After years in the dog house, the commodity markets are sizzling hot once again. Copper, lithium, tin, nickel, iron ore, manganese, corn, coffee, and lumber prices have all hit all-time highs. Meanwhile, those of aluminum, molybdenum, oil, natural gas, and even the world's least-liked commodity, coal, are trading at multi-year highs.
The commodity markets tend to be highly cyclical, mostly bending to the tune of the economy. The price movement of most commodities has historically been both seasonal and cyclical. However, the current commodity supercycle is mainly being driven by pandemic-driven supply bottlenecks as well as secular tailwinds such as ESG and the clean energy transition. With governments pouring billions of dollars in recovery funds into infrastructure and pollution-fighting green energy projects, this boom could last for years.
Quite naturally, commodity traders who have positioned themselves correctly have been making a killing in this market. For instance, one of the world's largest physical commodity traders, Trafigura Group, posted record profits in the first half of its financial year, generating a net profit of $2.1bn, up from $500m in 2020 on revenue of almost $100bn on the back of higher commodity prices and increased trading volumes. Meanwhile, the world's top oil trader Vitol Group has been smashing profit records in the midst of the energy crisis and high volatility in oil and gas markets.
But as is often the case in financial markets, opportunities to play in this market have been heavily lopsided in favor of deep-pocketed traders while the smaller fries have been left in the cold.
This is the case because banks have been increasingly unwilling to lend to smaller commodity traders who, ironically, need much bigger capital outlays now due to the commodity price surge. Banks such as ABN Amro Bank NV and ING Groep NV have been downsizing their lending to commodities firms as they double down on diligence following a spate of trader blowups and also due to pressure from shareholders shunning fossil fuel investments. To get a perspective of how dire the situation has become, consider that banks extended under $49 billion in commodity-finance loans to traders and producers in the first half of 2021, good for a 45% Y/Y decline and a 40% drop from the first half of 2019 as per WSJ.
Unfortunately, smaller traders have been the ones bearing the brunt of the lending drought, whereas it has mostly been business as usual for giant trading houses such as Trafigura, Vitol, and Glencore PLC thanks to their deeper pockets and proven track records.
But, again, as often happens in financial circles, where the big investment banks have been unwilling to go, other lenders have been happily stepping in.
Welcome to the world of shadow lending.
With a dearth in lending, trade finance is becoming an increasingly important alternative credit investment strategy where a growing variety of shadow banks and investment funds are becoming "the new banks".
Shadow banks–a term the industry generally resents–consists of financial intermediaries who facilitate the creation of credit across the global financial system. The shadow banking system can also refer to unregulated activities by regulated institutions, including hedge funds, unlisted derivatives, and even credit default swaps. One big distinction between shadow banks vs. traditional lenders: Shadow bankers are mostly exempt from regulatory oversight because these institutions do not accept traditional deposits. Naturally, they also charge much higher rates than traditional lenders–sometimes twice as high.
These companies have been seeing a surge in business during the ongoing commodity boom as banks turn their backs on smaller and higher-risk traders. A good case in point is one such fund, Scipion Capital Ltd., which has received 24 inquiries from energy and metals traders this year, compared with 15 in all of 2020, while prospective borrowers in the agricultural sector have risen to 24 from 10 as per WSJ. Their allure is such that even big traders are now turning to these alternative capital providers: Trafigura has lately been turning to nonbank lenders, recently issuing a $400 million perpetual bond and also managing to raise more than $4.5 billion through two securitization programs for its receivables accounts.
The elephant in the room is that shadow banks mostly provide lending to underqualified borrowers, sometimes using exotic investment instruments that triggered the 2008 financial crisis, thus fueling risk in the financial markets. You can think of them as the corporate equivalent of emergency loan companies for people with poor credit scores. But they have become so popular that their assets have ballooned to $52 trillion, a 75% jump from the level in 2010, the year after the crisis ended, according to bond ratings agency DBRS via CNBC.
Shadow banking appears to be even more rife in the beleaguered oil and gas sector.
Last year, shadow lenders and hedge funds with no misgivings about oil's carbon credentials scooped up hundreds of millions in oil industry debt. Many investment banks have been divesting their energy loan portfolios to alternative capital providers as they look to lower exposure to oil and gas lending. Many of these capital providers have been moving in to capitalize on oil and gas debt that may have been mispriced by the banks, as per Bloomberg.
Luckily, Wall Street is warming up to oil and gas companies, again.
After giving the energy sector the cold shoulder during the energy crisis, Wall Street appears willing to do business with oil and gas businesses again, but on one condition–the funds are to be used to pay down debt, not for new drilling.
Wall Street has been buying bonds from non-investment-grade U.S. energy companies, lending some $34 billion in fresh debt in the first half of 2021. That's twice as much as the industry raised over the same period last year.
Still, don't expect shadow banks or their allure to disappear any time soon.
By Alex Kimani for Oilprice.com
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