Too-big-to-fail risk looms over commodities

The open outcry pit at the LME.Photographer: Bloomberg/Bloomberg

A decade ago, Timothy Lane, deputy governor of the Bank of Canada, posed an intriguing question: Are commodity traders too big to fail? It was just after the 2008-09 global financial crisis, when policy makers were scanning the global economy looking for the next potential nightmare.

Lane was among a small group of officials who worried it was hiding in plain sight — that the likes of Glencore Plc, Cargill Inc., Vitol Group and Trafigura Group, the secretive giants that underpinned global trade in natural resources, represented a systemic financial risk.

"Could the failure of one of the large trading houses cause serious disruption in the commodities markets?," he asked in a speech in September 2012, arguing their size raised "the possibility" they were "becoming systemically important."

The events of the last few days, from the London Metal Exchange shutting down nickel trading to commodity titans rushing to raise credit lines, make Lane's hypothetical a crucial question right now. I have long argued that commodity traders don't matter to the global economy in the same way that Lehman Brothers did: the collapse of one won't trigger a global recession. And yet, they remain too big to be ignored — and a possible source of big trouble if left unattended.

In a letter to governments dated March 8, the European Federation of Energy Traders, a trade body that groups some of the largest commodity traders and utilities on the continent, pleaded for help. They warned that the industry was facing "intolerable cash-liquidity pressure" and may need "time-limited emergency liquidity support" to weather the crisis.

The federation said emergency liquidity could be provided directly by governments or "public-law financial institutions like the European Central Bank (ECB), European Investment Bank (EIB) or Bank of England." It warned in the letter, which was first reported by Risk magazine: "The current extreme market conditions lead to liquidity shortages which endanger the functioning of European energy markets."

The commodity market is witnessing the wildest price swings ever. Nickel, for example, surged 250% in just two days. The Bloomberg Commodity Spot index earlier this month posted a weekly jump of more than 13% — the largest one-week price increase in data going back more than 60 years ago.

The high — and volatile — prices create an enormous problem for commodity traders. They rely on bank credit to finance their cargoes of oil, aluminum, wheat and other natural resources. When prices rise, the value of those cargoes goes up, increasing their need for financing. In early December, the cost of a typical oil cargo of 2 million barrels was about $140 million. At one point last week, the same cargo was worth almost $280 million. The physical cost isn't the only problem. In the world of paper trading, as commodity prices rise and become more volatile, the amount of cash the traders need to back up their deals in the derivatives market rises significantly. Those so-called variation margin calls have run into several billions of dollars per company in recent days, according to industry executives. 

The surge in margin calls has exposed one of the weakest points of the commodity system. The LME is a case in point. When the exchange shut down nickel trading last week and canceled billions of dollars in trades, it said that without those actions, several brokers would have failed. The move on March 8 "created a systemic risk," the LME said. Matthew Chamberlain, the exchange's head, said it "would have been extremely difficult for some of our market participants to continue their activities." In a statement last week, the exchange said there was a "risk of multiple defaults."

The industry is a hidden giant of the global economy, with the largest four commodity firms moving the equivalent of more than $700 billion worth of raw materials per year. Adding every other firm, and the additional derivatives contracts beyond the physical flow, and the industry handles trillions of dollars worth of natural-resources contracts.

The LME nickel affair sounded very much like the stuff the Bank of Canada's Lane worried about a decade ago — although confined to commodity brokers, rather than traders.

Now, the nickel crisis was just a short-squeeze that wrong-footed a single Chinese tycoon and his posse of brokers and bankers. What if, instead, it had been a large commodity trading house, and not just in nickel, but across a dozen markets? And what if the commodities affected were not nickel, but rather oil, natural gas, electricity, or, God forbid, wheat and other food staples? That may not be as bad as a Lehman-induced recession but would still be a gut-punch for the global economy.

The LME trouble showed that regulators were asleep at the wheel — none saw it coming. They should quickly pay far more attention to commodity markets — not just financial, but also physical. For now, the biggest commodity traders appear well ahead of any regulators, having beefed up their finances. The spike in European natural gas prices in December was for many a wake up call. The current crisis found them better prepared. 

Then there's access to credit. High commodity prices may sound like wonderland for a trading house, but they can create hazards before generating profits. The higher the price, the more credit is needed — and right now, credit is in short supply, even for giants like Trafigura, which has been holding talks with private-equity groups for additional financing. Commodity prices have come down over the last three days, diminishing the pressure. But the industry as a whole is still under stress. In private, industry executives acknowledge they are skipping some deals to conserve cash. Lots of the price volatility of recent days can be traced by trading houses and others avoiding taking positions. The commodity market is trading risk, rather than supply and demand fundamentals. Liquidity is thin. 

Investors are showing nervousness, selling debt of some of the trading houses.  Oil trader Gunvor Group Ltd. notes due in 2026 fell on Wednesday to 69.1 cents, while the Trafigura bonds due the same year dropped to 85.1 cents. Louis Dreyfus Co., an agriculture specialist, saw its debt maturing in 2028 fall to 88.4 cents, according to Bloomberg data.

Commodities trading houses deal in U.S. dollars, but receive credit mostly from European commercial banks. If prices in multiple markets spike again because of, say, renewed sanctions on Russia, traders may struggle to access enough credit to continue buying raw materials. That's particularly a concern for the medium- and small-sized traders, who lack the deep pockets of the industry leaders. There's a serious risk that global commodity trade may freeze, even if only temporarily, creating turbulence for their bigger rivals. 

The number of banks providing commodity-trade finance in large size has shrunk significantly over the last decade, particularly with the departures of one-time industry leaders BNP Paribas SA and ABN Amro Bank NV. Today, the traders rely on the likes of ING Groep NV, Credit 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, have prompted many banks to scale back their lending to the sector or even exit completely.

The result is an industry that has fewer doors to try in a crisis. If commodity prices were to spike further, central banks may very well have to step in, making sure the flow of dollars continues, in a similar fashion to emergency liquidity injections the U.S. Federal Reserve and the ECB performed in 2008-09 during the global financial crisis. In public, all commodity traders, small and large, say everything is fine. Talk to executives in private, however, and the anxiety is plain — that their industry is one accident away from trouble. For now, we aren't there, but central banks and policy makers should prepare for that eventuality. 

Javier Blas is a Bloomberg Opinion columnist covering energy and commodities. He previously was commodities editor at the Financial Times and is the coauthor of "The World for Sale: Money, Power, and the Traders Who Barter the Earth's Resources."

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.