Commodity Traders’ Expansion on Easy Money Seen as a Risk

Commodity trading companies active in multiple markets have used easy access to finance to expand their physical holdings, creating a potential “systemic” risk, according to two research groups in Brussels.

The merger of Glencore and Xstrata Plc signals commodity trading has reached “a tipping point,” where more investments in physical holdings rather than futures or services may lift profitability, according to a report by the Centre for European Policy Studies with the European Capital Markets Institute.

The 10 largest trading houses, which include Vitol Group, Baar, Switzerland-based Glencore Xstrata Plc and Trafigura, had almost $1 trillion in revenue in 2011, according to the report. Glencore and Trafigura declined to comment, while Vitol said commodity traders are unlikely to pose a systemic risk.

“The use of financial leverage to increase physical holdings, through the easy access to international finance helped by accommodating monetary policies, may have systemic implications,” according to the researchers. Disclosure of physical holdings and a minimum amount of information that must be provided to regulators could reduce the risks for governments, the researchers wrote.

Any failure of a commodity trader wouldn’t pose a substantial risk to the economy, Craig Pirrong, a professor of finance at the University of Houston, said in May, citing an unpublished study for the Global Financial Markets Association.

Physical Positions

Vitol, the world’s largest independent oil trader, reported revenue of $303 billion last year and Trafigura Beheer BV’s sales were $120.4 billion. Glencore Xstrata, the largest listed commodity merchant, had $189.7 billion in marketing revenue last year.

“As highlighted by the collapse of Enron, one of the largest energy trading companies of its time, physical traders are highly unlikely to pose systemic risks -- their positions are largely physical, hedged, liquid and short-term,” Vitol wrote in an e-mailed comment. “Trading houses should be allowed to fail and, when they have, there has been little or no disruption to the orderly functioning of markets or the supply of commodities.”

More than 5,000 jobs and $1 billion in employee retirement funds were wiped out when Enron Corp. plunged into bankruptcy in December 2001. Investors sued to recover more than $40 billion in market losses.

“Information on financial and physical activities for some of these global firms is limited, so an assessment by supervisors of financial stability and market structure implications is currently very hard to perform,” the researchers wrote.

Policy Research

CEPS is a policy researcher, which gets funding from the European Union, companies and national goverments. ECMI is part of CEPS and produces policy briefings and research reports on European capital markets.

International coordination may be needed to share information about physical holdings by commodity-trading companies, according to the report.

The researchers found linking of the global physical commodity markets with the financial system and accommodating monetary policy have raised the effect of the economic cycle and commodities’ vulnerability to short-term shocks coming from the financial system.

Demand and supply fundamentals remain “solid” long-term drivers of commodity futures’ price formation in all studied markets, according to the report. CEPS and ECMI looked at oil, natural gas, iron ore, aluminum, copper, wheat, corn, soybean oil, sugar, cocoa and coffee.

‘Benign’ Role

The role of non-commercial operators in commodity markets has been “generally benign,” and the growth of index investments has not yet caused distortions in price formation, according to the report.

“An indiscriminate ban on legitimate trading practices may result in liquidity losses at the expense of the efficiency of price formation,” CEPS and ECMI wrote.

Claims that the size of futures markets compared to physical markets may distort price formation could be neither proven nor ruled out, according to the report. Annual volumes of trading in the main corn future is as much as nine times larger than physical production, it said.

Public spending on infrastructure or technology to improve production may be beneficial alternatives to price subsidies, which have a possible distorting effect, the organizations wrote. China overtook the U.S. as the biggest subsidizer of agricultural commodities in 2012 at about $180 billion, according to the report.

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