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Chapter 1: What are the foundational concepts of commodity finance?
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Hello and welcome to another episode of the All Thoughts Podcast. I'm Tracy Alloway.
And I'm Joe Weisenthal.
Joe, I think I've told you this before, but way back when I was starting in financial journalism, I really wanted to be a commodities reporter.
I get it. It seems fun. It seems real. It seems like one of the few areas of finance that's like not just a screen. You know what I'm saying?
Yeah. No, there's a physicality to it, right?
Yeah. Yeah. But also, like, you know, everyone's like, this is a relationship business. But I feel like commodities, you know, everyone in finance has that, right?
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Chapter 2: How do commodity financiers manage price risk?
And so, okay, here's like ā let's say we do not know ā I don't know what the cost of moving so and so many kilograms of copper from one place to another is. Whatever that cost is ā I probably don't want to tie up all of my capital at that.
I probably want to put down a fraction of the thing, borrow the rest, et cetera, then pay off that loan when the ship gets there, et cetera, so that I'm as liquid as possible at any given moment. This is just like, I'm sort of like, this is my first principles.
I don't know anything about this space, but I assume that there are a lot of calculations like this within the process of procuring, mining, delivering commodities.
Absolutely. So today we are going to learn about commodity finance. We're also going to try to get a handle on what's going on in the commodities world right now, given some of the disruptions that we've seen. And I'm glad to say we do, in fact, have the perfect guest. We're going to be speaking with Lewis Hart.
He is, of course, the head of corporate advisory and banking at Brown Brothers Harriman. So someone who lives and breathes commodity finance.
Thanks, Tracy. Thanks, Joe. It's great to be here.
Would you say you know more about commodity finance or 90s hip hop and R&B?
Oh, that's a tough one.
Very close. Very close. I'm throwing that out of nowhere. He's a big hip hop guy.
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Chapter 3: What role do warehouses play in commodity finance?
Well, it's really the business of financing motion. And so the classic example would be a commodity merchant. Okay. Commodity merchant kind of evokes a lot of history, right? You think back to Renaissance Italy and the Medicis and all the merchants that kind of pioneered global trade in those days and actually goes back even farther. You can go back to even the BCs and see trade finance happening.
Hmm. But the typical consumer is a physical merchant, and they may be in the energy space, they may be in the metal space, or they may be in the agricultural space. Their job is not to speculate on prices, contrary to popular belief. You think commodity trader, most people think speculation. That's actually not what they do. They are essentially supply chain managers. That's their role.
And they are the largest consumers of commodity finance. And what are they purchasing? They're purchasing, you said it well at the beginning, shiploads of copper cathode. containers of coffee, green coffee, unroasted coffee in burlap bags.
No, but like, so when I get a mortgage, I am purchasing the ability to have a minimal monthly payment that's spread out over 30 years. Yeah. So that is what, when I like enter it, when I interface with the bank or whatever, a mortgage broker, I am purchasing the ability to not destroy all my liquidity when I buy a house.
So what are they, setting aside the commodity that they're purchasing, what are they purchasing from the bank?
Yeah. So essentially the basic product is a line of credit, a secured line of credit. And that line of credit, kind of like a credit card, can be used to buy eligible commodities. So it's a line of credit that's self-liquidating, meaning once you make the loan, you know what the client's buying and you know what the source of repayment is.
That's very different than other types of lending that take much longer to repay. Okay. So it's very short term, it's self-liquidating, and it's secured by inventory. And then when the inventory is sold, it's secured by the account receivable that results from the sale of the inventory. The receivable gets paid, and then it keeps happening again and again. It revolves up and down.
The big variable that is always tricky is what's the price of that commodity at the time of the loan? And these structures are designed to give clients flexibility to buy the copper, whether it's $6 a pound, $4 a pound, $7 a pound. it's hard to predict these capital needs. And that's most lenders like fixed amounts.
This is a floating dollar amount, which is kind of a unique part of it, where the value of the loan changes as the price of the commodity changes.
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Chapter 4: How does financing differ between hedgable and non-hedgable commodities?
The time when they actually fix the contract and pay is when the coffee ships typically. And at that point, we don't know if the price is going to be $3 a pound, $2 a pound. $1 a pound. And so the capital needs, you kind of can figure them out within a band, but sometimes things happen that actually change what you thought.
And so the unique thing about a commodity lender is they're marking to market that inventory. So if you pledged me a pound of copper, I'll lend you 75 cents, 80 cents, maybe more of the value of that copper, whether it's $3 a pound, 350 a pound, or 250 a pound. Right.
Where does the commodity futures market play into this? Because when we're talking about the unpredictable nature of ā we don't know ā the price of commodities fluctuate. You can lock in prices in many commodities and not all, and I want to get into that, non-financialized commodities. But ā
To some extent, doesn't the futures market solve part of the problem of the variability of the pricing?
In one sense, it solves the price risk. So one of the key risks in commodity finance is the price risk. So if I'm lending against copper and the price goes down, I better be careful, right? My capital could be impaired. So you use the futures market, the derivatives market to hedge that price risk. So we like to say our clients are typically long physical, meaning they own the inventory-
And they're short paper. They're short futures contracts. That works really well. But when prices go up, that means they have to post margin calls. So if I have a $3 a pound copper shipment and the price goes to $3.50 while it's on the water coming from Chile to Georgia, that client says, I need to borrow more money to keep my hedge open.
And until the ship arrives and the client pays for the copper, that hedges on and you don't know what that margin call is going to be.
This is what happened with like nickel a few years ago, right?
Yeah, I think so.
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Chapter 5: What happens when a shipment is delayed, like in the Strait of Hormuz?
They have a pretty good shelf life and they can last for a pretty long time before they start to decay. But you have to keep moisture away. There are things you have to do to secure the quality of them. And the good warehouses are expert at handling those bags of coffee.
Okay. So this is actually a serious question then. When you're doing due diligence for a loan, what are the factors that you're taking to account? Would you look at something like the quality of the warehouse that commodities are going to be stored in?
Absolutely. You would have location eligibility requirements. So you'd say, I will lend against coffee that's in this warehouse, this warehouse, or this warehouse, but not coffee that's in this warehouse for whatever reason. So that's a big part of your diligence. That's one risk. The bigger risks are really what we touched on, price risk. Counterparty risk is the second one.
international risk, which I'm sure we'll talk about. Where is the good that you're financing? Hopefully it's moving. Sometimes it may not be. Not at the moment. Yeah, exactly. In some cases it may not be. And the biggest one I think that Brown Brothers Harriman particularly focuses on is the management, the owners of the business. What are their motivations? What's their reputation?
What's their character? We have something we call the five Cs of credit. It's kind of an old adage. And those are character, collateral, capital conditions. And the most important one we think is character, the character of the borrower, which really comes out when markets get volatile, how people behave. And these are, you started saying accurately, this is a super relationship focused business.
Character is really the most important thing in the business when you boil it all down.
So just to be clear here, when we're talking about, okay, a client comes and whatever they have need for some coffee or whatever, The other side, is this coming off of Brown Brothers Harriman's balance sheet? Are you a middleman for this, or is it your own balance sheet, or both?
Historically, this market was dominated by banks. There was sort of a group of banks, particularly European banks, that dominated. I would say in the last 10 years, many of those banks have actually stepped away from the market for a variety of reasons. And as a result, there are not that many in the U.S. who really specialize in this. We're one of them.
But there are plenty of European banks that really understand this business. And what we've seen is you're seeing more and more interest in this asset class from institutional investors. So they like short-term, floating rates, inflation protection, uncorrelated to the broader equity markets. There's some really attractive features in this. Yeah.
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Chapter 6: How do banks assess collateral in commodity finance?
And we have some partners that we work with. We have different banks that will essentially buy risk from Brown Brothers. But we're always holding a significant portion of the risk on our balance sheet.
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How come the banks have exited the business? Is that just like a 2008 regulatory capital story or something else?
It's definitely a Basel story to some extent. I think as Basel IV has kind of taken hold, you see more and more capital requirements that make it harder to issue letters of credit and things like that. That's definitely part of it. I think another big part of it is just the administrative intensity of running this business.
If you think about tracking all this collateral as it's moving around the world, you need people. Now, over time, digitization is going to take hold here. You still need know-how. You need people. And it's not easy to kind of run this business every day if you don't have the right people. We're fortunate to have a very experienced team that knows how to do this.
We started 206 years ago in this business. So we've literally been doing it for over two centuries. And That's a big part, I think, of why we've stayed committed. It's kind of the DNA of our of our firm. I think, you know, over time, you're seeing some banks coming back into it. But you also saw in the energy space in particular, First of all, big problems in 2015 during the correction.
Banks lost some money. And then you had ESG pressures, particularly around European banks, that caused some to say, you know, I don't really want to be in the business of financing this commodity or that commodity. I'm going to shift my resources more to the renewable sector, for example. So those are all the factors that I think have contributed to it.
But there is a group of banks globally that has stayed committed to this business through kind of thick and thin and knows how to do it, has produced good returns, very low losses over time.
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Chapter 7: What trends are emerging in the commodity finance market?
Hmm. Those bills of lading have numbers and you can type those numbers into, for example, Bloomberg Terminal has the marine tracker app. We look at that. So we're using public source data to really track that collateral when it's necessary. You typically don't need to do that unless it's something's going wrong because ships tend to go where you think they're going to go.
But that is a tool with technology that makes it much easier to actually track your collateral while it's on the water. Once it goes into a warehouse, you typically get a warehouse receipt, which also can be a title document, very important if it has those four important words. And in that case, you're often talking to the warehouse directly. So you may say...
The client may say, I'd like to release these five bags of coffee or one cappuccino to sell to this roaster. Is that okay? And our team is actually saying, yes, please release those. But that's on trust, what we call a trust receipt. And then they have to give us an account receivable to replace that within a certain number of days.
Interesting. OK, so obviously in the backdrop of this conversation is the closure of the Strait of Hormuz. And we'll get to that in a second. But it does raise a question I sort of hinted at in the beginning. We all know that oil flows through the Strait of Hormuz and there's a futures market for it that allows some ability to reduce volatility or take out concerns.
Pistachios also flow through the Strait of Hormuz. As far as I can tell, there's no pistachio futures. I just looked it up on the terminal. And I'm curious, first of all, A, do you do commodity finance for commodities that don't have hedging instruments?
So one of my colleagues, this may shock you, is on the board of the Peanut Tree Nut Association. Is it actually called the Peanut Tree Nut?
It's called the Peanut Tree Nut Association.
It's a big trade organization, and we happen to financeā Peanuts aren't tree nuts, hence the name has to be segregated. Yes, you need peanuts and tree nuts in the title. It's very, very important, very specific. So we actually are active in lots of non-hedgable commodities, like cashews is a good example, pine nuts.
Pistachios less so, but all kinds of non-hedgable commodities that would probably surprise you.
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Chapter 8: How might the future of commodity finance evolve?
So doing some rough math, that's tens of billions of dollars. Maybe it's more than 100 billion, but it's a massive number. And when all that gets trapped and you have potentially margin calls related to hedges on those inventories, that can really strain your liquidity if you don't have the right financing structure behind you.
And that's why in these situations, you need a bank that understands your business. So- If you were going to load an Afromax, which is like typically 700,000 barrels of oil, that's the capacity of an Afromax vessel. Before February 28th, the cost of that might be $40 million, $45 million. Today, it's more like $70, $75 million.
And so overnight, the cost of your single shipment went up a significant amount. And how do you finance that? Back to the earlier point, you need a bank that can be flexible enough to write a line of credit that allows you to do financing under a certain guideline.
Yeah.
So how are the banks actually handling this at the moment? Because on the one hand, like, OK, the cost of actually shipping stuff has gone up. On the other hand, the value of the underlying collateral, you know, assuming it's oil or maybe steel or something like that, has also gone up.
But on the other hand, as you point out, balance sheets are probably a little more restricted if you have these huge sums that are already tied up because the ships aren't actually moving.
Yeah. So I think going back to COVID and then Russia-Ukraine, first you had this huge supply chain disruption. We all remember images of container ships off the coast of Long Beach. Two years later, we had the Russian invasion of Ukraine and this huge disruption in natural gas flows from Russia to Europe. people didn't forget about those things.
So companies went out and raised more capital so that they were ready for the next exogenous event. So I think- Sorry, when you say companies- Commodity merchants. Okay. Commodity merchants in this case, yeah. Commodity merchants specifically went out as a result of the volatility in those two events, raised more capital. So they're coming into this crisis well-funded.
And so, so far things are working okay, actually. There's not evidence that things are breaking. If this lasts for months and months and months, who knows where it goes? But right now, the system is functioning well, actually. The banks are supportive. The commodity merchants are dealing with the liquidity needs. They have enough liquidity. We haven't heard of any
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