Nothing new about bank commodity exits, history shows

The recent exodus of banks from the commodities business is not a first. Alexander Osipovich looks back at the turbulent history of banks quitting the commodity markets, only to come piling back in a short time later

Banks in commodities: a boom-bust business

It's tough being a bank in the commodity markets nowadays. Over the past 18 months, many US and European financial institutions have either shut down or significantly scaled back their commodity units, including some firms only recently regarded as titans of the business, such as JP Morgan, Barclays and Deutsche Bank. The trend has raised questions as to whether banks have any future in commodities at all. But a quick review of recent history shows plenty of episodes where they retreated from commodities, often to jump back in a few years later once market conditions changed.

"On the way there were a lot of ups and downs, and booms and busts," recalls Jean-Marc Bonnefous, founding partner of London-based hedge fund Tellurian Capital Management and former global head of commodities at BNP Paribas. "There were a lot of cases where a lot of banks came in, hired a lot of staff, and kind of overstaffed and overdid it for a few years until they realised a normal rate of growth was actually slower... It was stop and go."

In the beginning

For centuries, banks stored precious metals and loaned money to farmers, coal miners and other such businesses, but the modern era of bank commodity trading has its roots in the 1980s.

In 1981, two significant deals began to break down the walls between Wall Street banks and physical commodity trading houses. In August that year, New York-based investment bank Salomon Brothers announced its acquisition by Phibro, a major global trader of oil, grains and other raw materials. Then, in October 1981, Goldman Sachs acquired J Aron, a US trading firm best known for its presence in the coffee and metals markets.

The core mission is still valid. You're not going to call a hedge fund to do your risk management

Other investment banks quickly followed suit. Morgan Stanley set up a metals business in 1982 and expanded into crude oil two years later. Goldman Sachs and Morgan Stanley soon became known as the ‘Wall Street refiners' because of their presence in oil and refined products, which existed side-by-side with more traditional banking businesses, such as stock and bond trading.

In bringing their financial know-how to the physical commodity markets, banks also introduced innovations, such as market-making. Previously, participants in the oil market had been either buyers or sellers. While the traders in the middle could be either long or short, they were generally not both at the same time. But the banks offered to buy and sell simultaneously, collecting money on the bid-ask spread.

John Shapiro, the second person to join Morgan Stanley's oil desk in 1984, recalls that one of his team's early successes was making markets in physical West Texas Intermediate (WTI) crude oil, in forward contracts going out as far as three to six months, which was unusual at the time.

"Nobody had ever done that before in oil," says Shapiro, who later became Morgan Stanley's global head of commodities and eventually retired from the bank in 2008. "It picked up slowly, and we did little pieces of business at first. But it was the start of an industry providing something the marketplace seemed to desire and it became fairly popular."

The biggest change that banks brought to the commodity markets was not on the physical side though. Instead, it was the introduction of commodity derivatives.

Futures markets had existed for more than a century, of course. The New York Mercantile Exchange launched heating oil futures in 1978 and WTI crude oil futures in 1983. But futures were not an ideal hedging tool for many companies due to mismatches between their cashflows and the futures expiry calendar, the need to post initial and variation margin, and poor liquidity further out in the curve, for example.

So, banks came up with a better tool: the over-the-counter swap. Drawing on their experience in the budding markets for interest rate and foreign exchange derivatives, they began pitching their clients OTC oil swaps as an energy risk management tool. Chase Manhattan Bank was the first to pull it off, executing an oil-indexed price swap with Kansas-based Koch Industries on October 6, 1986, which the bank used in turn to provide a jet-fuel hedge to Hong Kong-based airline Cathay Pacific.

Bonnefous, who set up Banque Paribas's commodity derivatives group in the late 1980s, executed another early oil swap with a French airline in 1989. OTC swaps enabled a much broader array of companies to manage their energy price risk than had been possible with futures, he explains. "There was really a gap to fill. We really created value by identifying that need and responding with solutions, in the form of new products, and then it became very standard," he says.

The burgeoning opportunities – in physical trading, futures and OTC derivatives – drew a wide array of banks to commodities in the 1980s and 1990s, including Bankers Trust, Crédit Lyonnais, Drexel Burnham Lambert, JP Morgan, Lehman Brothers, Merrill Lynch and Societe Generale.

The focus at the time was largely on crude oil and refined products, recall market veterans. "The 1990s were very much about oil," says Jonathan Whitehead, London-based global head of commodities at Societe Generale Corporate & Investment Banking (SG CIB), who began his career at oil producer Mobil in 1989. "The oil market really started embracing derivatives. It attracted a lot of speculative money because liquidity started going up, but the real reason it took off is that a lot of physical companies saw the benefits of using OTC derivatives, as opposed to futures. It was a virtuous circle: the more liquidity there was, the more hedge funds would get in, and the more hedge funds went in, the more liquidity would improve."

Rough patches

Yet many banks that ploughed into the commodity business in the 1980s and 1990s did not stick around. Aside from a few stalwarts, notably Goldman Sachs and Morgan Stanley, banks disappeared after their traders hit rough patches or after the institution itself ran into trouble unrelated to commodities.

Drexel, a major player in the early days of the oil swaps market, filed for bankruptcy in 1990, weakened by an insider-trading scandal centred around junk bonds. Salomon, which went through a complex series of name changes and battles for control in the 1980s, was crippled by its own bond-trading scandal in 1991, forcing Phibro – by that point a unit of Salomon rather than the other way around – to sharply cut back its physical trading operations.

Lehman Brothers, which had fought hard to join the club of the Wall Street refiners, changed course in the mid-1990s, announcing in 1996 that it was winding down its metals and energy business to focus on investment banking, equities and fixed income.

"A lot of banks would put their toe in the water, try for a little bit, get nowhere, lose some money and get out of the business," says Shapiro. "And there wasn't a lot of pressure to be in the business, so their staying power was very short if they couldn't make it."

The slump in oil prices in the late 1990s, which reduced volatility and trading opportunities in the oil market, prompted many banks to run for the exits in 1999, with JP Morgan, Merrill Lynch and UBS all leaving the OTC energy markets.

Commodities were unsexy at the time and other sectors, such as technology, appeared more enticing. "JP Morgan decided to embark upon a strategy they called ‘Lab Morgan'," Danny Masters, who was head of energy trading at JP Morgan in the late 1990s, recalled in an interview with Energy Risk earlier this year. "And Lab Morgan was JP Morgan's attempt to mirror what was going on in technology-land at the time. This was 1999, very close to the peak of the first tech bubble."

One London-based former commodities head believes the banks of that era failed to understand how much effort it took to build a profitable commodities business – a mistake they have made repeatedly over the years, he adds.

"In my view, banks underestimate systematically what you need to do to access that revenue pool," says the former commodities head. "They look at their foreign exchange, interest rate businesses and other fixed-income businesses, and say, ‘You know what? We know how to manage risk and we know how to measure risk, and these are core competencies of the bank, so therefore we can do it in commodities too.' And they underestimate that actually the way you make money in commodities is different, and the infrastructure you need to do that is different from those markets."

The booming 2000s

When the new millennium began, few people anticipated the stage was being set for a huge rebound in bank commodities trading. Two factors helped to spark the boom. First, the sudden collapse of Houston-based energy trader Enron in 2001 allowed banks to step into the recently deregulated natural gas and power markets it had dominated, along with other US-based merchant energy firms such as Aquila, Dynegy and El Paso, which quit energy trading soon afterwards.

Second, the start of the so-called ‘supercycle' – a generalised run-up in commodity prices, driven by a surge of demand in the developing world – brought back volatility. This helped to trigger a bonanza in bank commodities trading, which was more globalised and broad-based than before, spanning the whole commodity landscape. In addition to oil and refined products, banks could now enjoy robust trading opportunities in gas, power, coal, metals, agricultural commodities and even carbon emissions.

"Economies were firing on all cylinders everywhere in the world, China was growing like mad, and suddenly people woke up and realised there was two decades' worth of underinvestment in the supply of almost all commodities," says SG CIB's Whitehead. "A lot of people started to see tightness in supply-and-demand fundamentals for commodities, so that led to increased volatility, which stimulated the demand for risk management. So the banks had demand from their clients in terms of hedging, and volatility always attracts speculation as well, so all the hedge funds started piling in. It just grew, and grew and grew."

The banks that staged high-profile exits in the late 1990s returned: JP Morgan re-entered the markets by merging with Chase Manhattan and inheriting the latter's commodity derivatives business in 2000; UBS bought Enron's energy trading business in 2002; and Merrill Lynch acquired Entergy-Koch, the Houston-based energy trading joint venture (JV) of Koch and New Orleans-based Entergy, in 2004.

Some banks that had been second-tier players in the 1990s built out their businesses significantly in the 2000s. Barclays, which made a well-timed decision to invest in its commodities unit in 2000, grew into a major commodity derivatives dealer. Deutsche Bank, which inherited a sizeable commodities business from its acquisition of Bankers Trust in 1998, also raised its stature and began to appear regularly among the lists of top-five dealers in the annual Risk & Energy Risk Commodity Rankings.

The supercycle also stimulated interest in commodity index products, which banks marketed to hedge funds, pension funds and retail investors – a whole new line of business that sprang up alongside banks' traditional activity of executing hedges for airlines, refiners and other commercial firms.

Meanwhile, many banks deepened their involvement in physical trading, pushing into territory dominated by commodity trading houses such as Switzerland-based Vitol and Glencore. Morgan Stanley acquired Denver-based oil marketer TransMontaigne and Connecticut-based tanker operator Heidmar in 2006. Others took the route of working with trading houses, such as Credit Suisse's oil trading JV with Glencore, formed in 2005, or Royal Bank of Scotland's JV with US-based Sempra Energy – RBS Sempra Commodities – which was created in 2008.

With the ability to straddle physical and financial trading, the banks claimed to have insights into commodity markets that allowed them to be highly sophisticated one-stop shops for risk management. But some bankers were sceptical, particularly about the drive into physical markets. "When you talk about physically traded commodities, that's not in the DNA of a bank at all," says the London-based former commodities head. "Physical presents a whole additional layer of issues."

Crisis

The global financial crisis of 2008 set off a chain of events that gradually pushed many banks back out of commodities – if not because of the crisis itself, then as a result of the tough new rules imposed by regulators on the financial sector afterwards.

Bear Stearns and Lehman Brothers went bankrupt in 2008, sending their commodity units to new owners. JP Morgan acquired Bear's energy unit, along with the rest of the company. Barclays snapped up Lehman's North American assets, including its commodities business, although Eagle Energy – the Houston-based gas and power marketer Lehman acquired in 2007 – went to French multinational utility EDF.

Barclays and JP Morgan were to pick up more assets from other crisis-stricken banks. UBS announced it was exiting most of its commodity business in October 2008. The following months saw the Swiss bank sell its Canadian energy and global agricultural businesses to JP Morgan, while its base metals, oil and US gas and power businesses went to Barclays. Similarly, RBS abandoned many of its commodity market ambitions after the crisis; in 2010, RBS Sempra Commodities sold its oil, gas, power and metals assets to JP Morgan.

The eurozone sovereign debt crisis of 2010–2011, which in many ways was an aftershock of the global financial crisis, weakened a number of European banks and forced a shake-up of their commodity units. Crédit Agricole announced it was exiting commodities in 2011, while SG CIB and BNP Paribas also scaled back.

Meanwhile, new regulations were beginning to put the squeeze on bank commodity businesses. The US Dodd-Frank Act of 2010 and the European Market Infrastructure Regulation, which came into force in 2012, imposed a web of new requirements on swap dealers and pushed them to centrally clear OTC derivatives trades. Notably, Dodd-Frank included the Volcker rule, which imposed a ban on proprietary trading. The looming impact of Volcker, set to take effect in 2015, prompted many US banks to cut back their prop trading in commodities, causing many top traders to quit their jobs on Wall Street and move to hedge funds or physical trading houses.

In a separate process, the Basel Committee on Banking Supervision raised the amount of capital that banks need to hold against derivatives trades as part of Basel III, which was agreed in 2010 and 2011. Basel III makes it especially costly for banks to execute long-dated hedges for clients in volatile commodities such as power, and it has caused many to reassess the role of commodities alongside their other, more traditional banking businesses, such as equities and fixed income.

"When banks have less capital to deploy, they may decide to shut down the commodities business, not because they don't think it's a good business, but because it's expensive to run compared to others," says Benoît de Vitry, former global head of commodities at Barclays.

Finally, in another blow to beleaguered Wall Street commodity desks, US regulators and politicians began taking a closer look at banks' activities in physical markets. After a lengthy review, the US Federal Reserve signalled in January this year that it was considering imposing additional restrictions on banks' physical trading.

Faced with this prospect, some of the top commodity trading banks began to flee the physical markets they had embraced only a few years earlier. In July 2013, JP Morgan said it planned to exit physical trading, and in March this year it announced the sale of its physical commodities business to Switzerland-based trading house Mercuria for $3.5 billion – a deal that essentially unwinds most of the acquisitions JP Morgan made between 2008 and 2010. Morgan Stanley, one of the original Wall Street refiners, has also scaled back its presence in physical markets. In December 2013, the firm agreed to sell its global oil merchanting business, including Heidmar, to Russian oil producer Rosneft. In June this year, Morgan Stanley sold TransMontaigne to NGL Partners, an Oklahoma-based midstream company.

"The banks have really released all the things they worked to build from 2001 to 2008," says another former commodities banker, who splits his time between the US and the UK. "It's being unwound and it's going back to the trading houses. It's going back to the big, natural participants – the BPs of the world, the verticals – and to private equity companies. We've gone full circle."

Other banks have cut back even deeper, scaling back their commodity derivatives businesses as well as their physical operations. In December 2013, Deutsche Bank said it was shutting down its desks for energy, agriculture, base metals and dry bulk, while retaining a presence in precious metals and index products. In April this year, Barclays announced it was quitting all of its commodity activities, except financial oil and US financial gas, precious metals and index products. And in July, Credit Suisse said that it too would wind down its commodities unit.

When Credit Suisse announced its decision, it cited the need to reduce risk-weighted assets under Basel capital rules, as well as the low volatility in commodity markets in 2013 and early 2014, which hurt the unit's profitability. Bank commodity chiefs say the reduced volatility of recent years has also been a major contributor to the retreat from the business.

"A lot of people can't make money in these markets," says SG CIB's Whitehead. "Trading opportunities have diminished significantly in the past three or four years. Even if we had no Volcker rule, even if there were no change in regulation, you would have seen a significant drop in the profit of banks' commodities business."

With reduced volatility, fewer clients are approaching banks to execute hedges, undermining the core risk management business of commodity desks. At Morgan Stanley, Shapiro recalls that having a solid, consistent flow of hedging transactions was important to keeping his business going over the years. "Risk management made up for a lot of things," he says. "It was very reliable income. If you got your proprietary trading right, you'd have a great quarter; if you got your proprietary trading wrong, you still did okay, because you had this buffer. But now you can't do proprietary trading anymore, and the client business has dried up significantly."

So is the current retreat of banks from commodities just another cyclical exit, or is it a permanent reshaping of the landscape?

"The jury is still out," says Tellurian's Bonnefous. "A good part of me says it's part of the same cycle of in-and-out that we've seen for so long... This time, what has changed is the regulatory environment. The costs of conducting such an operation have increased quite a bit, so the threshold for entry has gone up."

Bonnefous argues there is still plenty of need for banks to keep dealing in commodity derivatives in order to give airlines, refiners, oil producers and other corporates a way to manage their commodity price risk – the same thing that caused banks' commodity desks to flourish in the 1980s and 1990s. And while some parts of the business have migrated to hedge funds or trading houses, banks still have an important role to play in providing hedges to their clients.

"The core mission is still valid," he says. "You're not going to call a hedge fund to do your risk management."