PURSUED BY A BEAR: implications of banks leaving the traded energy markets
With investment banks winding down or selling off their energy trading divisions, there is a void developing in the traded market. In this article, Ujjwal Deb, Rashed Haq and Lukasz Hassa discuss the reasons for the banks’ exit, the impact on market participants and how the market might respond to these changes over time.
The past year has seen an unprecedented exodus of global investment banks from the traded energy markets. This once-in-a-generation change is dramatically reshaping the commodity market landscape since the Enron debacle in the early 2000s, when many US merchants exited the energy markets and banks streamed in chasing high returns, which led to a commodities boom that lasted until 2008. Today, the industry is coming full circle, with banks leaving and commodity merchants reentering the market.
Commodity trading revenue in 2013 for the top ten banks was $4.5 billion, down from $14 billion in 2008, according to Coalition, a London-based business intelligence provider.1 The primary reasons for banks leaving the commodity business are the tightening of their margins, increasing reputational challenges and the new regime of regulation being implemented across the globe. The lack of volatility in commodity prices, especially for natural gas and oil in the United States and power in Europe, makes it harder to earn money from financial trades. Simultaneously, some of these banks have been levied hefty fines or have been investigated for manipulating markets. Finally, regulations, such as the Volcker rule limiting proprietary positions and CFTC position limits, are the latest in a long line of regulator actions increasing the burden of physical trading for banks. Of the ten largest commodity trading firms in 2013, eight were banks and six of those have exited or are looking to exit the market.
The lack of volatility in commodity prices, especially for natural gas and oil in the US and power in Europe, makes it harder to earn money from financial trades.
RESPONSE BY MARKET PARTICIPANTS
With the banks’ exit, how will the other market participants, such as utilities, oil and gas producers, consumers and merchants, respond to fill in the void?
With their business model under unprecedented threat from the onslaught of renewables, utilities are facing their own set of challenges. As a whole, European utilities lost half their market capitalization between 2008 and 2013, according to The Economist.2 Low wholesale power prices and a lack of volatility have contributed to lackluster results from their trading desks. If it were not for lower gas prices, US utilities would fare similarly. As a result, utilities’ ability to take over a big part of the role of the banks in the energy markets is uncertain.
Oil and gas producers and consumers have largely been bank customers focused primarily on trading just enough to satisfy the needs of their existing assets, such as refineries, pipes, etc. One notable exception is an oil major that announced last year that it will register as a swap dealer and provide some of the services traditionally offered by the banks. The remaining oil and gas companies are maintaining their prior position.
Hedge funds have had limited physical involvement in the commodity markets and may face some of the same challenges as banks. Emerging players, often backed by private-equity-funded balance sheets, are positioning for some of the market share that the banks are leaving behind. However, it will take time for these firms to grow significant market share.
This leaves the merchants, with large trading footprints, well placed to take advantage of the vacuum in the energy markets. Merchants have already begun to buy up energy assets across the globe and acquire businesses from banks (e.g., Mercuria buying JP Morgan’s business, Rosneft acquiring Morgan Stanley’s business).
EVOLUTION OF THE TRADED ENERGY MARKETS
This rise of merchants is considered good for overall market safety because while they have significant presence to provide liquidity, they are not considered to be too big to fail. This is primarily due to two reasons. First, they are simply not that big, although they will grow over time. For example, Glencore is the largest merchant by assets and would rank 60th on the list of banks by assets.
Second, banks are engaged in the business of taking short-term liabilities (bank deposits) and funding longterm assets (loans to corporates), which leads to a continuous need to roll over liabilities, leaving them very prone to bank runs. Merchants, on the other hand, do not generally engage in this kind of business and have current assets that are often greater than their current liabilities. Thus, the possibility of a merchant failure, giving rise to a wave of other failures, is remote.
There are, however, risks to the rise of merchants. The transition will move the major provider of liquidity and complex financial products from the most transparent and most sophisticated firms to possibly the least so. Merchants are often the least transparent participants in the market because they are generally privately held and are less sophisticated and less experienced than the banks in managing the risk of financial products.
End users who were used to having banks provide them with sophisticated hedging and other financial products will now have to look elsewhere to meet these needs. It is possible that merchants will ramp up this business area, especially since many have hired former bank employees. However, they will also face a steep learning curve in terms of process and system sophistication, something that took banks decades of effort and money to achieve.
Lastly, the merchants’ smaller balance sheets will limit the liquidity that the banks were able to provide as market makers, particularly in cases of temporary liquidity loss in a particular commodity.
AN ACTION PLAN FOR MARKET PARTICIPANTS
For merchant firms to take advantage of this opportunity, they will need to position themselves for renewed internal governance and possible regulatory oversight.
Internal governance will need to be enhanced to speed time-to-market for new business areas. Merchants will need to define an operating model that provides visibility across all business areas so that new products and offerings can be quickly assessed. Plus, they will need to establish relevant decision trees for hedging strategy and the review and management of residual risk in incomplete markets.
Merchants will need to overcome two key challenges for this shift in governance to work. The first entails moving the organizational mindset from a siloed decision authority to an integrated one—where some desks or business areas may have to take a small loss for other areas to make a greater profit, allowing the firm to benefit. Complex financial products cannot survive on their own: they need to live and thrive in an integrated portfolio.
The second challenge is to increase the sophistication and speed of the integrated business and decision processes through the improved use of technology and quantitative methods. This requires a level of investment and sophistication that is unknown to most merchant firms. While Commodity Trading and Risk Management (CTRM) systems may have been a source of competitive advantage in the early days, today they are a baseline requirement. As they enter the energy and commodity markets, merchants must focus on preparing their businesses from both a process and technology perspective in order to effectively compete. In fact, some of the larger players have already begun outsourcing the business process execution and technology pieces to vendors with proven experience and deep expertise with CTRM systems and the market. Undoubtedly, more will follow.
For years, merchants have been able to avoid heavy regulation because most are privately held. Regulatory oversight is likely to change over time. Across different jurisdictions, regulators are increasingly stepping up their focus on the energy and commodity markets. For example, REMIT in Europe will focus unprecedented scrutiny on all players in the energy and commodity markets. (Read more about REMIT in the article entitled, REMIT: bringing physical commodity trading into the regulatory spotlight, on page 54). Dodd-Frank and the CFTC have already put in place sweeping requirements for energy and commodity firms in North America.
There is some trepidation among market watchers about how well merchants can fill the vacuum left by banks in the energy and commodity markets. However, with the right focus on transparency and increasing the sophistication of their decision-making and business processes, merchants can be in a good position to step up and lead the energy marketplace.
is a Vice President at Sapient Global Markets based in the Netherlands. He has seen the capital and commodity markets evolve over the last 17 years as a trader, risk manager and an advisor. Ujjwal specializes in harnessing technology to solve complex problems in the energy industry and has been responsible for multi-million dollar engagements at a variety of energy firms, focusing on asset optimization, data management and deal lifecycle management.
is Vice President and Lead for Analytics & Optimization for Commodities at Sapient Global Markets. Based in Houston, Rashed specializes in trading, supply logistics and risk management. He advises oil, gas and power companies to address their most complex challenges in business operations through innovative capabilities, processes and solutions.
is a Business Consultant based in London. He has extensive experience in middle-office operations and trade lifecycle management in the capital and commodity markets. Currently, Lukasz is working as a project manager on a major implementation of a front-to-back oil trading platform.
- http://www.reuters.com/article/2014/02/18 banks-commodities-idUSL6N0LN19O20140218
- The Economist, “How to lose half a trillion euros,” October 12, 2013