Thursday, April 7, 2011

Crude at $175? Oil traders stress test the future

Crude at $175? Oil traders stress test the future

By Javier Blas

Published: April 7 2011 09:39 | Last updated: April 7 2011 09:39

Oil at $175 a barrel; copper at $12,000 a tonne and corn at $10 a bushel. As commodity prices rally, the world’s largest trading houses have been busy ‘stress testing’ to be sure their finances can withstand a “super spike”.

The levels are not a forecast – indeed, executives tell me they do not expect such hefty prices – but do signal a “worse case scenario” for which oil, metals and food commodities traders need to prepare.

“Can we reach $175? I don’t think so,” says a trading executive. “But there is a chance of a spike to that level for one or two days if something happens in Saudi Arabia.” The same reasoning justifies tests for copper at $12,000 a tonne (think of an accident at a big mine in Chile) or corn at $10 a bushel, which could, for example, be caused by bad weather during the US planting season in May and June.

The stress tests have become more common at the physical trading houses in London, Geneva and Singapore. There is reason for it. Contrary to popular wisdom, high commodities prices are bad for pure traders: they consume lots of capital as houses need to finance their cargoes and post more collateral with exchanges for their hedges, leading to a decline in returns.

Take oil: when prices were around $50 a barrel in 2009, traders needed just $100m of capital to finance a supertanker. At current prices, they need about $250m. Not surprisingly, trading houses are now on the capital market raising multibillion dollar one- year and three-year credit lines.

Some traders are also tapping the public bond market – Trafigura did last year – while others are turning to private placements in the US.

A banker who works closely with some of the world’s largest trading houses jokes that money, rather than oil, copper or corn, is the commodity in shorter supply. Of course, it is an exaggeration: the banks’ appetite to finance the houses is very strong and traders are raising money with little trouble. But the comment holds some truth: traders will need lots of credit this year.

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I do not expect that any trading house will run into trouble: the rollercoaster market of 2008 cleared the market of the small players unable to compete because of lack of credit. Traders have also learnt from the experience, with more standby lines with banks.

Moreover, the more vulnerable smaller players that rely on “transactional finance” are protected. Yes, they need more credit, but the value of the commodities they move and that they pledge as collateral has also increased, offsetting the blow.

Nonetheless, trading executives say they are thinking twice about some trades and acknowledge that what was profitable a few months ago on the basis of risk-adjusted return on capital is no longer worthwhile because of higher credit needs.

All in all, the rise in commodities will make the life of chief financial officers and treasurers at the trading houses more difficult. With banks happy to continue lending and credit still cheap, traders will be able to weather the storm. But if access to credit gets tighter, the smaller players, which have been able to grow rapidly over the past five years, will end up as the prey of larger, well financed rivals.

javier.blas@ft.com

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