Risk too big to fail hangs over commodities

High and volatile prices create a huge problem for commodity traders. They rely on bank credit to finance their shipments of oil, aluminum, wheat and other natural resources. When prices increase, the value of these shipments increases, increasing their need for financing. In early December, the cost of a typical 2 million barrel oil shipment was around $140 million. At one point last week, the same shipment was worth nearly $280 million. The physical cost is not the only problem. In the world of paper trading, as commodity prices rise and become more volatile, the amount of money traders need to back up their trades in the derivatives market increases dramatically. These so-called variation margin calls have amounted to billions of dollars per company in recent days, according to industry executives. The surge in margin calls has exposed one of the weakest points in the commodity system. The LME is a good example. When the exchange shut down nickel trading last week and reversed billions of dollars in trades, it said without those actions, many brokers would have failed. The March 8 ruling “created systemic risk,” the LME said. Matthew Chamberlain, the exchange’s head, said it “would have been extremely difficult for some of our market players to continue trading.” In a statement released last week, the exchange said there was a “risk of multiple defaults”. The LME nickel affair was much like what the Bank of Canada’s Lane worried about a decade ago – albeit confined to commodity brokers rather than traders. Now, the nickel crisis was just a short squeeze that caught a single Chinese tycoon and his band of brokers and bankers on the wrong foot. What if, instead, it had been a big commodity trading house, and not just in nickel, but in a dozen markets? What if the raw materials involved were not nickel, but rather oil, natural gas, electricity or, heaven forbid, wheat and other food staples? It might not be as bad as a Lehman-induced recession, but it would still be a blow to the global economy. The LME problems showed regulators were asleep at the wheel – no one saw it coming. They should quickly pay much more attention to commodity markets – not only financial, but also physical. For now, the biggest commodity traders appear well ahead of all regulators, having strengthened their finances. The spike in natural gas prices in Europe in December was a wake-up call for many. The current crisis has found them better prepared. Then there is access to credit. High commodity prices may seem heavenly for a trading house, but they can create risk before generating profits. The higher the price, the more credit is needed – and at present credit is scarce even for giants like Trafigura, which has been in talks with private equity groups for additional funding. Commodity prices have fallen over the past three days, easing pressure. But the industry as a whole is still under pressure. Privately, industry executives acknowledge that they are skipping some trades to save money. Much of the price volatility of the past few days can be attributed to trading houses and others avoiding taking a position. The commodities market trades risk rather than supply and demand fundamentals. Liquidity is thin. Commodity trading houses trade in US dollars, but mainly receive credit from European commercial banks. If prices in several markets increase again due to, for example, new sanctions against Russia, traders could find it difficult to access enough credit to continue buying commodities. This is especially a concern for mid-sized and small traders, who don’t have the deep pockets of industry leaders. There is a serious risk that global commodity trading will freeze, even if only temporarily, creating turbulence for their biggest rivals. The number of banks offering large-scale commodity trade finance has declined significantly over the past decade, particularly with the departures of former industry leaders BNP Paribas SA and ABN Amro Bank NV. Today, traders rely on companies like ING Groep NV, Crédit Agricole SA, Unicredit SpA and a handful of other largely European banks. Several scandals, including the collapse of Singaporean oil trader Hin Leong last year, prompted many banks to cut lending to the sector or even pull out altogether. The result is an industry with fewer doors to try in a crisis. If commodity prices were to continue to soar, central banks may very well have to step in, ensuring that the flow of dollars continues, much like the emergency liquidity injections that the US Federal Reserve and the European Central Bank made in 2008-09 during the global financial crisis. In public, all commodity traders, big and small, say that everything is fine. Talk to executives privately, however, and the anxiety is evident – ​​that their industry is one crash into trouble. We are not there yet, but central banks and policymakers must prepare for this eventuality.


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