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 In the thriving Texas Permian oil patch and beyond, banks are being
edged out by a handful of the world's biggest corporations including
BP Plc, Cargill and Koch Industries.
With Wall Street hamstrung by growing regulatory restrictions, a
recently finalized ban on proprietary trading and increased capital
requirements, these corporate behemoths are leveraging their robust
balance sheets and savvy global trading desks to capture as much as
a quarter of the global multibillion-dollar market for hedging
commodity prices.
New risks have arisen this year that could tilt the scales further,
as the Federal Reserve considers limiting banks' ability to trade in
real physical markets, the kind of deals that are increasingly
important for many of the smaller and mid-sized companies at the
fore of the U.S. energy renaissance.
Just ask Alan Barksdale, president and chief executive of Red
Mountain Resources, a conventional driller in the Permian Basin.
Early this year his company was shopping for a counterparty to
execute derivative trades that would protect some of its near 900
barrels of daily production from a possible price drop. Barksdale, a
former investment banker, was looking to lock in "costless collars,"
a type of specialized options trade.
After reviewing a number of offers, including some from Wall Street
firms, he chose BP Energy Corp, a unit of the oil and gas major's
trading division. In part that was because BP was already working
with the firm's lenders. But Barksdale was also interested in a
partner who could one day take physical delivery of his crude,
potentially netting Red Mountain an extra dollar or more per barrel.
"As you grow as a company, you'd like some flexibility to get some
physical delivery," Barksdale said. "When you're dealing with
somebody who is long a commodity, you get better service."
Ten years ago, only a handful of banks would have likely handled
such a trade. Over the past decade, however, more than a dozen
rushed into the commodity trading business, acting as lenders,
counterparties and risk managers.
Now some of the biggest are beating a hasty retreat. Deutsche Bank
became the largest victim last week, announcing plans to exit most
trading under mounting regulatory pressure and diminished
profitability.
Others are like JPMorgan Chase & Co and Morgan Stanley are poised to
carve out their large physical trading operations — things like oil
storage tanks, gasoline cargoes and power plants — but will still
compete fiercely on derivatives deals, trades they can combine with
financing or other activities. Goldman Sachs has been resolute that
the bank will continue trade both cash and paper commodities.
While most banks have blamed regulations and lower market volatility
for the sharp slump in commodity earnings, at least a portion of the
decline appears to stem from the corporate giants quietly stealing
banks' core business: serving clients.
Commodity revenues at the world's top 10 investment banks has fallen
from a peak of more than $14 billion in 2008 to just $5.5 billion
last year, according to consultants Coalition. One senior executive
at a top 10 commodity bank said corporations had taken as much as a
quarter of the global hedge book away from banks, including deals
with airlines and utilities.
"When you look at the market overall, the commercial firms are
making in-roads into the hedging business," says Andy Awad of
Greenwich Associates, which conducts an annual survey of hundreds of
companies that hedge commodity prices. "I would imagine the pace of
change is going to increase."
While the big non-bank companies have not yet cracked the top tier,
four of them made it into the top 20 U.S. energy hedgers this year,
he said.
RETURN OF THE CORPORATES
As banks withdraw, the conventional wisdom has been that foreign,
privately owned commodity merchants like Vitol and Trafigura — which
typically trade only for themselves — would fill the market void,
particularly in the costly, complex realm of physical trading.
While they may help bolster liquidity, most of those firms are
loathe to take on the onerous regulatory burden now required to
become a major derivatives trader.
Yet this year, units of BP, Royal Dutch Shell and Cargill all
formally entered the big leagues of derivative dealing, registering
as "swap dealers" alongside dozens of the world's biggest banks. As
the most heavily regulated type of derivatives trader under the
Dodd-Frank law's financial reforms, they face onerous record-keeping
and trade reporting rules, but also have the latitude to hedge with
far more clients, and to trade in excess of $8 billion in swaps a
year.
To be sure, banks retain many advantages in the business. As the
leading lenders to the world's industries, they can offer bundled
services and leverage existing lines of credit; the derivatives
operations of the biggest players, even those selling some parts
such as JPMorgan, remain competitive on pricing.
Yet they are suffering setbacks across multiple fronts.
Some of their most valuable traders are now being hired away by
private merchants who can offer higher salaries and bigger bonuses.
Tougher capital requirements under the Basel III international
accord are raising banks' funding costs and narrowing profit
margins.
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"We have a strong balance sheet and an ability to manage these price
risks," said Cody Moore, head of North American Gas and Power at EDF
Trading, a unit of France's government-backed utility, EDF.
The group was formed in 1998 and expanded its international reach
ten years later with the purchase of Lehman Brothers' physical
trading unit Eagle Energy during the financial crisis. Its revenue
has surged 60 percent since 2008; pre-tax profits at the firm, one
of the few to separate its financial performance from that of the
parent group, reached nearly 500 million euros in 2012.
With some 350 people in its Houston office alone, EDF Trading is now
the leading energy management provider for power generators in the
United States. Last year it hired a small team to expand into oil
market logistics.
Corporations have another advantage — unlike banks, they are not
banned from trading with their own money.
Under the Volcker Rule, which was formally approved by regulators
this month, banks can no longer engage in proprietary derivatives
trading — giving them less incentive to chase customers simply for
the benefit of valuable insight into a particular trend they may be
able to trade themselves.
"In the past, the information was worth something to a bank if you
had a proprietary desk," says Eric Melvin, a former trader at an
investment bank who now runs boutique Houston-based risk-advisory
firm Mobius Risk Group.
He estimates that investment banks now account for only about half
of the U.S. oil and gas-hedging business, with corporate merchants
accounting for some 40 percent, up from almost nothing just a few
years ago.
PHYSICAL STRENGTH
For most of these companies, one of their biggest selling points is
the ability to manage the risk of some of the most esoteric or niche
energy markets in the world — typically because they already trade
those commodities for themselves.
"We're willing to stand in as a provider of risk-management where
many or most others won't," says Steve Provenzano, BP Energy's Chief
Commercial Officer for client hedging in the Americas. "Obviously
our involvement in the physical business gives us credibility."
Long the largest U.S. natural gas trader and a major global oil
operator, BP also has 20 people who help arrange customer
derivatives trades in North American alone, and more than 3,000
wholesale customer worldwide, he said.
While Wall Street awaits the completion of a Federal Reserve review
of commodities trading — the results of which are expected early
next year — corporations that hedge energy prices are placing a
greater importance on the ability of a counterparty to trade in
physical markets, according to Greenwich Associates' latest survey.
"I think what we're seeing is that people recognize you can't
divorce the financial and physical, they're linked," says Awad.
Meanwhile competitors are stealing a march.
Minneapolis-based Cargill, better known for its prowess in
agricultural markets, has recently moved its Houston trading group
to a larger office with room for over 100 traders, online industry
publication SparkSpread.com reported this month. Cargill employs
more than 1,000 people in its Geneva-based Energy, Transportation
and Metals business, and executives have said they are looking to
expand as others divest.
A spokesman for Cargill declined to comment on the business.
Koch Supply & Trading, a unit of the $115 billion a year
conglomerate owned by Charles and David Koch, is famed for having
traded the first oil swap over 25 years ago, and says it now has
nearly 500 traders, marketers and energy and metal markets
professionals worldwide. It expanded its European natural gas team
last year, and minces no words in promoting itself as a more
constant alternative to Wall Street.
"While some financial institutions' market coverage varies with
global market cycles, KS&T companies take a longer term view," it
says in a recent online brochure. Koch offers market liquidity "at
times when others pull back."
(Reporting by Jonathan Leff; additional
reporting by Dmitri Zhdannikov in London; editing by Tim Dobbyn)
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