Dislocated supply-chains may represent the biggest ever challenge for commodity trading firms

According to a recent article on Bloomberg, “Bankers are increasingly reluctant to give commodity traders in Asia the credit they need to survive as the lenders grow ever more fearful about the risk of a catastrophic default.”

Anxiety reached new heights in the past couple of weeks after Singapore fuel oil trader Hin Leong Trading (Pte.) Ltd. announced that it was struggling to repay debts said to amount to almost $4 billion. Week’s earlier another commodities firm in the city-state, Agritrade International Pte, collapsed after a unit defaulted on its loans.

Access to capital is essential for a business that has traditionally been high volume, low margin. Although the largest businesses in the industry may be okay, it is the smaller operators that may find themselves on the hook if commodity prices move against them and other parts of the supply-chain are unable to take delivery due to covid-19 lockdowns. The problem becomes even more acute in the oil sector where storage capacity is at a premium.

What are commodity trading firms and what do they do?

A small number of huge commodity trading firms dominate the production, transportation and trading of commodities. Virtually all commodities must undergo a variety of processes to transform them into things that we can actually consume. These transformations can be grouped into the following categories: space, time and form. Firms that are involved in commodity trading attempt to identify the most valuable of these transformations, undertake the transactions necessary to make these transformations and engage in the physical and operational actions necessary to carry them out.

The areas where commodities can be efficiently produced, such as fertile land or mineral deposits, are usually away from, and often far away from, where those who desire to consume them reside. This first transformation requires the transportation of commodities from where they are produced to the places they are consumed.

The timing of commodity production and consumption is often disjointed as well. This is most readily seen for agricultural commodities, which are often produced periodically (with a crop typically being harvested once a year) but consumed continuously throughout the year. These mismatches in the timing of production and consumption create a need to engage in temporal transformations, namely the storage of commodities. Stocks can be accumulated when supply is unusually high or demand is unusually low, and can then be drawn down upon when demand exceeds supply. Storage is a way of smoothing out the effects of these shocks on prices, consumption and production.

Finally, commodities must often undergo transformations in form in order to be suitable for final consumption or for use as an input in a process further down the value chain. For example, soybeans must be crushed to produce oil and meal that can be consumed, and crude oil must be refined into gasoline, diesel and other products.

Given their size and importance to the global economy, are commodity trading firms too big to fail?

An unpublished* report from 2013, commissioned by the Global Financial Markets Association (GFMA) found that “it is unlikely that a large loss suffered by a single global commodity trading firm… poses a systemic threat to the broader financial system”, adding that “the nature of commodity trading, and the structure and capital structures of commodity trading firms makes them substantially more robust to [a financial crisis] than systemically important financial institutions”, like investment banks or big insurance companies.

*unpublished as it said the opposite of what the GFMA wanted it to say.

A more recent report (published in 2015) was carried out by Craig Pirrong on behalf of the commodity trading house Trafigura. Pirrong summarised the conclusions from his report on his personal blog:

The conclusion in a nutshell: commodity trading firms do not pose systemic risks, and therefore it is inappropriate to subject them to bank-like prudential regulations, including capital requirements. Commodity trading firms are not systemically risky because (a) they aren’t really that big, (b) they are not that highly leveraged, (c) their leverage is not fragile, (d) the financial distress of a big trader is unlikely to result in contagious runs on others, or fire sale problems, and (e) their financial performance is not highly pro cyclical. Another way to see it is that banks are fragile because they engage in maturity and liquidity transformations, whereas commodity trading firms don’t: they engage in different transformations altogether.

Indeed, a number of major trading houses have failed since 2000, without sparking disaster. Enron, which collapsed in 2001 after widespread accounting fraud, is the prime example. The entire merchant energy sector in the US imploded without disrupting the financial system or the trade in physical power and gas. More recently, Noble Group, one of the biggest names in the industry almost blew up in an accounting and and debt scandal before being restructured.

Notwithstanding the conclusion from these reports, I expect there will be lots more scrutiny over coming weeks and months. The extreme levels of price volatility observed across commodities have arguably not been tested in an environment where supply-chains are as disjointed as they are now with covid-19. With finance being pulled from many companies operating in Asia it is the smaller, less diversified firms that are most vulnerable in this environment.

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