The return of commodities

Commodity prices were volatile in the first half of 2009, but in the second half companies gained confidence to start hedging again, making banks optimistic about 2010.

Commodity prices had a rough ride in 2009. The Dow Jones-UBS Commodities Index, a measure of global commodities prices, dropped to $99.30 in July 2009 from an all-time high of $238.20 in July 2008. The index was at $130.30 in December 2009, up approximately 15% year-to-date.

"Trading companies do need price volatility," said Willem Klaassens, global head of commodity traders and agribusiness at Standard Chartered Bank. "If there is a flat price they can't trade and they can't make money. Too extreme volatility however, is dangerous as well." He cited oils drop from around $140 per barrel in July 2008 to near $40 a barrel by the end of 2009 as an
example of extreme volatility.

These rapid moves in price were behind the record hedging losses in 2008 and early 2009 at companies that implemented strategies at the height of the market. Hit especially hard were transport firms -- Chinese state-owned firms China Eastern Air, China National Aviation and Cosco lost a combined Rmb20 billion ($2.93 billion) in 2008 and Hong Kong's Cathay Pacific Airways lost almost $1 billion in oil hedging. While most of the impact was contained in the corporate sector, the financial industry felt its ripples.

In September 2009, China's State-owned Assets Supervision and Administration Commission (Sasac) said that it reserved the right to renegotiate over-the-counter commodities derivative contracts that 28 of the country's state-owned enterprises had signed with international banks -- tantamount to a default in the words of some media outlets. The companies named included Air China, Cosco and a haemorrhaging China Eastern Airlines, while the impacted banks were reported to include Citi, Deutsche Bank, Goldman Sachs, J.P. Morgan and Morgan Stanley.

But besides these ripples, the commodities story last year was largely positive for financial institutions. "Commodity finance business for banks is countercyclical," said Klaassens. "Even if the world goes bad, commodities are basic things everybody needs on a daily basis, especially if you consider agri-commodities and some others like oil."


Traders' hedging practices have changed. Back when commodity prices were sky high and rising, many companies adopted extremely aggressive strategies that looked more like speculation than hedging, with notional values that were often several times greater than their underlying exposure.

"When the market is bullish you are not exercised on your floor, you are exercised only on your cap," said Eric Simon, Asia-Pacific head of commodities sales at Societe Generale.

But, when the market started to come down, many hedgers were caught short. If a company's oil contracts had a $90 per barrel floor and $130 per barrel cap, it was happy as long as the price stayed above $90. But when oil went below that floor level, it continued paying $90 on a notional value that was two or three times its actual exposure -- not so much a hedge as an outright bet that went terribly wrong.

So, when oil fell to about $40 per barrel in late 2008, companies that had made these types of gambles lost a lot of money.

Various bankers described 2009 as a year of two halves, where the first half was about restructuring bull-market hedges and the second half saw traders cautiously start to put new hedges in place.

Needless to say, CFOs have turned their backs on these risky hedges. "Corporates have a need to hedge to secure a [certain] level of the commodities market, either as a consumer or a producer," said Simon.

"Clients didn't move away from derivatives, they simply moved away from too exotic structures back to vanilla hedging."

This back-to-basics trend among traders has benefited natural resource-focussed banks like Societe Generale. The French bank increased its Asia-Pacific commodities team head count by 20% in 2009 and plans to add an additional 30% this year. Standard Chartered added 30 to 40 people to its regional commodities team in 2009 and South Africa's Standard Bank has spent the past two years building up its China operation on the back of a need for natural resources financing between the country and Africa.


Demand for commodity hedging strategies is not the only thing that came back in the second half of 2009; demand for the resources themselves did as well. Not surprisingly, China and India took the lead.

"China has been the major and sometimes only source of demand for commodities in the second half of 2009," said Marius Kloppers, chief executive of Australia-based resources company BHP Billiton, at the firm's annual general meeting in November.

The country's November 2008 $585 billion stimulus package did exactly what it was supposed to -- stimulate the economy. During the first 10-months of 2009 investment in fixed assets rose 33.1% yearon year-on-year to Rmb150.7 trillion and consumer spending was up 15.3% to Rmb101.4 trillion according to China's National Bureau of Statistics; both infrastructure and consumption were targeted by the stimulus package.

Helen Henton, head of commodity research at Standard Chartered Bank, said in a report that the rise in the price of base metals in 2009 was a "direct result of China's stimulus package and early recovery". The decision by the country to close 1,600 small mines in Shanxi province by the end of 2010 is only expected to further push up prices.

In India, new coal-fired power plants helped push demand for the resource up 33% year-on-year to 48.1 metric tons in 2009 according to coal consultancy the McCloskey Group.

"You have a huge demand coming from China and you have a huge demand coming from India," said Eric Saux, co-head of natural resources and energy financing for Asia-Pacific at Societe Generale. "The financing needs are really quite huge, we're talking about hundreds of billions of dollars."

Liquefied natural gas (LNG) is another rapidly growing sector in the region with big commodity financing needs. Construction of the first phase of Australia's Gorgon LNG field is projected to cost $37 billion and more financing will be needed when it begins production in 2014.

"For the last few years [LNG] activity has very much been in the Middle East and Africa," said Mark Westley, head of Asia-Pacific shipping and asset-based finance at Societe Generale. "It's now Asia-Pacific's turn to see a bit more activity."

For commodities at least, 2008's upsets are a thing of the past. Companies that trade them regularly are taking advantage of weakened competitors to consolidate local markets, backward integrate and make new upstream investments.

Standard Chartered's Klaassens said: "During the last few years all commodity prices have gone to a higher platform and that will mean that most commodities can attract more investment for development. The commodities business all over, not just in financing but also in trade, will be buoyant for the coming year."

The story was first published in the December/January issue of FinanceAsia magazine.

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