COMMODITY TRADING FIRMS: MORE DARKER AND SINISTER THAN CORPORATIONS
This is an old article spread across three parts that I wrote about 2 years back. It was shared with a few of the recipients on the present list back then, but, the purpose is to re-share it with a larger set, for an almost intense discussion Nishank, Anirudh and me engaged on the topic on Saturday evening on corporations and resisting them and these CTFs, which are the real threat financialisation of capital throws around densely at almost everyone, without being in the knowhow. CTFs is ideology par excellence, if I were to merely go by Marx's definition. Also, archiving it on the blog is a decent enough idea. All of it remains unchanged by way of data/charts/arguments. So, apologies for cross-posting on one hand, and technical morass on other.
WAC or any other mutation of it sounds soap and it largely depends on TRPs, or takers/viewers. So far, so good, so what? Assuming deregulation from the governments and many of the giant corporations could be pushed down the hill, a homicide that would bring smiles to millions. Right? Yes, partly, but there is a dark trajectory, an obscured world that is omnipresent and omniscient touching everyone of us in more malignant ways than could be even remotely imagined. Where am I heading here? Maybe into oblivion as thats already designated. But, pause I will and ask this. Have you heard of Vitol, Archer Daniels, Mercuria, Noble and Wilmar? What about Glencore? Well, probably not. These are not gamers, or porno-pharmacopeia of sorts swarming the Internetwork and looking for hosts and nodes to sneak into the surveillance bazaars, or even tiers in heaviness of metal sounding junk. These are “commodity firms”, trading into commodities and fixing prices of the most basic commodities from food to energy sources to pharmaceuticals, and what have you. So, what I pay is linked with mathematical calculations wrought by often young, arrogant and brilliant number crunchers.
Let us explore, with a view to comprehend a world of finance as dark as the world of Internetwork, the Darknet, where one could not just make hay while the sun shines, but merry when the moon phases in and out. This is particularly ugly and compels me to put forth the argument that major financiers from IFIs, NFIs, and Investment Bankers are much too benign in comparison.
Rolling Stone magazine once said this for Goldman, “a great vampire squid wrapped around the face of humanity.” Such a qualification could fit any of the commodity traders, and especially Glendora, who operate out of a wealthy Swiss village, and has annual revenues of $214 billion, that is 60x FB’s or 5x what Google manages to pull in. And, this is not small tributary that swells economies, but maybe, in the most extreme analogical manner an underground tributary with a shadowy existence, since outside the stocks that trade on it, a lot of what it does is not liquid and done off the balance sheets. There goes the challenge of mapping, transparency and accountability. With an IPO of $11 billion, this price fixer has the potential to spark off riots, destabilise economies, and still manage to stay stealthy, for who would take them on radars?
With a truly frightening knowledge of the flow of commodities around the world, incredible performance culture, the firm hefts a fear factor of 3x investment banking, to say the least. With a clientele that is a roll call of world’s largest corporations viz. BP, Exxon Mobil, Chevron, ArcelorMittal, Sony and the national oil companies of Iran, Mexico and Brazil, and public utilities in France, China, Japan and Spain, to name a few, the ideal philosophy they bank on is simple: make money by finding customers for raw materials and selling them at a mark-up by concocting complex hedge funds, market swings, piracy and regime change. Oh!, this is simple huh! In other words, the simplicity lies in one word: CONTROL. They want it and they get it in high-risk environments, reproducing an ugly baby with a parentage of meshed-up financial engineering and old-fashioned conservative/orthodox/traditional commodity trading. With just two designated classes of employees: “thinkers” - who massacre numbers and “soldiers” - who seal the deal/negotiations, the quiet cognitariats release a juggernaut of extreme arrogant efficiency.
The firm was started by Marc Rich, who escaped the Nazis, set shop for spot market for crude oil, evaded taxes, sold oil to Iran during the hostage crisis in the dying 70s and growing 80s, apartheid SA, assisted Mossad and the icing on the cake: engineering a deal for a secret pipeline through which Iran could pump oil to Israel during Shah’s rule. The rule of notoriety ended when he smashed hard to ground in a valiant attempt to control Zinc market by splurging $1 billion. The reins were handed over to a German metal trader, Willy Strothotte, who translated the majority stake into $600 million, making it close to $100 billion in worth today. Glencore, often referred to as an acronym of Global Energy Commodities and Resources (though, this could be some linguist’s word play exercise) often found itself implicated in controversial dealings, but never lost sight of prowling for opportunities.
Moving on from part 1, which painted a historical notoriety for commodity trading firms, this part deals borders on some operational aspects and a view of dashing financial moves in a stealthy manner.
Way back in 1993, I picked up from the flea market in Poona, Kerrang!, world’s largest read rock and metal magazine. I still remember the words then: From the Quaint Swamps of Milwaukee, comes a force that can be described in one word: Viogression, redefining music and speed spiced up with aggression. This was a death metal band from Wisconsin, and the advertisement was for Milwaukee Death Fest, a converging point for Death Metal fans. Obviously, the speed has been surpassed exponentially ever since. But, why this? As an analogy, Glencore comes brutalizing financial sways and swings, upsides and downsides from a quaint village of Baar in Switzerland, unleashing its ferocity on the London-stock exchange listing and a registered office in Saint Helier, Jersey. As brutal as the band could get on the Milwaukee music scene then, the commodity traders have unleashed their fury on the financial stage and continuing to accelerate its spawn.
The contingency of operations make for a smart move, for in contingency is the scent of an opportunity rather than the stench of risk. This ain’t the twisted version, but rather a crude philosophical one for the commodity trading firms (CTFs hereafter). The opportunity is built over offtake deals, where other financial institutions fear to tread for uncertainty lying over repayment for whatever gets invested. This is as much a part of the risk investment. Such deals materialise, mostly in natural resources, when with significant capital costs involved in extraction of the resources forces the company to have a guarantee that its product will be sold, that there shall be a secure market. Such a situation is promised, and if the company were to slide into a financial quandary, a likely debt-burden gets slashed by bringing in swapping loans-for-rights/ownership issues, thus offloading the equity for uploading it to the CTFs. In financial parlance, such a move is termed prosaically: right to convert debt into equity in the tail. ‘In the Tail’ connotes tail risks, which are low probability events that have an outsized impacts on prices, more than often inordinately large. In present times, the nightmarish tail risk is the perennial China hard-landing, which, if it were to occur would exponentially rise costs of basic commodities, diverge them due to supply disruptions rather than demand overflow, thus churning faster the global economy and sickening consumption in course as a result of shrinking supply. When Merrill Lynch conducted a survey in the beginning of this year asking about the biggest tail risk for the global economy, fund managers answered China hard-landing/collapse in commodity prices. And yet, technically the commodity index is breaking out on the upside. Interestingly, only about 5% of fund managers really worried about inflation risks.
Merrill Lynch observed that a net 23% of investors are currently underweight commodities, which is only a slight improvement from net 31% underweight in December 2013. Current readings in exposure are extremely under-owned at 1.7 standard deviations below its decade long average. The situation as it stands today resembles 2008, when just about every fund manager and policy maker was pessimistic on commodities and inflation right before the prices bottomed out and rallied powerfully in coming quarters. But, if inflation was to surprise the markets to the upside, then stocks could get oblivious, since history has time and again proved that commodities have always been the best hedge against inflation. Sigh!, Huh!
Moving on, CTF’s operational key lies in flotation, listing its shares on the stock market, albeit in a split manner as was talked off in part 1. The issue of safeguards and adherence to strict guidelines is robust here, for potential investors are not to be misled. Once new shares are issued on the primary market, trading sets off in the secondary market, in that trading transactions occur between investors without any involvement of the CTF. This still is procedurally under check, but CTFs invent a twist, for they list with the clause for a permanent capital base. Rationale is simple here: In private partnerships, payouts to departing partners shrink the capital base, while public companies’ equity remains intact even if the shares change hands at dizzying speeds. Most cardinally, such a move injects reassurance in credit agencies that not only shy from keeping at bay any relegation of CTFs to junk on the one hand, but allows the CTFs enough manipulability with flexible capital structures going in for the kill, meaty acquisitions on the other. Getting back to Glencore, this example for once sets up a sneak peek into what the CTF is capable of, and how it is well-nigh difficult to locate movements in such financial transactions. Transactions that make possible coming out clean and acquit being cornered to a dock. When speculations were rife in 2010 of a possible merger between Glencore and London-listed Xstrata, shareholders of the latter opposed it, arguing that the valuation of the former be dictated by market forces and not dealt with behind closed doors. To force things to a head, Glencore set the clock ticking on a change in its set-up by issuing a convertible bond. These types of bonds not only can be converted into a predetermined amount of the company’s equity at certain times during its lifespan, but also helps facilitate the CTFs to alleviate any negative investor interpretations of its corporate actions. From investors’ point of view, the bond has a hidden stock option, and helps her with a lower rate of return in exchange for the value of the option to trade the bond into stock. The package was set thusly: convertibles pay a staid interest rate of 5% every year till their maturity in 2014, but are laden with incentives for Glencore to transform itself. In other words, the package contains this: If by December 2012, Glencore does not float or merge with another company, bondholders can sell their bonds back to Glencore at a price which would give investors an annualised return of 20%, in line with the sorts of returns one might expect from equities. By this, the CTF will not be penalised if markets turn lower and if the IPO turns to be unattractive. A smirk invades faces!!!
CSOs can take up the archaeologist’s role, and dig they will in order to turn opacity into at least translucency, if not outright transparency, for CTFs deal with a chain that is particularly vulnerable to mismanagement, and therefore scrutiny becomes the sine qua non to bring these onto the radar screens. There is an actionaid page on Glencore’s tax dodge in Zambia here and the cover up this tax probe here by none other than European Investment Bank. These wolves make their money at the margins, and profits by working in the global margins, margins of what is legal, erecting walls of shell corporations, weaving complex webs of partners, offshoring accounts in order to obscure transactions, and working with shady intermediaries (Financial Intermediaries in the case of IFIs could be coaxed into differential calculus of presenting themselves into the developing world, but as it holds true invest far and between into repressive political regimes: safeguards and recourse mechanisms at least on paper guarantee this) to obfuscate what is legally corrupt and what is not. No wonder, titularly, the post makes sense: what does one do these?
I apologize for the length of this concluding part and the series thats been flooding your inboxes for the last three days. The idea behind the series emanated after a twitter discussion with a couple of friends, where we wanted to understand the dark movements of commodity trading financing and its ramifications for a political habitat where notions of post-industrial capitalism could be brought to light in at least comprehensibility, if nothing more. Thanks for the patience.
Leveraging information in times of wild commodity-economic swings is cashed on. Trading and hedging all the way, it is akin to a casino, where the ‘house’ always wins, a spot of volatility, where eagles dare, nah, where the wolves dare. In one of the most interesting euphemisms ever from Deutsch Bank on Glencore, the German Bank said, “Key drivers of growth: copper in the Democratic Republic of the Congo, coal in Colombia, and Gold in Kazakhstan. All are places with a heady, dangerous mix of extraordinary wealth and various degrees of instability, violence and strongman leaders. But, these guys need to adapt as well, and adapt they do undermining transparency. In a pretty hubristic manner, Marc Rich said, “Discretion is an important factor of success in the commodity business. They probably don’t have a choice. Transparency is requested today. It limits your activity, to be sure, but it’s just a new strategy to which they have to adapt.” (Italics/emphasis mine).
Hedge: an investment position intended to offset losses/gains that may be incurred by a companion investment. Hedging is the practice of taking a position in one market to offset and balance agains the risk adopted by assuming a position in a contrary or opposing market or investment.
Derivatives: special contracts that derives its value from the performance of an underlying entity, which could be an asset, index, or interest rate. Derivatives as used here are used in insuring against price movements/fluctuations (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard to trade assets or markets. Thanks Wiki.
Moving on backwards for a time, CTFs chiefly perform arbitrages, while facing a wide array of risks, which are often times managed by hedging, insurance and/or diversification. Probably taking a leaf from Richard Morgan, a force in himself on the science-fiction space, I’d have no second thoughts in underlining that these guys are adept in transferring risks to the financial markets using instruments of hedging in derivatives or purchasing insurance. The principal funding comes through mixing debt and debt maturities, to which we shall turn shortly. Upon emaciating my bitterness as exhibiting in parts 1 and 2, the suggestion that CTFs are potentially the sources of systematic risks like the banks, and hence be open to regulations, the faltering point comes with the fact that these are not too big to fail, and at most of the times keep themselves in check from engaging in kinds of maturity transformations that make banks highly susceptible to run. Moreover, these are not major sources of credits like the IFIs and their ilk, and thus are not very leveraging entities, and if at all these encounter any financial distress, these simply transfer the distress to others.
In the penultimate section, let us deliberate on risk factors, before concluding with modes of financing. I’d try to keep mathematics to the bare minimum, and would circle on attempts at popularising. Risks have numerous paths of departure from the way IFIs and their ilk define, negotiate and deal with. Traditionally, CTFs deal with Flat Price Risks, where flat price is the absolute price level of the commodity to be traded. The firm transacts a commodity, and hedges the relative commodity position through derivatives transaction, by for e.g. selling future contracts to hedge inventory in transit. This is carried out with the intention of transforming the exposure to commodity’s flat price into an exposure to the basis between the price of commodity and the price of the hedging instrument. Flat Price Risks do not always materialise into distress, for hedging sees to it that an exchange of Flat Price Risk for a Basis Risk transpires, i.e. the risk of changes in the difference of the price between the commodity being hedged and the hedging instrument. Such a price differential is possible because the characteristics of the hedging instrument are seldom identical to the characteristics of the physical commodity being hedged. The differential is, moreover built on a positive feedback mechanism that creates a virtuous cycle, standardising hedging instruments for commodities and inducing market participants to trade these standardised contracts with less of a basis risk, but more of a transaction cost. In short, Basis Risk is commodity-contextual and opportunistic for the firms to accept, and pregnant with what in financial jargon is termed ‘a corner or a squeeze’, by which is meant an exercise of the market power in a derivative market, a tendency to cause distortion in the basis that can possibly inflict harm on hedgers. Certain rogue traders can cause ruptures by either spreading risks across margins between the sale and purchase prices depending on volumes of transactions, or even cause ruptures in operations. Well, it is not very difficult to realise that this is part of a contractual risk, when the other party defaults. This could be quite detrimental for the CTFs for the sellers of commodities to consumers have an incentive to default when prices rise subsequent to their contracting clause, and the CTFs are left to lurk for finding the necessary supplies. To escape the trap of such situations, CTFs devise ways to enter and exit positions to negotiate Market Liquidity Risks, where liquidity as a node of causal chain in market flip-flops can cause huge distress. But, if caught in such scenarios, funding this liquidity risk becomes the imperative. Both, funding liquidity and market liquidity are in a relationship of correlation, of interaction, in that stressed conditions in financial markets result in decline of both market liquidity and funding liquidity, compounded through large price fluctuations and movements leading to greater variation margin payments and thus increasing financing. Lastly, appreciation and depreciation of local currencies tied with political economy of the geographies and vulnerability to legal transgressions often face the CTFs in the face of legal reputation getting hit and imposition of legal sanctions looming large. At present times, when commodity manipulation is subjected to considerably intense political and regulatory attention and scrutiny, CTFs bank on difficulties in legal proceedings on the one hand, and on the other, their expertise regarding the economic frictions in transformation processes that make their activities profitable and their financial size big enough and thus almost lending them a position to do so through a term mentioned in the beginning of this sentence, manipulation.
Turning to financing now. As is well known that debt and equity issued by CTFs link them to a broad financial ecology, and therefore any capital structure envisaged by CTFs opens them up to vulnerabilities of market swings. CTFs traverse from gearing/leverage, forms of leverage these employ and rights/ownership of equities. Pure trading firms that own relatively few fixed assets tend to be more highly leveraged than firms that also engage in processing and refining transformations that require investments in fixed assets. At the same time, firms engaged in more fixed asset intensive transformations have a greater proportion of long-term liabilities. CTFs do not always engage in maturity transformations as do the banks, and when they do, it is the reverse of the borrow short-lend long transformation that makes bank balance sheets fragile, and exposes banks and financial intermediaries (FIs) to runover risks. Additionally, since CTFs’ primarily hedged inventories and trade receivables tend to be highly liquid and of high credit quality, these firms run less liquidity risks than FIs and banks. CTFs rely on bank borrowings to finance these transformation activities, by either through short-term borrowings that could also be routed through unsecured credit lines via an arrangement that is syndicated. A typical case involves bilateral credit lines, and are secured by saleable commodities in liquid markets that are marked to market and hedged, and thereby benefiting these exposures to short maturities, which in turn present less credit risks as compared to a credit secured by less liquid collateral. Other than these, non-bank financial vehicles like shadow-bank transactions are often used to securitise inventories and receivables. Glencore specialises in this format, the format that dals with FIs through the issuance of debt outside the insured banking system. The financing mechanisms get complex when tied with ownership rights, where if inefficient risk bearing is the major cost incurred in private ownership, it is the idiosyncratic risks of commodity that get diversified, thanks to shareholders when the firm is publicly listed. But, private firms have a way out inked in financial contracts whereby risks outside the gamut of management control can be transferred to others. This structure built into the contract not only incentivises benefits to the private CTFs, but also score mighty in comparison to public-listed firms, where risk bearing capability is modest at best. But, there is a catch here that swings the pendulum in favour of publicly-listed firms and was possibly one of the chief reasons for Glencore going public. In large-scale investments where equity investments can shoot the budget of private players and expose them to humungous risks, a transference of risks by means of non-equity financial contracts to others is not feasible, and thus a recourse to businesses that can be hedged in derivatives, credit and insurance markets is undertaken. In short, with increasing asset intensity and accumulation of sorts, a movement away from private ownership to going public is indispensable. The obvious question in many minds at the moment would naturally be: what about disclosure then? Who scores and who wins here? The private firms are obligated to keep accounts and records to be kept in accordance with accepted accounting principles and standards, but the laws regarding what information must be disclosed is discretionary upon jurisdiction. In the case of US, private firms have to provide information to their lenders and derivatives counterparts, and at any time with their discretion can provide their financial information in ways similar to those employed by their public counterparts. Importantly, with respect to disclosures to government regulators, CTF positions in listed derivatives are available to exchange staff and government regulators.
What about their relation with FIs? CTFs supply financial intermediation servies to their customers through trade credits, structured transactions that bundle financing, risk management and marketing services. A CTF selling a commodity to a customer has better information about the buyer than would a bank, thus giving the option to the CTF to have a better preparedness on evaluating creditworthiness as compared to a bank. As is a well known fact that cash is more fungible than a commodity, any diversion with cash input is more likely than with a commodity, and thereby more risky. One way to reduce this risk susceptibility is through an off-take agreement, where a CTF agrees to purchase a contractually specified quantity of a commodity from a producer usually at a floating price. the process starts off with refinancing involving three parties: the borrower, CTF and the bank. Borrower and the CTF enter into a prepay arrangement with the bank providing the necessary funds to the borrower. When the commodity is delivered to the CTF, the CTF pays the amount it owes under the off-take agreement to the bank to repay the loan. Wow!, the bank has no recourse to the CTF, and bears all the credit risk associated with the loan to the borrower. What, then is prepay? Two variants emanate in this regard: in the 1st, the bank provides limited recourse financing to the CTF, and the trader assigns the rights under the off-take arrangement to the bank as a security; the CTF provides funds to the producer, but the bank absorbs the credit risk on the loan (there could be instances when the CTF may keep a risk participation), in the 2nd, the bank provides full recourse financing to the CTF, which then makes a loan to the borrower. Thus in the 2nd variation, the CTF bears the risk that the borrower will not repay the prepaid amount. The CTF, in turn, can offload all or some of this credit risk by entering into an insurance policy, and depending on the terms of the financing provided by the bank to the CTF, the bank may be the loss payee on this insurance policy. A CTF can also engage in a Tolling arrangement, where the CTF supplies a commodity processor with an input and takes ownership of the processed commodity. The CTF pays a fixed fee to the processor, pays the market price to acquire the input, and receives the market price for the refined products. This type of an arrangement is common with oil as the main input. Thee structures bundle together multiple goods and services. For e.g. in a simple off-take agreement, the CTF provides marketing services and hedging. A prepay incorporates these elements and a financing component as well. The seller receives cash upfront, in exchange for a lower stream of payments in the future with the discount on the sales price being effectively the interest on the prep amount. A Tolling arrangement bundles input sourcing, output marketing, price risk management, and working capital financing. The working capital element exists because the CTF has to finance the input from the time it is purchased until it can realise revenue from the sale of the refined goods after processing is complete. The benefits of Tolling entail a need for working capital to finance the timing gap between cash outflows and inflows. But, there is an ethical dilemma here: providing financing for working capital is a traditional activity banks have hitherto engaged in. When the lender lends to an entity, it leaves the entity to acquire input and market outputs, and bear and perhaps manage the price and operational risks associated with those activities. This leaves the lender exposed to risks where any adverse movements in prices could leave the entity into a financial distress and cause default. The lender could require the borrower to hedge, and if it does not, or does not do it effectively, the lender bears the risk. This undermines the incentive of the borrower to hedge, and hedge well. The lender can monitor, but this is costly and often times imperfect. The ethical dilemma is addressed by passing the risk to the lender. A prepay or Tolling does this well. These implicitly provide the funding to bridge the outflow-inflow gap, and pass on the price risks back to the lender. The lender can manage these risks and the agency costs in this arrangement is on the lower side, and since the lender bears the price risk, there is no ethical dilemma anymore. Most crucially, it takes on the incentive to manage the risks, thus quashing any need for monitoring it. the implication is that bundling price risk management and financing can reduce the cost of funding working capital needs. Furthermore, the lender may have a comparative advantage in managing risks due to specialisation and expertise in this function: CTFs and banks have a comparative advantage in risk management. CTFs with their specialisation in logistics and marketing smoothly navigate scale and scope economies. For instance, it may be cheaper for a CTF to provide marketing and logistical services thereby eliminating any associated overheads with these activities. Less sophisticated firms, on the other hand benefit hugely by delegating marketing, logistics and risk management services to specialist firms that can exploit the scale and scope economies. Thus, bundling financing and FIs make for a complementarity.
In conclusion, CTFs are here to stay, but need serious attention of regulators, for there is a scare that traders’ ownership of infrastructure allows these firms to manipulate local prices, even if they do not have the heft to rig global markets. Mochas Kituyi, secretary-general of the United Nations Conference on Trade and Development accuses the industry of corruption and illicit flows and large-scale trade mispricing in the developing world. And this is where their potential hazardous nature surfaces. Importantly, activists need the necessary instruments to dig deep in transactions that more than likely result in CTFs ride out with profit when cornered and/or investigated. In this era of black swans, the sharpening of teeth eating into the flesh of CTFs should generally commence from the knowledge economy/ecology with no truck for the dichotomy.