[miningmx.com] – IN October 2000, in the small London-based office of globalCOAL, we signed Enron as a market member to trade physical coal on our internet exchange. At that time, Enron was the king of commodities.
We had recently developed globalCOAL, ultimately responsible for the commoditisation of the international coal market, and for creating standard index prices for export coal out of Richards Bay and Australia, and into Europe.
However, we all knew the real excitement would come when the banks came on board. It was then that we knew we had made it and that the coal market would have “matured”.
In August 2010, there was a healthy market for both physically and financially traded coal, the financial indices for coal being derived from underlying trade in the physical market, either via globalCOAL itself or via a range of commodity journalists (McCloskey, Argus, Platts).
The established commodity exchanges (NYMEX, ICE, etc.) were all trading huge volumes of coal while the European coal utilities had become experts at coal price risk management, and were sometimes making more money from trading coal than from generating electricity.
The banks had become the liquidity providers, hiring expensive physical traders from the utilities and from the old masters, Glencore and other Marc Rich descendants. A coal trader by the name of Chan Bhima was trading for JP Morgan. His strategy went something like this…
Chan’s physical coal portfolio was essentially short physical freight, with seaborne freight being required to move coal from, for instance, Richards Bay to Rotterdam. To hedge against this structural short in his portfolio, Chan went long “implied freight”.
Implied freight is basically a mathematical formula, being the difference between the delivered coal price in Europe (API#2) minus the export price in Richards Bay (API#4).
Physical freight cannot go negative. However, implied freight can indeed go negative, i.e. when Richards Bay coal prices trade at higher levels than European coal prices. This situation has occurred a few times when European utilities dumped their spot South African coal cargoes in favour of cheaper supplies from Colombia and the US, thus forcing European coal prices down. At the same time, demand from India for South African coal helps to keep the Richards Bay coal price high.
Chan didn’t see this coming. His ego was writing cheques that JP Morgan couldn’t cash. Every time his short physical freight versus long implied freight trade went against him he would double up, believing that in time the situation would correct.
However, Chan was called in several times to explain his position to the JP Morgan credit committee. Yes, the big banks do have credit and trading limits, but they are typically big enough to ride out the swings of the market and ensure that ultimately the bank will profit.
Finally, once the mark-to-market losses had reached around $200m, Blythe Masters (the head of JP Morgan’s commodities unit) ordered the position to be cut and to take the loss on the chin. Commodity trading was basically a free option: do well and buy a Ferrari a year, or screw up and get fired.
TIME RUNNING OUT FOR BANKS
The world of commodity trading is far removed from what most people associate with banking. The real kings nowadays are the huge Swiss-based trading companies such as Glencore, Cargill, Vitol, Trafigura and Mercuria.
The man largely responsible for starting it all was Rich. He had few scruples and iron testicles, a trait which many would say is still required to succeed in the tough world of physical commodity trading. He sold Soviet oil to apartheid South Africa and ultimately lived a life of exile in Switzerland for US tax evasion, racketeering and for “trading with the enemy”.
Glencore was formed as a management buyout from Rich, with Ivan Glasenberg ultimately taking the reins. Glasenberg’s timing in the coal market was perfect, soaking up long-term supply from South Africa and elsewhere just before the coal market price boomed.
Another commodity trader was Lloyd Blankfein. In 1982, he started as a gold sales trader at J. Aron and Co (Goldman Sachs commodity division) and is now CEO of Goldman Sachs itself.
Banks were once as powerful as the international trading houses, but because they are highly regulated it is becoming increasingly difficult for them to justify being in the physical commodity business.
Since the 2008 credit crunch, banks, such as Goldman, converted to Bank Holding Companies, meaning they acquired retail banks with their mortgage and deposit base. At the same time, they were given a five-year grace period during which they had to divest their non-core businesses (physical commodities).
Those five years are now up and the Fed is due to rule in September. Of course the banks have been lobbying wildly to keep these massive profit generators running and have been spinning commodity entities off in special purpose vehicles, which would have made Enron proud.
HOW DO BANKS TRADE COMMODITIES?
Let us examine how banks deal with commodities in general.
1. Investment Banking Division, Resource Finance: This is where a bank might loan senior debt into a new mining venture. If there is equity involved it is usually on behalf of someone else.
2. FICC Division, Client Sales: Here the bank uses its access to the financial commodity markets (via its range of trading counterparties or direct exchange access) to provide hedging and trading abilities to its clients.
So, for instance, Blankfein may have called up AngloGold Ashanti to get it to hedge some of its gold via J. Aron. Here, the bank simply takes a small margin on the trade between the client and the market. This is similar to share broking and clients need to guard against the bank “front running” them.
3. FICC, Proprietary Trading: Here the bank uses its trading muscle to try and make a trading profit for itself from outright punts in the market. I knew of many prop traders who would book profitable trades to their own account and losing trades to a client account. Thankfully proprietary trading is now effectively a thing of the past for the big banks.
4. FICC, Physical Trading: This area is currently under investigation by the Fed. Here the bank is often invested in many subsidiaries that form part of the physical value chain, e.g. from the producing mine to the warehouse to the logistics providers.
This business is hard to separate from more core debt financing, but essentially it involves providing capital upfront in return for some profit margin downstream by securing and then trading the underlying commodity.
This is the realm of off-take finance or project finance that the large international traders are experts in.
Consider the current issue with LME warehouses.
The forward curve for physical copper and aluminium is in relatively steep contango, i.e. forward prices are trading at higher levels than spot prices. So when metal becomes available in a warehouse, the bank or trader simply buys up the spot material and hedges (sells) the physical metal forward on the back end of the curve, thus capturing an implicit time spread margin.
This margin is greater than the cost of carry (including storage costs and interest charges, especially when you own your own warehouse), so it’s essentially a profitable risk-free trade.
Owing to the fact the metal needs to move, you simply move it from one warehouse to another.
However, the problem comes when someone actually wants the metal to fabricate something useful, e.g. Coca Cola wants to make cans but unfortunately all the metal is tied up in these funding deals. After all, banks and trading companies don’t make cans, but they do make profits.
Clearly these profits are coming at the expense of both the original miner and the final consumer of the metal. And we all end up paying more in the end.
I don’t feel guilty about helping to commoditise coal. Commodity exchanges and the ability to trade commodity indices for hedging purposes, etc. have some value in a proper risk management strategy, for example a large coal utility. They are simply the tools of the trade.
It is when the large players, with outsized balance sheets, get involved in these physical markets to skew the profits in their direction that the trouble starts.
I think some of the big commodity traders have seen the backlash coming. But it is the regulated banks that are under the most scrutiny and that is probably a good thing as we all feel the pinch from escalating commodity prices.
Once again, the South African banks emerge as the good guys who never got their fingers dirty in the physical commodity business. Or perhaps they just couldn’t afford to employ those high-priced commodity traders in London, Geneva and Singapore.
Bevan Jones is a physical and financial commodity trader. He co-founded globalCOAL in London, and is currently working with Thebe Investment Corporation.
