Macaskilll on markets: Towards a lower-octane commodities business
The end of the commodities super-cycle of rising prices is being accompanied by a series of humiliating reverses for some of the biggest bank traders in the energy and metals markets. These banks might struggle to retreat to a sustainable, client-based commodities business model, given over-ambitious former revenue targets, the over-sized egos of some of the main players involved, and the extent to which they have alienated customers and regulators.
JPMorgan has become a symbol of this hubris, with the tribulations of its commodities head, Blythe Masters, drawing some attention away from the many problems faced by the traditional big-two bank traders of commodities, Goldman Sachs and Morgan Stanley.
JPMorgan in July backed down from its opposition to a hefty fine for manipulation of the US electricity markets and only narrowly avoided personal censure for Masters and some of her staff for providing misleading testimony to the Federal Energy Regulatory Commission.
The fine is likely to wipe out any profit from commodities trading made by JPMorgan in the last year or more, as well as compound the bank’s other recent reputational mis-steps. JPMorgan made an aggressive push into commodities trading after Masters was appointed to run the group in 2007 and was competing with Goldman to be revenue leader in the sector among banks by last year, with over $1 billion of revenue, according to industry estimates. Rival dealers estimate JPMorgan’s substantial staff costs and do not believe that the firm currently makes much actual profit from commodities, however. The electricity-trading abuse fine is likely to outweigh any recent profit just as revenues from the sector are falling sharply and is especially embarrassing given that Masters is head of regulatory affairs for JPMorgan’s corporate and investment bank, as well as its commodities chief.
At the same time as JPMorgan was negotiating the terms of its fine for electricity-market abuse, there was a growing drumbeat of criticism in Washington of the way banks including Goldman Sachs use their ownership of metals warehouses to profit from bottlenecks in commodity supply chains. This prompted the Federal Reserve to announce that it is reconsidering its current rules that allow banks to deal in physical commodities, in turn forcing dealers to re-evaluate how to position their activity in the sector to shareholders and clients.
Goldman is run by two commodities veterans – CEO Lloyd Blankfein and president Gary Cohn – and has former commodities head Isabelle Ealet as one of its global securities co-heads.
This might be informing an attempt by the bank to counteract a perception that it will be forced to slash its commodities business because of falling revenues and reputational issues.
"We entered that market in 1981 and it has been core to our clients and the integrated strategy of the securities business," CFO Harvey Schwartz said on the firm’s quarterly earnings call in July, stressing Goldman’s "multi-decade commitment" to commodities, in what sounded like a prepared talking point to address concern among both employees and clients about a potential pullback.
Morgan Stanley CEO James Gorman is a former management consultant who has no obvious sentimental commitment to individual business lines, especially in sales and trading sectors that can produce earnings volatility. Morgan Stanley has been relatively open about its move to scale back its commodities staff numbers, with cuts of 10% or more already under way, and it has done little to dampen speculation that it has been trying to sell the entire business.
This can be seen as a clear-headed approach to a sector that might struggle to top $4 billion of revenue for banks this year, down from levels comfortably above $14 billion in 2008 and $12 billion in 2009.
But it also has its risks for Morgan Stanley, which was historically the most reliant on commodities as a proportion of overall fixed-income revenues among the main dealers. Morgan Stanley has so far failed to meet its goals for increased market share in the rates sector that is the single biggest fixed-income business line for banks. If it is viewed as being in headlong retreat from commodities trading there could be renewed questions about whether or not the bank can remain in the top tier in fixed income globally.
Other banks that have bigger rates and credit businesses than Morgan Stanley are also scaling back their drive into commodities trading, with reputational issues proving to be one of the main problems as they attempt to find the right size for their presence in the sector.
Barclays, which was for a while a member of a top three in commodities revenues alongside Goldman and Morgan Stanley, has cut dealing staff by around a third, including high-profile departures such as last year’s move by former commodities head Roger Jones to Swiss trading firm Mercuria.
Deutsche Bank, which had made a multi-year push into commodities, also shed its veteran commodities head last year, with the exit of David Silbert, and cut staff in key sectors, ranging from oil to gas and power trading.
Barclays had some metals-trading stumbles in recent years, in markets such as copper and aluminium, but two keys to its scale-back seem to have been the capital required for long-dated commodity derivatives trades, such as volumetric production payment (VPP) deals, and broader reputational issues stemming from its commodity trading. Like JPMorgan, Barclays has received a substantial fine for electricity-trading abuses in the US, although it has pledged to fight its $435 million penalty.
Structures such as VPP deals had an appeal for both dealers and their clients that at one stage seemed to set the scene for growth in revenues for banks that was not predicated on taking proprietary exposure to commodity price direction.
Banks including Barclays could offer funding to clients secured on their oil or gas revenues and sell on exposure to different types of investors via derivatives based on the energy flows, to reduce the on-balance-sheet exposure retained by the bank.
As with many other long-dated derivatives trades this business is becoming uneconomical for banks as new capital rules are implemented, however. And the example of VPP deals for Chesapeake Energy shows how commodity market innovations can bring reputational headaches to both dealers and their clients, even when there is no evidence that the bank has been trying to exploit any customer.
Chesapeake’s veteran CEO, Aubrey McClendon, was forced out of his role earlier this year in part because it emerged that VPP deals with Barclays and others had saddled the firm with far greater liabilities than it initially disclosed, for example.
Now Barclays, like other banks, faces the challenge of reshaping its commodities business to focus on financing and risk management, with additional investor product revenue as a potential bonus. As with many areas of investment banking it will be a lower-octane and lower-margin business, but potentially at least more stable.