Professor Craig Pirrong, Professor of Finance at the Bauer College of Business, University of Houston, and Guest Professor at the University of Geneva, shares with us his insights on current trends in the commodities trading business and where he sees the industry heading over the coming years.
Professor Pirrong: For businesses and end-users, low prices are of course a good thing in this era of cost control – but not necessarily for commodities traders. You have to distinguish between the causes of low flat prices. Low flat prices due to high supplies are good for traders, because high supplies translate into high volumes and high margins. Low prices due to low demand, on the other hand, are not good at all for traders, as they result in lower volumes and therefore lower margins. It does mean traders have less room for error before margin erosion starts to hurt them, but I don’t see business models really changing as a result. Traders that are struggling may become smaller and be forced to focus more narrowly. This gives rise to opportunities for the larger players, however, to move into the market segments the smaller players are exiting, or even to acquire the smaller players through M&A.
The real wildcard is the impact on capital requirements. Depending on exactly which, and how, regulations are implemented, capital requirements could prove to be a massive burden. Also the costs of compliance will add up and will increase the cost of doing business. It will make trading less profitable. Again, the biggest impact will be seen on smaller traders where it may even drive some out of the market. Ironically, a policy that is supposedly intended to address “too big to fail” problems may favor the bigger firms at the expense of smaller ones.
If demand for commodities remains low, I think we will see less investment in midstream assets over the longer term. Even though they are generally less risky than upstream assets, midstream assets make traders more vulnerable to slowdowns in volumes and flows. You can already see some companies in the US, for instance, suffering significantly as a result of a heavy midstream asset footprint. There’s also a serious risk that current conditions could lead to stranded assets.
The first thing I would say is that there will be no move towards public equity, as this just doesn’t make sense at the moment. I expect financing structure models to remain stable – as they have been for some time – in the absence of anything happening in the regulatory field to really change this. For commodities traders, it’s their business strategy that drives the financing approach rather than the other way round. Some traders have become pretty clever in putting in place long-term funding strategies without sacrificing the core part of their business. These strategies most notably include spin-offs, minority shareholdings and very long-term debt. One change I think is possible over the coming years is private equity’s entry into the market. Private equity is a very good complement to the private nature of trading. The attractiveness of the commodities trading sector to private equity of course depends on whether the trading industry grows or shrinks. I can see private equity being a useful source of fresh growth.
It goes without saying that the scale of the trading industry will be very much determined by macroeconomic developments in emerging markets, especially in China. These have the capacity to impact greatly commodity demand, specifically for the metals segment, with reduced demand and lower infrastructure investments. On the other hand, I see a bright future for LNG as a traded commodity. In my view, an oversupply in LNG might be a very good thing for traders, as it will undermine the traditional model of LNG being contracted under long-term contract with little spot trade. In other words, I can really see oversupply leading to a shift in LNG such that it becomes traded more like oil. LNG will also be boosted by negative developments in coal, which is vulnerable due to threats from renewable energy sources as well as growing environmental concern. In the metals segment, really capacity needs to be withdrawn from the market. That, like most of the trends we’ve discussed, will play out over the long term.
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