The trickle of banks leaving the commodity space has become a veritable flood. Over the past six months some of the biggest global banks have announced plans to either dramatically scale back operations or exit the physical trading business entirely, leaving the space increasingly in the hands of specialized merchant banks—e.g., Mercuria and Tudor Pickering—and industry players such as Rosneft and Glencore. The reasons for the mass exodus are well known—increased regulatory scrutiny and political pressure/lawsuits, higher capital requirements as a result of the new Basel III framework, and lower profits thanks to reduced volatility and sliding prices in recent years—but less obvious is the potential impact on commodity prices and investors. In our view, the recent turmoil is unlikely to have long-term ramifications on the sector, but short-term effects are more unpredictable. Our expectation is that things will sort themselves out relatively quickly; our biggest worry is that an exogenous shock hits before things fully play out, exposing markets to price dislocations without the market infrastructure to adequately handle them.

How Did We Get Here?

As is so often the case in finance, the current bank exodus has been driven mainly by the merry-go-round of government regulations leading to corporate reactions and lobbying, followed by further regulations, causing additional reactions. Rinse. Repeat. In short, the combination of the Gramm-Leach-Bliley bill—which repealed the Glass-Steagall–mandated separation between banks and investment firms—and actions taken in the heat of the 2008 crisis—most notably granting bank holding status to JPMorgan and Goldman Sachs—resulted in certain financial firms effectively controlling access to physical commodities, thus encouraging them to create artificial shortages and boost prices.

In one widely publicized example, Goldman Sachs bought a network of Detroit aluminum warehouses called Metro International Trade Services in February 2010, at which point the average wait time for an aluminum delivery from the network was about six weeks. Over the next few years the amount of aluminum in the warehouses rose substantially—from 850,000 tons in 2010 to 1.5 million tons in 2013, up from a mere 50,000 tons in 2008—to represent about a quarter of all aluminum stored in warehouses overseen by the London Metal Exchange; wait times, meanwhile, skyrocketed to an average of 16 months, thus driving up prices. According to some estimates, Goldman and other banks may have profited as much as $5 billion over a three-year period from this artificial boosting of prices.^[1]Reuters reported on May 20 that Goldman was actively shopping the Metro unit.

The activities of Goldman (and others) generally appeared to follow the law, but as Matt Taibbi put it in a piece for Rolling Stone earlier this year, “while they may have been following the letter of the law, they were certainly violating the spirit.” In response, new regulations including Dodd-Frank and the Basel III accord have imposed restrictions on banks’ commodity-related activities, and several major banks have been hit with lawsuits and stiff fines.

It is true that banks’ commodity profits have also fallen sharply in recent years. According to the research group Coalition, commodity-trading revenues of the top-ten banks fell 18% last year to $4.5 billion, down roughly two-thirds from their 2008 record of $14.1 billion; this reversed in first quarter, with revenues up 26% year-over-year to $1.8 billion. However, this seems more of a secondary reason for banks to exit, or even simply a convenient excuse given the stepped-up regulatory pressure. Indeed, it seems noteworthy that the two banks facing the biggest fines (Barclays and JPMorgan) have arguably beaten the fastest retreat.

Et tu, Banks?

We are most concerned, of course, with the potential impact on commodity prices/investors. As noted, we expect the long-term effects to be next to nil; the dance between banks and regulators is a permanent part of the ebb and flow of capital markets, and we see nothing in the current situation that suggests a fundamental change to the business. Players such as Barclays and JPMorgan are extremely unlikely to stay out of commodities forever.

The most likely outcome is one in which banks exit the business or scale back for a time (three years? five?), then re-enter when outrage over recent excesses has cooled. Goldman’s decision to seek a buyer for Metro seems a clear signal that the pendulum has swung fully to the side “against” bank involvement in the sector. That said, a plausible case could be made this will not last long—the resurgence in money-losing IPOs and securitized debt, as well as the US government’s current push to loosen standards for home loans, are stark reminders that memories have become ever shorter in recent years.

Further, at least part of the void left by departing banks looks to be filled by … other banks. As firms like Barclays and JPMorgan leave, others are openly stating their intention to either maintain or expand operations (e.g., Citigroup, Credit Suisse, and Goldman Sachs, notwithstanding its decision to shop Metro), while still others see the situation as an opportunity to gain a foothold in the business (e.g., CIBC, Macquarie, Standard Chartered, and Wells Fargo).

What Could Go Wrong?

We are clearly entering a period where banks will play a more limited role in commodity trading, raising the prospect that an exogenous event (e.g., a China crash or geopolitical crisis) could roil markets during, or even after, this transition. As Chip Register, managing director of Sapient Global Markets and a veteran of several merchants, recently noted, merchants “lack the credit-worthiness and often the technology and processes to support the big deals done to manage risk for large commercial lending or project financing deals, or even sometimes just plain portfolio hedging many producers and consumers transact as a matter of due course.”^[2]Chip Register, “Some Banks Haven’t Given Up On Trading Commodities. And That’s a Good Thing,” Forbes, April 29, 2014.

More specifically, the issue is whether there are adequately large, well-capitalized, and willing parties to stand on the “other side” of a trade during a market dislocation. Many in the energy industry specifically cite the aftermath of the 2001 Enron collapse as an example of banks stepping in to fill the void and preventing a far worse outcome. As Register recalls, “They had big balance sheets, big risk appetites, and the ability to mobilize globally within hours to avert a larger crisis. Sure, they made money doing it, but when the markets (and the world) needed a hero, they were there. ^[3]Ibid. One can easily conjure scenarios that would roil markets today—wars in Asia, the Middle East, or Ukraine would certainly qualify—and stress the existing infrastructure in hard-to-predict ways. While new entrants could prove equal to the task, their smaller size and shallower pockets make such an outcome less likely.

The Bottom Line

The growing bank retreat from commodity-related activities is merely another act in the perpetual tussle between banks and regulators, and we fully expect banks to re-enter the space when conditions—both regulatory and in the markets—are more favorable. While timing is of course unknowable, the return (and in some cases official encouragement) of 2007-style excesses, which were themselves less than a decade removed from the late 1990s tech bubble, suggests banks’ commodity “exile” may be shorter than many assume.

Contributors

Eric Winig, Managing Director
TJ Scavone, Investment Associate

Exhibit Notes

Commodity Trading Activity at the Ten Largest Global Investment Banks
Sources: Bloomberg L.P., Coalition, Financial News, and Thomson Reuters Datastream.
Notes: Numbers in parentheses show total net revenues for each banks; ordering of banks is by revenues from commodity trading as ranked by Coalition as of December 31, 2013: (1) JP Morgan Chase & Co.; (2) Goldman Sachs & Co,; (3) Morgan Stanley; (4-6) Barclays Plc, BNP Paribas SA, and Deutsche Bank AG; (7-10) Bank of America Corp., Citigroup Inc., Credit Suisse, and UBS AG.

Commodity Trading Lawsuits & Fines Levied Against Ten Largest Global Investment Banks
Sources: BBC, Bloomberg L.P., New York Times, and Thompson Reuters Datastream.
Note: As of April 30, 2014, ten banks and brokerages have been find a total of $6.0 billion for manipulating the Libor interest rate in a scandal that dates back to 2005.

Commodity Revenues of the Ten Largest Global Investment Banks
Source: Coalition.