Prices of commodities have soared since bottoming out in the early days of the pandemic, driven by huge stimulus spending, production cuts and widespread bottlenecks across supply chains. Geopolitical events, the inability to shift energy usage away from fossil fuels fast enough and implement decarbonisation policies have created long lasting supply-demand dynamics that will continuously place upward pressure on prices. Industry alone will not be able to address all of today’s supply-chain challenges Governments and specialist finance will have to be involved.
This has led to the highest inflation in four decades in the US and UK, prompting central banks to raise interest rates. Signs that China is easing tough measures to fight the coronavirus have also helped send prices higher. The conflict in Ukraine has had an immediate impact in severely disrupting energy and grain supplies, this at a time when supplies were already strained. The Russian invasion has simply compounded this further.
As many of the knock-on effects of Russia’s invasion of Ukraine begin to embed themselves across the world economy, we look at how supply chains are changing and consider the impact of additional factors less well publicised.
What are the wider effects of the move to deglobalisation with energy and food security becoming a priority? For example, we have already seen Germany cut back on Gas usage in power generation and industrial use to ensure they have enough gas storage for the winter(1). Their switch to coal was less about price as per tradition (as the gap in Natural Gas and Coal prices began to narrow this year) instead it was driven by the desire to safeguard supply of Gas for the future.
As Natural Gas prices continue to remain high the Utilities are in need of cheaper alternatives (such as petroleum products, Biofuels, LNG.) However, as we saw with the impact of the explosion at Freeport LNG at the start of June in Texas (that had been sending 70% of it’s cargoes to Europe and accounts for 20% of US LNG processing), in a tight market like this, any unexpected albeit not hugely significant, decrease in supply can have an over exaggerated effect on price. Based on the fact Freeport will now be offline until later in the year, European buyers look set to lose around 3-4MT this year(2).
The immediate challenge faced by the west is replacing Russian Natural Gas that powers much of Europe so that factories and homes can keep functioning (especially during next winter). This requires replacing two thirds of its Russian imports of 155bn cubic metres a year. It is expected half of this will come from LNG(3). However, many LNG operators are at full capacity already and much of this output has already been sold under long term contracts. Increasing these volumes will take time – ramping up in the US takes 6 months so whilst production has been increasing since last year, it is still below the levels seen during the fracking boom of 2015.
The push for localised or regional sourcing of energy supplies is also being observed in the Nuclear market with Japan slowly bringing some of its reactors back online and France, with the most nuclear capacity in Western Europe, moving to reinvigorate its industry – a fifth of its 56 reactors are currently offline(4). Much like the time from extraction to consumption in the metals markets, or the time taken to ramp up production from oil fields, it is not a simple case of turning a switch. Many of these processes take months to multiple years to distribute into the supply chains, and this requires a constant stream of financial liquidity into the system.
The shift from global to regional sourcing was already well underway prior to the pandemic due to the China – US trade war. The disruptions during and after the pandemic followed by the invasion have merely served to accelerate the movement by Western Companies to reduce their dependency on China’s manufacturing (components and finished goods) and on Russia for transportation (pipelines, ports) and raw materials. Political factors will also naturally contribute to a more robust regional movement – if China backs Russia in the conflict for instance. The policies driving transition to a decarbonised energy system are also play a significant part. In the example of EV’s, renewable energy technology and installation, battery composition and electrification, they all require certain well-known commodities such as copper, nickel, zinc, lithium, aluminium as well as a multitude of other lesser-known materials and minerals. The supply and processing of these units involves a varied transportation system and we are beginning to see planning by some of the bigger consumers (such as Tesla(5)) to build upstream supply and become fully integrated and increase their control of the full supply chain.
We must not lose sight of the fact that, in the case of batteries, they do not create electricity – they store electricity produced elsewhere, predominantly through coal, uranium, natural gas power plants or diesel-powered generators. Matching the intricacies of the supply, demand and delivery becomes a sphere for the experts – we may see some of the major commodity corporates access this as specialists in energy distribution.
As oil and gas prices increase there is a natural correlation to higher transportation costs. However, what is equally important is that the imposed sanctions on Russia have a direct impact on constraints on the ability to use Russian transportation infrastructure to support manufacturing in Asia. Many companies build components and finished goods in China and use the Russian rail system to move these items to consumers in Europe. Alternative routes and methods are having to be implemented – but at what financial costs? To create localised manufacturing capability will take time and considerable investment. Again, increased finance in the system allows for a more efficient shift and an increase in the ability to adjust these supply chains. There is a commercial need from all parties involved to find solutions as the cost of static product or risk of demurrage penalties (over extended stay at the Port) can quickly erode any margin and profit locked into the transaction.
Commodity finance is a sector that underpins the movement of the world’s raw materials and is a process that links almost all global trade and development. The worlds essential commodities are typically moved in large quantities, involving complex operations and have high notional values. This makes the various layers of finance a critical component of enabling the links between producer and consumer.
The size of this market is today circa $20 Trillion USD(6) of transactions annually. The transactions were traditionally put together by major global banks where capital was lent in secured structures against a known buyer and known seller of a commodity that would self-liquidate against a secured payment on delivery of product. The bank would put down almost zero of its own capital as a result of which, these transactions were fully asset backed by both a commodity and some form of payment security like a Letter of Credit. As such, this formed a division within these banks that was extremely profitable and was an area of extremely low actual historical defaults (~0.02bps according to ICC Trade Report). The impact of regulation (Basel) on the commodities market has been well documented – and as we move into the next implementation of Basel (iv), due in January 2023, there will be further pressure on liquidity in the market.
In the diagram below we highlight the importance of a robust supply chain in enabling a relatively standard transaction, that is typical of the movement of essential commodities.
EXAMPLE TRANSACTION – OIL PRODUCER TO END USER OF REFINED PRODUCTS
The Commodities Supply Chain
In this infographic, the oil producer is selling crude oil to the physical trader via Bills of Lading which gives title of transfer for the goods. The physical trader then takes the crude to a refinery to further process into oil products. These products are then railed to a port and loaded into a terminal.
The physical trader then charters a ship which loads the products from the terminal for final sale to the end user to generate the profit. The end user purchases and takes title of his goods via the Bills of Lading. These types of transactions almost always use trade finance.
Typically, the movement of these commodities involve the production (supply) in one location (e.g West Africa) to another location where the processing / refining occurs (Rotterdam) and then delivered to consumers (by truck, rail etc.)
Each layer and procedure of the supply chain requires financing – logistics (truck, ship, pipeline, rail), refining / blending, and storage (terminals, ports, warehouses and the ships themselves.)
Source: Global Risks in Trade Finance Report 2017, ICC Trade Register.
KEY COMMODITY PLAYERS
Much as trade finance is often wrongly used as a catch all description, the world of commodities and it perceived risk is too. In our opinion the key players in the movement of physical commodities around the world are some of the most robust, and high calibre businesses across any asset class. Louis Dreyfus, Cargill, Bunge, ADM have been running since the 1800’s. Vitol, Trafigura, frequently have turnovers of over $300bn per year and profits of over $2bn(7). (In our view these two were public companies they would be some of the best performers of the FTSE100.) In our experience commodity traders perform too, with ROE’s between 40% to 200%+ (if they can leverage) common place. It is not only the independent traders that dominate their various areas of expertise – BP, Shell, Total, Anglo American, Glencore etc all have physical trading arms too to optimise their production and extract maximum value across the entire value chain. The one common denominator is that all these businesses have withstood the various tests of time (multiple crises, conflicts) and have often thrived in these situations where volatility is high. These businesses have a long-term view and as we go further into the energy transition phase their expertise in every step of the value chain that encompasses energy distribution should be noted. Ultimately, they are purpose-built specialists and highly capable adaptors.
FINANCING THE MOVEMENT OF ESSENTIAL COMMODITIES
Large financial institutions and Major commodity corporates have historically supplied the majority of credit needed to finance the flow of trade. The knock-on effects of banks’ capital constraints in lending means the principal users of bank financing are directly impacted (Major commodity corporates). This has further effects across the supply chain to the small and medium sized traders that rely on their financing from the Majors (due to the regulatory squeeze on bank lending to smaller, specialist players.) This further strain on liquidity and finite dollars in the system is also contributing to pressures on supply (the increase in commodity prices create an environment where banks will hit credit limits sooner, albeit on the same risk.)
According to the IEA(8) Russia produces just over 30% of the worlds energy (Crude, Natural Gas, Coal) where will the supply come from and where will the sanctioned products go to? There are currently large volumes still circulating in the system (pipelined crude into Hungary and Germany for example) and whilst this looks to be changing in the near future, it does feel that this delay seems to be playing into Russian hands. Earlier this summer major trading houses had begun a wind down of legacy deals ahead of a 15 May deadline to halt all transactions with state-controlled Rosneft, Gazprom Neft and Transneft.
Naturally there is now huge focus across Europe to find alternative supplies to Russian Crude and products (3m barrels per day (bpd) and this will take time OPEC has just 1.5m bpd of extra capacity currently. First call would be the Middle East, and we have recently seen Kuwait suggest adding an extra 1m bpd. Saudi Aramco plans to add an additional 1m bpd by 2027(9). Iran, Libya, and Venezuela capability is also being calibrated.
During the next year we believe the US will become a primary focus as they continue to become a key exporter. As this is 100% waterborne, the transactions will need to be financed across the entire supply chain.
We estimate the US could potentially accommodate an extra 1-3m bpd on top of the 6m bpd of products they currently export (according to estimates from the IEA).
The European, along with the Nordic market can change to become waterborne (oil/LNG) buyers, to compensate for the lack of pipelined natural gas flowing from Russia. Historically their crude mix was made up predominantly from Urals, but also included crude grades from the Middle East, West Africa (WAF), the North Sea, and the Gulf Coast. Coupled with this other pipeline suppliers, (such as Algeria, Azerbaijan and Norway) increased their deliveries during the start of 2022 to the European market compared with last year, demonstrating the availability of alternative supply routes.
Lower Russian pipeline flows have been compensated in part by higher liquefied natural gas (LNG) inflows, which (according to research from the IEA) increased by 63% year-on-year through October until year-to-date. LNG inflows to the EU and the UK reached an all-time high of 13 bcm in January of this year.
Whilst some of the initial shortfall of energy supplies has been accounted for, it should be noted that the infrastructure needed for LNG (Regasification terminals, pipelines as well as ships) is expensive and will take time to develop further. The lack of recent investment will also have a delaying impact. Notional amounts to finance and hedge these LNG cargoes also requires significant finance (LNG spot cargoes soared to $205m following the recovery from the pandemic)(10).
The Mediterranean Refineries used Urals (from the Black Sea), however also mixed in other crudes such as Siberian light, Azeri and North African (Egypt, Algeria), Middle East and West Africa (WAF,) and will need to adjust these inputs accordingly. The main disruption is predominantly refinery feedstocks / crude – Natural Gas, Condensates, VGO, Straight run, MTBE and Gasoline blending components. In terms of underlying, we believe this is one of the lowest risk in the energy sector due to the liquidity and flexibility of the products (ie there is need for the products in multiple areas.) While crude prices may have decreased, diesel and gasoline cracks increased to record levels, pulling up refinery margins and end-user prices. Limited spare capacity in the global refining system, together with reduced exports of Russian fuel oil, diesel and naphtha have further contributed to the tightness in product markets, which have now seen seven consecutive quarters of stock draws (storage). According to the IEA June report, Refining capacity—which has dropped by some 3 million bpd since COVID—is expected to rise by 1 million bpd this year and 1.6 million bpd next year, per the agency’s estimates. However, they also expect the products market to remain tight sighting concerns over diesel and kerosene supplies:
“OECD industry stocks of middle distillates have fallen by 25% since January 2021 to their lowest levels since 2004. That very limited cushion is driving middle distillates prices to record highs, with a knock on effect for other products, (such as Gasoline) which could cause more pain at the pump just as pent-up demand is unleashed during the peak driving and summer cooling season,” the agency added.
They also added that their view was that oil demand growth is set to accelerate next year, with global demand averaging a record 101.6 million barrels per day (bpd) and exceeding pre-COVID levels. The higher prices and weaker economic outlook are moderating consumption currently, a returning China and the start of the driving and cooling season will begin to drive up consumption again. Next year will see further strain on supply as further sanctions begin to get implemented at the end of the year.
UNDERSTANDING THE RISKS
Increased scrutiny, process, and experience will need to be called upon to ensure that no sanctioned products, looted Ukrainian grain, nor disguised Russian ships are part of the value chain.
As we have seen the sanctioned Urals and other materials will likely go to China, and India, and possibly some parts of the Middle East and Africa, North Korea, Pakistan, as well as some of the LATAM countries. How can we establish whether they are entering the system elsewhere?
These consumers will have to pay using Roubles, Debt, barter trades or possibly Crypto Currencies.
The dry bulk cargoes used for Metals and Agricultural products are generally smaller, with smaller volumes being transported. This means the calibre and scrutiny of maritime processes can some times be less stringent – smaller players can play in this market, where reputation is less important to protect and the need to do business at any cost is high. The lower financial grade, and lower necessity of top tier financing may lead to an increase in risks.
Crude is still the most robust underlying – there are many different grades, all of which are easily resalable, notional size is large, with good calibre counterparts (due to the inherent size), and there is depth, with crude being the largest commodity by notional value. This allows for greater selection and choice, which ultimately provides the ability to say no to a transaction.
In order to mitigate as much of the risk as possible Due Diligence needs to be done through the whole value chain, with an understanding of the flows behind the relevant transaction being a critical component. Key requests can be made such as proof of a certificate of origin by the chamber of commerce or ministry, who is the beneficiary of the company, and an in depth understanding of all counterparts and their roles across the entire chain.
What is clear is that even prior to the pandemic the supply side had been tightening (due to under investment and the energy transition move.) The pandemic, followed by increased consumption post pandemic, the conflict and now China’s (the world’s second largest energy consumer) forthcoming emergence out of various quarantines have all compounded in the shortfall of available supply. The reduced supply of raw materials have a direct impact on the prices of the refined materials (Gasoline and Diesel, Steel Rebar, Copper Cathode, Flour.) This increased margin ultimately needs to be passed on to the consumer.
To conclude, the market is adapting and with new commodities flows being established and energy and food security policies are being implemented. The need globally to increase storage of essential commodities will continue to ensure stocks are in good shape for the cold months and industry can continue to function, and food sources are available. The need for more liquidity into the market, in times of high prices, regulatory burdens, and a shift from global sourcing to regional will be crucial in providing a solution to freeing up the movement of these essential commodities. The major players have been through these situations many times over the last century and their expertise in navigating these volatile times should not be underestimated.
Next time we will be producing a Primer on bulk commodity supply chain financing – describing and illustrating the chart below. This will explain what each financial leg does and why. We look forward to sharing that in August.