July 15, 2014 7:05 pm

Goldman seeks commodities edge as rivals retreat

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Goldman Sachs’ commodities business, known for its muscular trading operation, is rapidly expanding in a plainer and less politically charged area even as listless markets and increased regulation force rivals to beat a retreat.

Commodity finance is among the fastest-growing segments of Goldman’s commodities business, the bank’s executives said.

“The financing side of the equation has gone from being a sort of appendage to being a really major organ for us,” Greg Agran, Goldman’s global co-head of commodities trading, said. “When we think about growth going forward over the next few years, I actually think the commodity finance business is one of the areas we are most excited about”.

The shift is one way that Goldman plans to prosper in commodities even as sideways markets and increased competition hit profits and drive rivals such as Barclays, Deutsche Bank and JPMorgan Chase axe or scale back operations. .

Commodity finance lubricates the global trade of raw materials. It encompasses everything from short-term lending against international shipment of metal to providing working capital to oil refineries.

Within the industry it is seen as a low-return, low-risk activity and for many years was dominated by large commercial banks in Europe, not investment banks.

Goldman’s J Aron commodities business, acquired in 1981, is one half of the duopoly that for years dominated commodities trading on Wall Street. The other half, Morgan Stanley, is selling its global physical oil merchant business, reducing its footprint.

Goldman has also cut, with 240 front-office commodities staff equal to about 75 per cent of peak headcount. Revenues have declined, too.

But senior Goldman executives have publicly committed to keeping the business, which insiders say they intuitively understand. Lloyd Blankfein and Gary Cohn, chief executive and president, respectively, are two of the most prominent members of a powerful cadre of J Aron alumni.

“At Goldman, you always have to be careful that you’re not going to be knocked off when you’re sitting at the top. They’re throwing their lot in with the commodities business because they probably feel if they can turn it round in the next couple of years, it will strengthen their hand,” said a former Goldman commodities executive.

Reporting second-quarter results on Tuesday, Goldman said its fixed income, currency and commodities business continued to face a challenging environment as “market volatility and levels of activity generally remained low”.

Banks involved in commodities trading face headwinds. The new Volcker rule ban on betting with a bank’s own funds leaves fewer rewards for traders. Coalition, a consultancy, estimates the revenues of the top 10 banks in commodities fell last year to $4.5bn from a record $14.1bn in 2008

Derivatives trading, which bankers said constitutes a majority of Goldman’s commodities business, has become more standardised in markets such as benchmark crude oil. The trend of processing more derivatives through clearing houses has eroded Goldman’s advantage as a financially secure counterpart in off-exchange markets.

As a result, Goldman’s derivatives book has shifted towards specialised deals such as contracts tracking geographic differences in natural gas prices, or more obscure grades of crude, executives said.

“Instead of having a shack open selling hot dogs all day long, they are more in the catering business, looking for big transactions,” said Mark Vonderheide of Geneva Energy Markets, an oil swap dealer.

In the US, public scrutiny of Goldman has turned to its physical commodities business. While executives say this is the minority of the bank’s trading, it is nevertheless extensive. It is also important to its other parts of the business such as trade finance, said Mr Agran.

“The underlying collateral we take in on almost every trade finance transaction is a physical commodity. Our understanding of the market allows us to evaluate the collateral,” he said.

J Aron imported more than 100,000 tonnes of aluminium to the US in the past year, show customs data compiled by Panjiva. The shipments relate to Goldman’s aluminium finance business, which is managed separately from Metro, the metal warehousing unit Goldman has put up for sale, bank executives say.

The bank also supplies refineries with oil. In a legal filing to a federal energy regulator, J Aron said its “activities include supplying, purchasing and selling crude oil nationwide”.

In the first quarter of 2014, when cold weather pushed up energy prices, J Aron’s North American physical natural gas sales rose 39 per cent to 6.25bn cubic feet per day, or almost a tenth of US gas production during the period, according to Natural Gas Intelligence.

“J Aron has swum upstream relative to their banking brethren and said, ‘I like the opportunity in the commodity space,’ ” said an executive at a rival gas trader in Houston.

These kinds of businesses are now under review by the Federal Reserve, which cited the 2010 BP oil spill in the Gulf of Mexico as it weighs cracking down on physical trading by banks.

In an April letter to the Fed, Goldman disclosed the BP disaster led it to create a “Physical Commodity Review Committee” charged with evaluating the risks of new activities and investments. Goldman argued that “the risk of market contagion in regards to commodities is in fact small, given that any one environmental incident is unlikely to coincide with similar events ” at other large banks.

Regardless, Goldman – along with Morgan Stanley – may be potentially more insulated from the Fed review than rival banks. The two were grandfathered by a law enacted before they became Fed-regulated bank holding companies, allowing them to own not only physical commodities but the tanks or power plants that store or consume them.

“If Goldman Sachs is able to maintain its merchant trading business as part of a Federal Reserve grandfathering decision . . . the firm will be able to increase its already strong commodities market share,” Brad Hintz, the departing banking analyst at Bernstein Research, said in a recent report.

None of these benefits would emerge overnight. For now, like many other bank trading businesses, commodities has been pressured by low volatility. But Goldman is ready.

“I would say with complete and utter confidence that nobody knows anything,” Mr Blankfein told shareholders in May. “We’re prepared for a market that stays this way, we’re prepared for a market that’s lower. We’re prepared for a market that’s more volatile.

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