Macaskill on markets: How durable is the commodity trading bonanza?

Global commodity markets were relatively stable as the one-year anniversary of Russia’s invasion of Ukraine passed on February 24.

Oil traded within a $10 a barrel range for the first two months of this year, in stark contrast to the swings seen in 2022 as supply disruption caused by war compounded the inflation already under way in energy prices.

Natural gas was also relatively steady after retracing much of the rise seen in 2022. This is a welcome trend for consumers, but it casts doubt on the durability of the recent boom in commodity dealing revenue.

As Euromoney predicted on the day of the Russian invasion, the resulting volatility in commodities delivered a trading revenue boost to banks, led by Goldman Sachs.

Even in an environment when its hard-pressed executive team is unusually keen to stress market leadership positions, Goldman does not break out its commodity dealing revenues, but the total for 2022 is reported to have been well over $3 billion and may have come close to record annual levels of around $4 billion seen before the Volcker Rule limited proprietary trading by banks.

Dan Dees, global banking and markets co-head for Goldman who pitched his division’s strengths at the bank’s second investor day on February 28, gave commodity trading a couple of name checks as he rattled off product lines where the firm is a leader.

But he did not highlight that commodity dealing is one of the few areas where Goldman is a clear number one by revenue among banks, after it opted to maintain scale when its closest rivals Morgan Stanley and JPMorgan cut costs and shifted to reliance on derivatives trading.

That might be because Goldman wants to stress the reliable nature of much of its revenue – or its durability, to use a word that the bank’s top managers deployed repeatedly in their investor-day presentations.

Goldman has been able to deliver strong revenue performance in a variety of commodity market backdrops in recent years – including both when oil briefly fell below zero in 2020 and in 2022 when prices spent months over $100 a barrel.

But the firm’s executives are well aware that commodity trading income is always cyclical and dependent on factors including price direction, the right amount of volatility and market conditions where margin calls do not result in excessive counterparty risk for dealers.

Commodity revenues for all banks globally probably hit around $20 billion last year and specialist traders performed even more strongly – Trafigura alone more than doubled its annual profit to $7 billion, for example.

Trafigura noted that its total commodities trading volume in its financial year to September 2022 was actually lower than the year before, however.

It attributed this counterintuitive data point to lower oil trading in the second half of its financial year, due to sanctions on Russia; reduced availability of hedging in derivatives markets; and “a decision to focus on higher-margin opportunities”.

The pitfalls of chasing high-margin opportunities in commodities dealing were highlighted on February 9 when Trafigura announced that it will take a $577 million charge to its 2023 first-half results after being the apparent victim of a fraud in nickel trading.

As with a number of recent commodity trading scandals, there was an element of comedy to this episode. Trafigura, which highlights its ability to manage risk, had paid for containers of nickel that “were found not to contain nickel”, as the firm put it in a statement.

The mishap was reminiscent of a fraud perpetrated on Trafigura’s rival trading house Mercuria in 2020, when thieves in Turkey switched containers of copper for painted rocks that were only discovered when ships arrived at their destination in China.

The more recent fraud is deeply embarrassing for Trafigura, but the company noted in its statement announcing the charge that it still expects group profits in its first half of 2023 results to be higher than in the same period in 2022.

Trafigura’s net profit for the six months to March 31, 2022, was $2.7 billion, so it seems that the overall business of commodity dealing is still performing strongly for the trading firm.

Banks are generally less exposed to physical commodity trading risk than firms such as Trafigura and Mercuria. Only Goldman still conducts much physical trading, while most of its banking peers focus on commodity derivatives activity.

But another nickel scandal last year was a reminder that banks can incur effective commodity trading exposure without taking ownership of containers or ships.

The chaos seen in nickel trading on the London Metal Exchange (LME) last March was due to concern about margin calls linked to short positions taken by Chinese nickel tycoon Xiang Guangda, the founder of Tsingshan Holding Group.

The LME made a highly controversial decision to cancel trades conducted during a spike in the price of nickel futures of around 250% on March 8. But even after many trades were reversed, banks, led by JPMorgan, were still forced to broker a deal to ensure that Guangda was able to post margin on his exposure.

The margin standstill agreement, and a secured liquidity facility arranged by firms including BNP Paribas and Standard Chartered alongside JPMorgan, gave the banks time to reduce their own exposure, but it was a reminder of the many risks posed by commodity dealing, including counterparty risk.

These risks have not deterred non-bank dealers in commodities, however, and the prospect of high returns has increased demand for experienced professionals, which may be another reason why Goldman chooses not to trumpet the performance of its business.

Anthony Dewell, one of Goldman’s top oil traders, left to join multi-strategy hedge fund Millennium Management last year, for example, and other fund groups that are active across asset classes, such as Citadel, have also been expanding in commodities.

There is also demand for experts in commodity index creation and trading – an area that does not generally deliver big dealing windfalls but has been seeing strong growth.

Dan Deighton, Goldman’s former head of commodity index and agriculture trading, joined hedge fund Balyasny Asset Management last year as co-head of commodities; while Will Scott, Morgan Stanley’s head of commodity index trading, left to join Verition, another hedge fund.

The consensus among analysts in recent polls is that oil will move above $90 a barrel in the second half of 2023, while many specialists predict another push above $100, and Goldman’s own in-house analysts are relentlessly promoting the idea that we are on the brink of an “underinvested supercycle" for commodities.

The unravelling of the crypto markets has also left real-world commodities as the best option among a bad bunch of potential hedges against inflation.

With the right amount of volatility and client demand, Goldman and other firms might be able to keep the commodity revenue bonanza going.

Risk-management challenges in the sector will remain substantial, however. Reputational threats are elevated in commodity trading compared with other asset classes, for example, with inadvertent breaches of sanctions on Russia now joining a host of other potential pitfalls such as association with old-fashioned corruption.

Trading returns can only be judged as truly durable when all associated risks have been conclusively managed.