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10/9/2008 2:37:00 PM
Lacking Credit, Trust, Banks Exiting Physical Energy Markets
NEW YORK (Dow Jones)--Banks are beating a hasty retreat from the physical oil and fuel markets, as the credit crisis cuts financial institutions out of a once-promising line of business.
Much like the credit market itself, the trading of physical barrels of oil or refined products for prompt delivery relies on trust. Deals are arranged between two parties or through a broker, and most agreements aren't cleared, meaning that if one side doesn't hold their end, the other takes the loss.
Physical deals are priced off of benchmark futures contracts, which are traded on exchanges in financial transactions that rarely involve exchanging actual commodities.
Companies often use borrowed cash to finance inventories and the transportation of oil and fuel by pipelines or tankers, making it difficult for companies seen as default risks to operate in the market. Over the last month, confidence in the banking sector has been badly shaken, with several failures, a rash of forced mergers and expectations of even more government support. In some energy markets, banks are being kept at arm's length by oil companies and refineries that are wary of not being paid should a counterparty join the list of failed banks.
Financial institutions are more active in the futures exchanges, where all trades are cleared.
Some large oil companies have issued internal memos forbidding their traders worldwide from dealing with Morgan Stanley (MS) and Merrill Lynch & Co. (MER), two of the more active banks in physical commodities. Merrill Lynch agreed in September to be acquired by Bank of America Corp. (BAC). Spokespeople for both Bank of America and Merrill Lynch said it is too early to say what will happen to either bank's trading desks.
"They are reducing their exposure," said one broker of physical oil on the Gulf Coast, who is not cleared to speak to the media and requested anonymity. "And they really don't have a choice because the traders are not trading with them."
The chilly reception in the markets is a dramatic turnabout for financial institutions whose executives prided themselves on having the foresight to get into trading of physical crude and oil products before prices surged. Until recently, major investment banks had been planning expansions into physical markets long dominated by producers and refiners. Now, those same banks are saddled with losses tied to mortgage-related securities and can no longer dependably raise new funds in the credit market. Turning a profit has also gotten more difficult in the physical energy markets as underlying oil and product futures have plunged 40% or more from summer highs.
Oil futures recently traded 1.9% lower at about $87 a barrel, compared with an intraday record of $147.27 a barrel on July 11. Gasoline futures hit a one-year low of $1.95 a gallon on Wednesday.
The banks' absence is noted in lower trading volume in markets ranging from U.S. Gulf Coast crude to Asian fuel trading. Energy companies say they are still using the markets to manage supplies without difficulty. What's not clear is when financial companies will have the strength to return to previous levels of trading activity - or if the banks still standing will want to.
And Then There Were None
Every major U.S.-based investment bank involved in physical commodities markets has succumbed to the financial crisis either by selling to a rival, filing for bankruptcy or converting to a bank holding company.
Goldman Sachs Group Inc. (GS) and Morgan Stanley, the U.S. banks with the biggest commodities operations, both went the commercial route on Sept. 21. Commercial banks have a strict limit on how much they can borrow in excess of assets, and the big ones, including Citigroup Inc. (C) and Bank of America, have generally not been as active in physical oil and products markets, where trading is by necessity often funded through short-term loans.
Both bank holding companies say the conversion will not affect their energy trading operations, though Morgan Stanley's chief financial officer indicated to a UBS AG (UBS) analyst this week that physical commodities could be divested.
"We found this comment a little surprising as we always thought of the physical component of the commodities business as a major source of Morgan's 'edge' in this business," wrote Glenn Schorr, the analyst.
Morgan Stanley has definitely lost its edge, said a trader with a European trading house.
"In the past, it was Morgan Stanley who would decide who it would trade with," the trader said. "But now it's a totally different story."
Some investment banks, particularly those based outside the U.S., are still active in the markets, or even expanding.
"Barclays Capital remains committed to all of our business activities in commodities, including physical energy trading," said Seth Martin, a spokesman for the U.S. subsidiary of U.K.-based Barclays PLC (BCS). "We continue to invest in our capabilities in those markets and have found our clients to be receptive to our participation."
New Rules Of The Game
The banks remaining in the market do so under far more onerous terms.
Producers and refiners, which use the physical market to smooth out their day-to-day operations, now require financial institutions to pre-pay, secure letters of credit or clear transactions on the New York Mercantile Exchange, said Javier Loya, chief executive at OTC Global Holdings LP, a large energy broker. Clearing involves posting a margin, or collateral, to help guarantee that each party meets the terms of a deal.
"We have seen trading companies and major oil and gas companies reduce counterparty exposure to financial institutions," Loya said. "Because of the credit crisis, financial institutions, in turn have reduced their inventories."
Clearing physical oil deals would help protect companies should their trading partner go bankrupt. When SemGroup LP, a large, private oil trading firm, filed for bankruptcy protection in July, the company left trading partners with unsecured debts as large as $159 million. SemGroup failed after placing large, losing bets in oil futures, in contrast to banks, whose troubles stem from markets unrelated to energy.
Losses in the physical markets are unlikely to sink either the banks or their trading partners, however. Physical commodities represented less than 1% of banks' assets in most recent public financial statements. In the case of SemGroup, the largest debts were owed to large energy companies, such as BP PLC (BP), which could easily absorb the losses.
Reduced trading activity does increase the risk of supply bottlenecks or gluts. Spot fuel prices jumped on the U.S. Gulf Coast in mid-September, as Morgan Stanley is a large owner of storage tanks and is a major supplier of jet fuel in the Northeast. In crude oil, the banks control a small portion of inventories compared with producers and refiners, and their absence is unlikely to cause many ripples, said Stephen Jones, a principal with energy consultants Purvin & Gertz in Houston.
Any impact to inventories when banks began to pull out of physical markets in mid-September was likely overwhelmed by the severe disruptions caused when Hurricane Ike forced refineries and ports in Texas to close at the same time.
"I don't envision it being a major shift in the marketplace," Jones said, though he added, "one additional barrel adds another barrel of transparency and liquidity to trades."
-By Brian Baskin, Dow Jones Newswires; 201-938-2062; brian.baskin@dowjones.com
10/9/2008 2:37:00 PM
Lacking Credit, Trust, Banks Exiting Physical Energy Markets
NEW YORK (Dow Jones)--Banks are beating a hasty retreat from the physical oil and fuel markets, as the credit crisis cuts financial institutions out of a once-promising line of business.
Much like the credit market itself, the trading of physical barrels of oil or refined products for prompt delivery relies on trust. Deals are arranged between two parties or through a broker, and most agreements aren't cleared, meaning that if one side doesn't hold their end, the other takes the loss.
Physical deals are priced off of benchmark futures contracts, which are traded on exchanges in financial transactions that rarely involve exchanging actual commodities.
Companies often use borrowed cash to finance inventories and the transportation of oil and fuel by pipelines or tankers, making it difficult for companies seen as default risks to operate in the market. Over the last month, confidence in the banking sector has been badly shaken, with several failures, a rash of forced mergers and expectations of even more government support. In some energy markets, banks are being kept at arm's length by oil companies and refineries that are wary of not being paid should a counterparty join the list of failed banks.
Financial institutions are more active in the futures exchanges, where all trades are cleared.
Some large oil companies have issued internal memos forbidding their traders worldwide from dealing with Morgan Stanley (MS) and Merrill Lynch & Co. (MER), two of the more active banks in physical commodities. Merrill Lynch agreed in September to be acquired by Bank of America Corp. (BAC). Spokespeople for both Bank of America and Merrill Lynch said it is too early to say what will happen to either bank's trading desks.
"They are reducing their exposure," said one broker of physical oil on the Gulf Coast, who is not cleared to speak to the media and requested anonymity. "And they really don't have a choice because the traders are not trading with them."
The chilly reception in the markets is a dramatic turnabout for financial institutions whose executives prided themselves on having the foresight to get into trading of physical crude and oil products before prices surged. Until recently, major investment banks had been planning expansions into physical markets long dominated by producers and refiners. Now, those same banks are saddled with losses tied to mortgage-related securities and can no longer dependably raise new funds in the credit market. Turning a profit has also gotten more difficult in the physical energy markets as underlying oil and product futures have plunged 40% or more from summer highs.
Oil futures recently traded 1.9% lower at about $87 a barrel, compared with an intraday record of $147.27 a barrel on July 11. Gasoline futures hit a one-year low of $1.95 a gallon on Wednesday.
The banks' absence is noted in lower trading volume in markets ranging from U.S. Gulf Coast crude to Asian fuel trading. Energy companies say they are still using the markets to manage supplies without difficulty. What's not clear is when financial companies will have the strength to return to previous levels of trading activity - or if the banks still standing will want to.
And Then There Were None
Every major U.S.-based investment bank involved in physical commodities markets has succumbed to the financial crisis either by selling to a rival, filing for bankruptcy or converting to a bank holding company.
Goldman Sachs Group Inc. (GS) and Morgan Stanley, the U.S. banks with the biggest commodities operations, both went the commercial route on Sept. 21. Commercial banks have a strict limit on how much they can borrow in excess of assets, and the big ones, including Citigroup Inc. (C) and Bank of America, have generally not been as active in physical oil and products markets, where trading is by necessity often funded through short-term loans.
Both bank holding companies say the conversion will not affect their energy trading operations, though Morgan Stanley's chief financial officer indicated to a UBS AG (UBS) analyst this week that physical commodities could be divested.
"We found this comment a little surprising as we always thought of the physical component of the commodities business as a major source of Morgan's 'edge' in this business," wrote Glenn Schorr, the analyst.
Morgan Stanley has definitely lost its edge, said a trader with a European trading house.
"In the past, it was Morgan Stanley who would decide who it would trade with," the trader said. "But now it's a totally different story."
Some investment banks, particularly those based outside the U.S., are still active in the markets, or even expanding.
"Barclays Capital remains committed to all of our business activities in commodities, including physical energy trading," said Seth Martin, a spokesman for the U.S. subsidiary of U.K.-based Barclays PLC (BCS). "We continue to invest in our capabilities in those markets and have found our clients to be receptive to our participation."
New Rules Of The Game
The banks remaining in the market do so under far more onerous terms.
Producers and refiners, which use the physical market to smooth out their day-to-day operations, now require financial institutions to pre-pay, secure letters of credit or clear transactions on the New York Mercantile Exchange, said Javier Loya, chief executive at OTC Global Holdings LP, a large energy broker. Clearing involves posting a margin, or collateral, to help guarantee that each party meets the terms of a deal.
"We have seen trading companies and major oil and gas companies reduce counterparty exposure to financial institutions," Loya said. "Because of the credit crisis, financial institutions, in turn have reduced their inventories."
Clearing physical oil deals would help protect companies should their trading partner go bankrupt. When SemGroup LP, a large, private oil trading firm, filed for bankruptcy protection in July, the company left trading partners with unsecured debts as large as $159 million. SemGroup failed after placing large, losing bets in oil futures, in contrast to banks, whose troubles stem from markets unrelated to energy.
Losses in the physical markets are unlikely to sink either the banks or their trading partners, however. Physical commodities represented less than 1% of banks' assets in most recent public financial statements. In the case of SemGroup, the largest debts were owed to large energy companies, such as BP PLC (BP), which could easily absorb the losses.
Reduced trading activity does increase the risk of supply bottlenecks or gluts. Spot fuel prices jumped on the U.S. Gulf Coast in mid-September, as Morgan Stanley is a large owner of storage tanks and is a major supplier of jet fuel in the Northeast. In crude oil, the banks control a small portion of inventories compared with producers and refiners, and their absence is unlikely to cause many ripples, said Stephen Jones, a principal with energy consultants Purvin & Gertz in Houston.
Any impact to inventories when banks began to pull out of physical markets in mid-September was likely overwhelmed by the severe disruptions caused when Hurricane Ike forced refineries and ports in Texas to close at the same time.
"I don't envision it being a major shift in the marketplace," Jones said, though he added, "one additional barrel adds another barrel of transparency and liquidity to trades."
-By Brian Baskin, Dow Jones Newswires; 201-938-2062; brian.baskin@dowjones.com