Commodity finance markets rocked by Russian invasion; US financial stress monitoring
April 14, 2022
Since Russia invaded Ukraine on February 24, prices for a range of commodities, including energy, food and metals, have seen some of the biggest increases since the 1970s. awards were exceptional both in their scale and their speed.
The moves were also notable for the magnitude of the shock across the various commodities. Although volatility in commodity markets is not unusual, rapid and correlated price increases for many types of commodities at once are much rarer.
In addition to the invasion of Ukraine, these moves coincide with international sanctions against Russia and have put pressure on financial sector intermediation in global commodity markets.
Recent evidence of risk management weaknesses at the London Metal Exchange — the lack of monitoring of large positions, the suspension of trading and the tensions reported on several clearing members in the nickel trade – is another concern.
Ongoing commodity developments need to be monitored for potential impacts on broader financial conditions.
Commodity prices and intermediation: possibility of a negative feedback loop?
Major participants in commodity markets include producers, commodity trading companies and banks. Some entities play more than one role – for example, Glencore PLC, the world’s largest commodity trading company, is also a major producer of several commodities.
While high commodity prices generally increase the profitability of commodity producers and trading companies, when prices rise sharply, companies that rely on bank credit have to seek more to finance the raw materials they stockpile, dispatch, negotiate and/or transform.
Additionally, entities involved in commodity trading and production often hedge their exposures using derivatives markets, primarily with futures and options, to protect against unexpected or extreme price movements. Traders and producers are usually required to do this by covenants in their bank loans to reduce the risk of default.
Derivative hedges for companies that are long in the underlying commodity are generally referred to as offsetting “short” positions, i.e. the derivative position protects against a decline in commodity prices. These hedges, however, have liquidity implications for the companies that use them.
Specifically, although the two positions offset each other economically, the cash flows do not offset each other. For example, a commodity trading firm might buy a physical commodity and then spend money on a derivative hedge against falling prices. However, if commodity prices rise, the derivative position taken to hedge against a price decline loses money. Margin calls from the derivative counterparty may follow, forcing the trader/producer to provide additional hedge funding and drain more liquidity.
More generally, global commodity financing needs increase dramatically as prices rise. When commodity prices rise rapidly, not only do commodity prices increase, but the associated price volatility also increases the size of margin calls (Chart 1). Rapidly rising prices for a whole range of commodities mean that commercial enterprises need additional credit to finance not only the goods they buy, but also the margin they need to make.
Liquidity constraints associated with margin calls for hedging may induce firms to trade more derivatives. To protect against further spikes in commodity prices, companies can buy commodity options with higher strike prices — the price at which an option can be exercised — to generate cash inflows that offset calls. margin on their short commodity futures positions.
For example, while some of the growth in out-of-the-money options on oil may reflect market views on future price movements, some of that activity may also come from firms seeking to minimize market constraints. liquidity associated with other derivative positions. (Chart 2). Essentially, the company that normally seeks to position against a loss is also taking the opposite position (to limit gains) to reduce the potential cash flow strains associated with its hedging activity.
In this environment of growing commodity financing needs, banks are the primary source of credit for commodity trading companies. There are reports of banks cutting back on spending and not wanting to increase their exposures to these companies. While so far commodity trading firms appear to have obtained the necessary credit to continue their intermediation activities, the recent situation highlights some vulnerabilities.
A decline in credit to a few commodity trading firms could prevent the remaining ones from meeting demand for commodity intermediation, potentially creating a negative feedback loop that would cause commodity prices to rise further.
How International Sanctions Against Russia Are Affecting Global Commodity Financing
International sanctions against Russian entities complicate global commodity finance markets in two ways. First, banks may be reluctant to provide financing to commodity trading companies involved in the acquisition, storage or distribution of Russian commodities. This may be due to the expanded sanctions, the potential for expanded sanctions due to reported atrocities against civilians or a further escalation of Russia’s war against Ukraine and the reputational risk associated with this intermediation. Commodity companies can also decide to self-sanction their activities involving Russian raw materials
To be clear, the intention of the international sanctions is to negatively affect intermediation in the Russian economy and, therefore, to end the conflict in Ukraine.
Second, there is a risk that international sanctions will extend to foreign subsidiaries of Russian state-owned commodity producers (such as Gazpromthe commercial subsidiary domiciled in the United Kingdom or the subsidiaries of the integrated oil company Rosneft), which are active in the sale, trade or distribution of raw materials outside Russia.
Like commodity trading firms, these firms may be active in the physical commodity and derivatives markets. Their inability (or even unwillingness) to meet physical deliveries or derivative obligations could lead to losses for non-Russian counterparties, including European utilities and refineries.
Such a situation could play out in the European utilities sector similar to what happened to some power producers during the February 2021 freeze in Texas. Some Texas electricity providers have been forced to make costly spot market purchases for natural gas used in power generation or have been unable to generate and deliver the electricity that they had sold forward on the derivatives market. (These risks may provide some context for a recent German government decision to take control of a local Gazprom subsidiary.)
U.S. oversight of global commodity intermediation
Monitoring the evolution of commodity market intermediation is essential for at least three reasons:
- First, price or counterparty shocks could trigger a negative feedback loop that would cause commodity prices to rise further. Further increases in commodity prices, exacerbated by financial stress, could lead to demand destruction while increasing realized and expected inflation.
- Second, a further sharp rise in global commodity prices due to intermediation problems could weigh heavily on risky assets and increase volatility, leading to an abrupt and significant tightening of financial conditions.
- Finally, because commodities are largely settled in US dollars, companies depend on US and foreign banks for dollar funding to fund both their physical commodity purchases and the associated derivative hedge positions. Since commodity financing from foreign banks is often denominated in US dollars, disruptions in commodity financing can weigh on offshore dollar liquidity (Chart 3).
In response to tensions to date, a European energy trading group has called for facilities backed by the European Central Bank that could provide emergency liquidity to energy markets. Should another commodity price shock occur, the correlations between commodity prices and offshore dollar funding costs could rise again. That said, the threshold for central bank intervention in unregulated markets is high; it would be prudent for companies active in commodity markets to proactively assess and further strengthen their liquidity profiles.
about the authors
The opinions expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.