market risk professional and an independent thought leader in ESG and risk solutions in all commodity-related industries. He most recently served as the Chief Commercial Officer at Global Risk Management and spent over 25 years working on Wall Street in Energy Banking, Trading, Sales, and Risk Management.