Streetwise Professor

March 16, 2022

The Current Volatility Is A Risk to Commodity Trading Firms, But They are Not Too Big to Fail

The tumult in the commodity markets has led to suggestions that major commodity trading firms, e.g., Glencore, Trafigura, Gunvor, Cargill, may be “Too Big to Fail.”

I addressed this specific issue in two of my Trafigura white papers, and in particular in this one. The title (“Not Too Big to Fail”) pretty much gives away the answer. I see no reason to change that opinion in light of current events.

First, it is important to distinguish between “can fail” and “too big to fail.” There is no doubt that commodity trading firms can fail, and have failed in the past. That does not mean that they are too big to fail, in the sense that the the failure of one would or could trigger a broader disruption in the financial markets and banking system, a la Lehman Brothers in September 2018.

As I noted in the white paper, even the big commodity trading firms are not that big, as compared to major financial institutions. For example, Trafigura’s total assets are around $90 billion at present, in comparison to Lehman’s ~$640 billion in 2008. (Markets today are substantially larger than 14 years ago as well.). If you compare asset values, even the biggest commodity traders rank around banks you’ve never heard of.

Trafigura is heavily indebted (with equity of around $10 billion), but most of this is short term debt that is collateralized by relatively liquid short term assets such as inventory and trade receivables: this is the case with many other traders as well. Further, much of the debt (e.g., the credit facilities) are syndicated with broad participation, meaning that no single financial institution would be compromised by a commodity trader default. Moreover, trading firm balance sheets are different than banks’, as they do not engage in the maturity or liquidity transformation that makes banks’ balance sheets fragile (and which therefore pose run risk).

Commodity traders are indeed facing funding risks, which is one of the risks that I highlighted in the white paper:

The extraordinary price movements across the entire commodity space have resulted in a large spike in funding needs, both to meet margin calls (which at least in oil should have been reversed with the price decline in recent days–nickel remains to be seen given the fakakta price limits the LME imposed) and higher initial and maintenance margins (which exchanges have hiked–in a totally predictable procyclical fashion). As a result existing lines are exhausted, and firms are either scrambling to raise additional cash, cutting positions, or both. As an example of the former, Trafigura has supposedly held talks with Blackstone and other private equity firms to raise $3 billion in capital. As an example of the latter, open interest in oil futures (WTI and Brent) has dropped off as prices spiked.

To the extent margin calls were on hedging positions, there would have been non-cash gains to offset the losses on futures and other derivatives that gave rise to the margin calls. This provides additional collateral value that can support additional loans, though no doubt banks’ and other lenders terms will be more onerous now, given the volatility of the value of that collateral. All in all, these conditions will almost certainly result in a scaling back in trading firms’ activities and a widening of gross margins (i.e., the spread between traders’ sale and purchase prices). But the margin calls per se should not be a threat to the solvency of the traders.

What could threaten solvency? Basis risk for one. For examples, firms that had bought (and have yet to sell) Russian oil or refined products or had contracts to buy Russian oil/refined products at pre-established differentials, and had hedged those deals with Brent or WTI have suffered a loss on the blowout in the basis (spread) on Russian oil. Firms are also likely to handle substantially lower volumes of Russian oil, which of course hits profitability.

Another is asset exposure in Russia. Gunvor, for example, sold of most of its interest in the Ust Luga terminal, but retains a 26 percent stake. Trafigura took a 10 percent stake in the Rosneft-run Vostok oil project, paying €7 billion: Trafigura equity in the stake represented about 20 percent of the total. A Vitol-led consortium had bought a 5 percent stake. Trafigura is involved in a refinery JV in India with Rosneft. (It announced its intention to exist the deal last autumn, but I haven’t seen confirmation that it has.). If it still holds the stake, I doubt it will find a lot of firms willing to step up and pay to participate in a JV with Rosneft.

It is these types of asset exposures that likely explain the selloff in Trafigura and Gunvor debt (with the Gunvor fall being particularly pronounced.). Losses on Russian assets are a totally different animal than timing mismatches between cash flows on hedging instruments and the goods being hedged caused by big price moves.

But even crystalization of these solvency risks would likely not lead to a broader fallout in the financial system. It would suck for the owners of a failed company (e.g., Torben Tornqvuist, who owns ~85 percent of Gunvor) but that’s the downside of the private ownership structure (something also discussed in the white papers); Ferrarri and Bulgari sales would fall in Geneva; banks would take a hit, but the losses would be fairly widely distributed. But in the end, the companies would be restructured, and during the restructuring process the firms would continue to operate (although at a lower scale), some of their business would move to the survivors (it’s an ill wind that blows no one any good), and commodities would continue to move. Gross margins would widen in the industry, but this would not make a huge difference either upstream or downstream.

I should also note that the Lehman episode is likely not an example of a domino effect in the sense that losses on exposures to Lehman put other banks into insolvency which harmed their creditors, etc. Instead, it was more likely an informational cascade in which its failure sent a negative signal about (a) the value of assets held widely by other banks, and (b) what central banks could or would do to support a failing financial institution. I don’t think those forces are at work in commodities at prsent.

The European Federation of Energy Traders has called upon European state bodies like European Investment Bank or the ECB to provide additional liquidity to the market. There is a case to be made here. Even though funding disruptions, or even the failure of commodity trading firms, are unlikely to create true systemic risks, they may impede the flow of commodities. Acting under the Bagehot principle, loans against good collateral at a penalty rate, is reasonable here.

The reason for concern about the commodity shock is not that it will destabilize commodity trading firms, and that this will spill over to the broader financial system. Instead, it is that the price shock–particularly in energy–will result in a large, worldwide recession that could have financial stability implications. Relatedly, the food price shocks in particular will likely result in massive civil disturbances in low income countries. A reprise of the Arab Spring is a serious possibility.

If you worry about the systemic effects of a commodity price shock, those are the things you should worry about. Not whether say Gunvor goes bust.

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5 Comments »

  1. Lehman Brothers in September 2008, not 2018, right?

    Comment by Dave Mason — March 16, 2022 @ 5:03 pm

  2. I am reminded of a period I worked and lived through: The collapse of the Gas & Power traders due to Enron’s failure. I recall all the Enron folk at the time trying to make the argument they were too big to fail and supposedly going to (the late) Treasury Secretary (and former Alcoa CEO) Paul O’Neill. All I could think was good luck with that. The Energy industry in the 1990’s were divided between traditionalists who were hard asset & control types and the Enron financial and contract (asset lite) types. O’Neill struck me as highly in the former camp. And as a PhD & former government economic bureaucrat, he didn’t buy what Lay (also with both those backgrounds) was selling.

    Anyway, after the fall out, liquidity in the gas market got real low and bid-ask spreads very wide. Buddies who were able to stay afloat could (again) make real money trading (like the early days of the gas market – say late 1980’s). Most of the best Enron & other traders found new financiers and made big bank elsewhere. And as it rebuilt, posting LC’s became the norm and the true economics of trading to everyone were exposed.

    Comment by JavelinaTex — March 17, 2022 @ 10:44 am

  3. Another thought on the Lehman situation and the informational aspect of the crisis. That was that perhaps the AAA rated tranches of the securitized mortgages were not so sound. And that, after (I think) Sarbanes Oxley that all financial assets should be “marked to market” (as opposed to the old not really joking: “mark to model”). Anyway, I had one financial adviser state (and I think ultimately correctly) that that requirement should be removed. The mark to market had been in place in 1937 (coming out of early New Deal reforms) and all it did was cause a massive bank liquidity crisis in the 1937 “Recession”. FDR cancelled it, and that was policy until the early 2000’s. Anyway, anyone who lived through the 1970’s to early 1990’s knew at times that the S&L’s and many Banks of all sizes, including many of the largest, were technically insolvent. If I recall correctly, the overwhelming majority of those AAA tranches paid off at par. So all Mark to Market accomplished was to create a massive liquidity and financial crisis out of relatively short term market phenomenon.

    Comment by JavelinaTex — March 17, 2022 @ 10:58 am

  4. Did the volcker rule have a role in curbing the size of commodity linkages into financial firms? I vaguely remember Senator Levin’s committee hearings from 2013 where nearly all TBTF banks were playing in commodity markets, hoarding oil due to contango etc etc. all manner of commodity involvement, post GFC. Did Volcker save us here?

    Comment by Kiers — March 18, 2022 @ 4:31 pm

  5. Juck Foe Biden

    Comment by Joel — March 21, 2022 @ 7:30 pm

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