For more than 3,000 years, holders of capital have enabled and supported the exchange of goods through evolving mechanisms that we have come to know as trade finance. Along the way, shifts in the structure and operation of markets for commodities like oil, metals, and wheat have shaped the fortunes of customers, traders and their financial backers.
A recent wave of regulations designed to stop unrelated excesses in the global financial system, combined with a consistent move towards consolidation and vertical integration across the commodities market, has made it increasingly hard for physical commodity traders to turn profits. As such, there is an opportunity for new entrants, such as credit funds and private equity, to compete in the commodity trade industry.
Times were not always as complicated for this ancient pillar of the global economy.
Looking back just a few decades, trading firms and investors benefited from relatively opaque markets and fixed prices for commodities such as oil. In the 1970s, oil price shocks birthed risk management and derivative products associated with commodities. By the time I began my oil trading career in the late 1980s, brokers were trading physical forwards, and futures exchanges like the International Petroleum Exchange (now ICE Futures) had become part of the landscape. These changes created more lending activity, much greater liquidity, and encouraged new competitors within the industry.
Since then, I have seen the deep financial support for commodity trade become a thing of the past. Regulations imposed following the 2008 financial crisis, particularly Basel III, have driven down the availability of credit for trade finance and caused a growing number of commercial and investment banks to leave the market. For them, trade finance simply was not important enough to merit the executive attention required to manage risks appropriately. Instead, banks have favored products they feel more comfortable investing in, such as equities and bonds, despite the underlying risks that exist in both categories.
These developments are particularly bad for physical traders, who will face margin pressure as their individual transactions become less profitable. With less credit at play in the market, traders can expect to face rising costs of capital from the smaller number of remaining institutions in the space. As banks have decreased their lending, international trading houses and NOCs have reemerged as large industry players. The three largest commodity traders – Gunvor, Trafigura and Vitol – have all increased volumes in the past few years, with Vitol’s LNG trading volumes more than doubling since 2016 (source).
In their cycle back to the forefront, the big traders and NOCs have focused on establishing high-value asset portfolios and strong synergies with trading arms, by creating their own fully integrated trading departments. As wholesale trading margins are pressured, Trafigura, and other large traders, have moved into the downstream market by acquiring retail and supply distribution businesses. A recent example is Vitol’s acquisition of Vivo Energy from Shell for $250 million (source). At the same time, oil companies like ExxonMobil, have begun building their own trading capabilities to access margin and supply optionality, adding to the constraints pure-play physical traders are facing.
A substantial move towards a fully integrated model would have a considerable effect on the time it takes to realise profits – as the process includes extraction, storing, shipping, delivering, and payment. As a result, physical traders are likely to feel pressure on their profit margins and greater stress in terms of working capital supporting long value chains.
Ultimately, I expect more consolidation within the market as big players continue to strive to dominate every facet of the value chain. If the industry consolidates in this way, the physical trading community will quickly feel the effects as money made on trading assets will not be worth the cost of extraction. In such a context, traders with the greatest flexibility in terms of leverage – such as state-owned players, oil majors, and the largest privately-owned trading businesses – will survive, as well as firms that are able to manage their costs most effectively.
What can be done to keep money flowing toward commodity trade deals?
We need more alternative private credit lenders, working alongside the trade finance banks to finance longer-term deals, which physical traders are no longer able to support. The emergence of credit funds will remove concentration and systematic risk away from large traders and distribute risk across the wider institutional investor base. Risk-adjusted funds that do not have the same pressures on their balance sheets as established trade finance banks are well positioned to become the most viable lenders.
Additionally, a greater understanding of the true risks and opportunities associated with trade finance deals may encourage some players to return and new players, like private equity houses, to enter the fray. It may prove too late for the weakest trading firms and traders, but for the growth of the global economy, it is critical that new lenders understand these underlying issues and enter the space knowledgeably.
Mikael Bonalumi is managing director of Auriga Commodities and head of physical risk management at Audentia Capital Management