10 October 2014
Faced with lower margins, more regulatory burdens and increased risks, big banks have been fleeing the commodity markets on a grand scale in recent years, which can present challenges for some U.S. natural gas and electricity markets while presenting opportunities for large and mid-level players both domestic and abroad.
Large financial institutions have played an important role in the commodity markets in recent years, often making markets in otherwise illiquid gas and power swaps and physical markets. But given reduced profits, increased risks and heightened scrutiny, many have moved for the exits in recent years.
"I think you will see players step in to fill that void but given the amount of banks that have left the market, at least in the near term, there probably will be some liquidity concerns in the market," Ryan Hardy, partner for global energy and utility practice at PA Consulting said Oct.8.
Louis Caron, executive lead, commodity risk at SAS said that in Calgary, of the dozen or so banks doing business in the physical gas and power market five to 10 years ago, less than half remain today.
The exit of banks also should hurt the swaps markets, which can make hedging difficult and could even complicate the financing for new projects.
"On the power side… putting a financial hedge or structure in place, particularly for new generation development, is incredibly important to get an equity commitment," Hardy said. "Banks especially don't want to deal with wild volatility in the near or short term. They want a hedge in place."
"The pinch on liquidity certainly limits the flexibility in terms of putting hedges on, which can really increase the risk of those contracts."
Filling the void
As most major banks head for the exit in the North American commodity markets, others are peering in, seeing possible opportunity.
Caron said he sees well-capitalised middle-tier energy marketers helping to fill the void left by the big banks to offer energy companies the customised transactions they need for risk management.
He referred to "companies that might have some smaller assets – maybe some generation, or refining, or midstream – companies that have some assets and also are positioned to take on another [more customer-focused] book of business."
However, it is not just U.S. companies looking to fill the void in the commodity markets. "A lot of European folks are setting up shop," he said, noting Total SA and E.ON SE among interested parties, as well as Latin American companies such as Petrobras. "Companies backed by companies from Netherlands, Spain, Portugal, Italy, Germany," he said.
Hardy also noted some "international players… that are looking at the banks vacating the market and seeing this as a potential opportunity to step in."
According to Hardy, the international players also include Chinese banks and Russian energy companies, as well as large trading houses and even utilities in the European Union.
"Part of it comes down to a cost-of-capital decision," he said. "Even expanding outside of trading, we're seeing a lot of interest internationally – Asia, China, Europe – interest in U.S. infrastructure, U.S. assets. The natural corollary to that is the interest in the commodity markets as well."
Markets to watch
Hardy said he does not expect any tremendous reaction from futures prices, especially in natural gas markets. "In our view, we don't really see the futures markets, in terms of prices, being impacted," he said. "Commodities prices will behave as they always have, especially in gas."
However, some physical electricity markets have already seen a change.
"On the power side, the Northeast is still very strong in terms of liquidity – New England, New York, the Mid-Atlantic. In terms of being able to go to the market for power and gas hedges, that market is still fairly liquid," Hardy said.
"But in the Southeast and in the West, outside of California, these are the markets that have really taken a hit in terms of liquidity… and that's tough for those that remain."
However, these are short-term issues, Hardy said. The ERCOT power markets in Texas, in particular, are "competitive and liquid enough" to present opportunities for new players to emerge, including larger, international trading house, utilities and energy companies.
"Certainly there are ones that are looking at the opportunity," Hardy said. They are looking at the U.S. as a whole to see where the opportunities are "that they may play in terms of building out a trading book. And a lot of them are looking to build that [trading book] organically rather than trying to buy one of these existing books."
The exit of big banks
The exposure of large financial institutions in the commodity markets reached a peak around 2008, when Hardy estimates the top ten biggest banks reaped total revenue of close to $14 billion from commodities. By 2013, that total annual revenue had dropped to close to $4 billion, he said.
But it is not just about the money being made, or not made, in the commodity markets.
"The primary driver of the banks leaving the [commodity] markets is absolutely the regulatory pressures," Hardy said in an Oct. 8 interview.
"We've heard announcements and a lot of rhetoric from the banks for some of the reasons – lower margins, the opportunity to deploy capital elsewhere at more favorable returns – but the main driver is really regulatory, and it's especially Dodd-Frank regulations, that are making it more difficult for the banks to play in the commodities space."
"It really comes down to collateral," he said. "To carry the same trading book and the same positions they would have had back in 2008 or just a couple of years ago, there has been a significant increase in the collateral requirement. That's just tying up more capital at the bank, which then makes it just that much more difficult to justify because now you're contributing that capital towards holding that book when you could be deploying that capital elsewhere.
"And we're in a six-year bull market, where equities have just been through the roof, so it's been that much more challenging for banks to be able to justify tying up that capital," he said.
"For a bank, capital is everything," Caron noted. "In this case, if you are going to have to tie up a lot more capital, it's a pretty easy calculation to decide to flow the capital into a different business that generates an anticipated fixed rate of return."
He also highlighted that the volatility of energy commodities "dwarfs the volatility of other asset classes," including foreign exchange and interest rates.
'Not a market you can just dabble in'
Another issue pushing banks out of the commodities space has been governance issues.
JPMorgan Chase & Co. recently completed the sale of its commodities assets to Mercuria Energy Group Ltd. after settling claims of manipulating the power markets in the Midwest and Western U.S.
Other banks have pursued a similar course. Barclays Capital Inc. and Deutsche Bank AG also have scaled back their commodities exposure, also after being heavily fined by FERC for their alleged manipulation of the power markets.
"I think the risks certainly increase as we've seen products become more exotic," Hardy said. "And really to be profitable in any of these commodities, it takes an incredible amount of infrastructure and focus in that given market.
"It's not a market you can dabble in," he said. "You're either fully invested in it or you're not. You're going to have competition from well-integrated trading houses that are focusing specifically on a given market, whether that's oil, NGLs, gas or power.
Caron agreed that in the commodities space, big banks ran into both operational and regulatory challenges.
"You need infrastructure that's a bit different from what banks are used to," he said.
"It's not just taking on the purchases or sales of gas or electricity. You need controllers; you need people monitoring the flow, physical balances, monitoring systems for physical, unscheduled outages.
"The banks weren't ready and by the time they got staffed to do all this, the physical business itself… probably caused quite a bit of cost," he said. "It was more expensive than they anticipated."
At the same time, the financial collapse in 2008 led to an increase in regulatory scrutiny that was fueled by "the fact that many of the regulators and commissions are funded through fines so they have been going after banks for alleged market manipulation."
"Just the risk of an investigation, which can be detrimental to your stock price… that's something that's going into business plans now for the banks," Caron said. "They're saying, 'this energy business, there's just too much risk.'"
Goldman Sachs remains
While several big banks have already started divesting their commodities positions and assets, Goldman Sachs & Co has remained committed to commodities.
"Certainly Goldman has said they're here to stay," Hardy said, noting the bank's year-on-year increase in trading revenues.
"Part of that [commodities revenue growth] is probably the result of some of the other banks leaving; part of that is the result of a very volatile winter for gas and power," he said.
The possibility of one major bank such as Goldman Sachs remaining behind as most other major banks sever from commodities is "certainly a challenge" but "can work both ways," Hardy said.
"You need counterparties in the market," he said, noting that Goldman's existing presence should put them at an advantage to any new players in the short term.
However, a major market maker such as Goldman Sachs remaining behind could also benefit some of the smaller, more customised physical and swaps markets.
"Customised hedges for power plants that involve things like basis risk, [Goldman Sachs] understand that market, they will be one of the few players that offer that kind of product and because of that they will be able to command a premium for offering those kinds of products to the market."