Mitigating the Element of Surprise in Commodity Finance

Posted on 18/09/2020

Commodity Finance

For many reasons, this year has been a rollercoaster for the commodity finance market. Understandably, it has led some participants to reassess their market activities. But rather than withdraw from the sector, there is an alternative: lenders can instead seek closer relationships with their clients. This way, risks can be managed appropriately – and hopefully in advance of real issues arising.

August this year saw large and respected European players retreat from commodity finance – which demonstrates just how severe the shocks have been for the market this year. Coronavirus-induced fluctuations in demand and impeded trade flows had severe knock-on effects on trade volumes and revenues and the Free Market Commodity Price Index recorded an almost 40% decline in commodity prices year-on-year in April 2020.

Risks abound

Sudden price collapses haven’t helped matters, either. Notably, the oil-price’s fleeting venture into negative territory earlier this year presented enormous hedging challenges. If a trader lacks an adequate buffer within their banking facilities to allow them to cover that urgent liquidity requirement, the consequences can manifest very quickly – if you don’t cover your margin calls within 24 hours of a price shock, the hedges are closed out, so reacting quickly to market conditions is essential.

And even beyond the pandemic-induced woes, high-profile bankruptcies in Asia have compounded perceptions that high risks abound in the commodity finance space. To such an extent that some large lenders are withdrawing their capacity from the market – a trend that could spell bad news for some traders, depending on their liquidity position.

As with any industry, risk is manageable provided it has been accounted for, priced in – and fully understood. Lack of transparency is a criticism that has long been levied at the market. But, in our view, this can be overcome by conducting appropriate due diligence when on-boarding clients and on financing transactions thereafter. By contrast, using balance sheet-based analysis to assess a client’s financial position – which has become a growing trend in recent years – can often lead to an inaccurate risk profiling and overly flexible lending structures.

Experience is king

Analysing the underlying trades and transactions helps develop a better understanding of a client’s business – and this becomes even more important during times of crisis. Contrary to moving away from offering commodity financing, we believe that cultivating a closer relationship with clients, can allow lenders to safely continue to extend financing on a prudent basis, ultimately promoting adherence to the highest possible standards across the industry – something that is beneficial for all involved.

For our part, we carefully select territories that we can ensure we are well-positioned to develop such relationships and do not spread ourselves too thinly. In a post-crisis environment, financing of commodity flows will be increasingly important to ensure that economies can recover. Experienced lenders with a strong expertise and a specialised in-depth knowledge of funding physical commodity traders will be essential to supporting that recovery. But for some, this may mean a reassessment of internal controls and procedures to ensure due diligence is as robust as possible.

The brave new world of financing commodity traders may seem daunting to some, however, if both financiers and lenders consistently look for ways to improve their standards, then some good may yet emerge from the current situation.

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