Asian demand spurs commodities boom

Asian demand for commodities continues to be insatiable. Alex Davis looks at how western investment banks are looking to take advantage of the opportunities presented by the growth

European and US investment banks have been rapidly building up and building out their presence in Asian commodities markets over the last 18 months, especially in physical products.

Goldman Sachs recently confirmed expanding its headcount in Asian commodities by 20% over the past year, with plans still to hire more, while building out its physical presence in Australia and Indonesia.

Morgan Stanley undertook a joint venture with Bank of Tokyo-Mitsubishi UFJ (BTMU) in June last year, which included commodities referral and business referral agreements in Asia.

Goldman Sachs and Morgan Stanley have long been established as the biggest commodities players both globally and in Asia, but several banks in the second tier are seeking to grab a larger share of the expanding possibilities.

The most recent move came from JP Morgan, who announced in May that it will open its first Asian precious metals vault in Singapore during Q3 this year. This has followed aggressive recruitment drives from banks that started last summer and are still on-going.

Within days of each other, Bank of America Merrill Lynch and JP Morgan announced scooping up five and seven new commodities traders respectively for Asia in September last year. Accompanying these expansions, banks have been creating new senior positions to head up the growing commodities businesses.

Citi created a new position when it hired Ted Huang from JP Morgan as director in commodities marketing and origination for Asia in August 2009, capping a four-year period of growth that saw the Asia commodities team expand from three to 20. Deutsche Bank also created a new position in February this year for Kenichiro Yamaguchi, who joined from Bank of Tokyo-Mitsubishi UFJ as head of commodities in Japan.

The current trend has its roots in 2007, before being halted somewhat by the global economic crisis during 2008 and the first half of 2009. JP Morgan separated its commodities and currencies business, with the aim of expanding global energy trading staff from 110 to 150. Deutsche Bank created the head of Asia commodities position, initially filled by Simon Grenfell, who was replaced earlier this year by Gunnar Hoest, Grenfell returning to work for Deutsche Bank in London.

In addition, Barclays Capital hired Steven Chiang as director, commodities trading, Asia-Pacific crude oil and refined products to develop a physical presence in the oil markets in the region, a process that has culminated with the company now managing close to one million barrels of crude oil storage space in Asia.

There have been several false dawns regarding opportunities in Asia in the last 20 years, but in this instance many of the banks are confident that the expansion of the commodities’ business is set to be at the very least a medium-term trend.

“We see the increasing momentum of physical commodity market developments in the region, mainly driven by the growing needs of industrialisation and urbanisation in many of the Asian countries,” says Tim Wilson, managing director and head of Asia marketing of JP Morgan’s global commodities.

BarCap’s Chiang believes that the trend will continue for even longer than the medium term. “As a trader, 15 years is an eternity and at this moment, looking at the markets, this feels like this is going to continue for a decade, if not longer,” he says.

At the behest of their clients, there has been a notable increase in involvement from banks in commodities worldwide, particularly since 2008, as Richard Jefferson, managing director, head of commodities sales, global commodities at Deutsche Bank, points out.

“With fears over capital preservation and fears over banks in general during 2008 and the early part of 2009, you’ve seen investors wanting to own assets, commodities,” says Jefferson. “You’ve seen banks developing physical gold products, but also, increasingly you see demand for natural resources and therefore demand from long-term investors to own those same natural resources. That can pervade itself as equity – for example Asian wealth funds owning mining companies. As an investment bank, when we start to see macro activity like that then it makes us have a look as well.”

Rising demand for commodities

This increase in commodities activity has resulted from the ravenous appetite in Asia, particularly from China. It is well-documented that China is expected to overtake the US as the world’s biggest importer of oil in the next few years. Asia also currently consumes between 40% and 70% of global metals output, while China and India alone account for more than half of global coal consumption (China for 47% and India 8%).

“The flow of commodities into the region has changed quite a lot, especially with the surge of imports into China,” says Olivier Godin, managing director for commodities in Asia for Société Générale Corporate & Investment Bank (SGCIB). “Developing countries like India are more active today than they were five years ago in energy and other products. Each time you get a flow of physical commodities coming in, you’ve got more volume; you’ve got a market that creates itself around it. That generates services in the regions.”

He cites coal as an example. “There are fewer long-term contracts and there is more and more price risk for the traders and the consumers, and the banks have seen a gap in providing risk management,” he says.

This Asian demand has done more than merely provide opportunities for the banks. BarCap’s Chiang believes that a fundamental shift is taking place that is actually now transferring global pricing influence away from the West.

“[China and India] have redefined the price-setting mechanisms and shifted them from regions that were so used to trading in the Atlantic basin, towards Asia,” he says. “Our management have had the foresight to see that the price curves are about to be far more dictated by eastern economics and fundamentals and we have to invest in the East to keep our eyes and ears open for impending changes.”

The huge and growing magnetic pull from Asia on the world’s commodities has called for risk management skills that Asian banks cannot yet provide.

“Some of the local banks are very aggressive and are trying to provide risk management, but a lot of the local banks don’t have the culture of commodities [in US and Europe],” says SGCIB’s Godin. “It’s quite natural that American and European banks are leading the charge. Also in newer or less arbitraged markets, there are opportunities that people are trying to capture.”

Getting physical

As well as the established services investment banks provide in the derivatives markets, they have been increasingly getting involved upstream, in the actual physical markets themselves. It seems that having ownership of physical commodities is becoming a business necessity for the banks.

Having a physical capability provides the banks with a greater understanding of entire market chains, which generates more trust from their investors.

“The physical side of business involves several key elements, such as purchasing, sales and distribution while on the financing side there are funding and treasury services,” says JP Morgan’s Wilson. “The combination of these enables you to have visibility and a more complete picture of the overall market, and therefore you will be able to give clients better insight into what is happening around price development in both financial and physical markets.”

The relatively undeveloped state of many of Asia’s commodities markets is perhaps the most important factor requiring physical market involvement, a necessity explained by Harry Soh, head of commodities for Asia at Morgan Stanley.

“One of the reasons we’ve seen increased competition in these [physical] markets is that there is not the depth or liquidity on the derivatives side. So if you want to get exposure and build business around some of the emerging areas, probably the only way is to get physical.” he says.

He also cites the coal market as an example of this. “Commodities such as iron ore and thermal coal can only be accessed through physical [markets]. So for example, in the case of thermal coal from Indonesia, the varying production zones and qualities make it difficult for a benchmark – and thus paper markets – to thrive, and therefore it makes sense to see physical develop faster than paper markets.”

Finally, there are those in Asia who are cautious in their approach to financial derivatives, especially after western banks including Goldman Sachs and Morgan Stanley had carried out trades that resulted in large losses for Chinese state-owned enterprises at the end of 2008.

“A lot of the more traditional corporate players are not comfortable with the derivative product and they still like to see their exposure coming through physical fixed prices, or risk in a physical form.” says Soh.

Even though banks have been pouring into Asia, the migration has not all been one-way. Keen to build out their own commodities capabilities and thus wield more influence on global market flows, Asian banks have been pushing out into the US and Europe.

BTMU’s joint venture with Morgan Stanley gives it access to US and European opportunities, while the commodities derivatives desk in London has expanded from three to 20 since 2007, with plans to add more. Earlier this year, Japan-based Nomura acquired Nexen Energy Marketing London Limited (NEML), a physical gas & power trading and marketing business focused on Europe. Both Mitsui and Sumitomo have announced plans this year to expand their commodities trading desks. One Asian commodities head stated off the record that its aim was to be at the top of the second tier within two years.

For US and European banks, the key question is how long before their dominance in commodities in Asia is challenged.

“One of the key strengths of global investment banks is the connectivity between different regions and that is tremendously powerful when it comes to global homogeneous products like most commodities,” says JP Morgan’s Wilson. “There’s no reason why over time Asian banks can’t develop that global connectivity, but it’s clearly more of a challenge for them to develop the connectivity in the West. In comparison, some of the western banks have made progress in the past few years and have developed quite a sizeable Asian presence.”

The time frame before the Asian banks can jostle for the top positions is a long one, according to participants based with US and European banks.

“At the end of the day, a trading organisation in a client-driven business like commodities is going to be driven by experienced head counts. If a Malaysian bank uses $200 million and hires an entire experienced trading team, they’ll have it by tomorrow afternoon, but I think that is difficult to achieve.”

However, Morgan Stanley’s Soh warns that there are still no guarantees that Western banks can be fully integrated in to Asia, particularly in China, or that this period of expansion will be fundamentally different to previous attempts.

“What is different is that a number of institutions have invested heavily and upped their game in this space. And while some of those institutions have made a considerable investment and commitment, at the same time I’m not convinced that all will stay the course,” he says. “Building sufficient scale takes a considerable investment in time and resource, and at the end of the day there have to be returns for that investment. If the returns aren’t sufficient over the investment cycle, then we’ll see some scaling back in the next two to three years.”

Finally, despite China’s greedy appetite for the world’s commodities, none of the banks has yet found a way to tap into the inland commodity market potential for the country.

“China’s marginal consumption is important to price discovery, but price regulation and controls make it difficult for a direct commodities onshore presence in China, and is evidenced by how few commodities teams are set up there,” says Morgan Stanley’s Soh. “Commodities risk in China is currently not really open to foreign markets.”