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Commodities Spring Cleaning

Written By Briton Ryle

Posted April 21, 2014

Have you performed your portfolio spring cleaning yet? The major banks certainly have, with commodities products and services being scaled back in good measure.

U.K.-based Barclays Bank (NYSE: BCS) will soon be joining other top tier banks including JP Morgan Chase (NYSE: JPM) and Morgan Stanley (NYSE: MS) in combing through their commodities operations and weeding out the poorly performing segments.

Barclays, along with other major investment banks, expanded their range of commodity products and services during the bumper opening years of the century when everyone was looking for the newest exotic vehicles to trade. But in the wake of cooling commodity prices over the past two to three years, conservatism has replaced exoticism, forcing the entire commodity investment space to return to the basics, leaving the banks with some house cleaning duties as they eliminate their poor selling products.

What does this mean for commodity investors? Will fewer products and services cut into your commodity investment options? Should we be exiting commodities ourselves?

Barclays’ Likely Reasons

The scaling back of commodity services by the major banks is unlikely to affect most commodity investors, since only those less profitable segments are being cut back – which most traders probably weren’t using anyway.

The Financial Times reports that Barclays “is making the move because conditions in the commodities markets have grown unfavorable recently. Revenues have fallen and regulators have increased their scrutiny of the space.”

Ever since the out-of-control swaps and derivatives markets almost singlehandedly brought down the entire financial system from 2007-09, regulators have introduced more stringent guidelines in evaluating the risks associated with certain investment products, often resulting in hikes to the amount of capital banks need to set aside to back them.

In an era of ultra low interest rates, banks need to deploy their capital more efficiently than ever before, and are thus scaling back services that have become too capital intensive to be profitable. Barclays Chief Executive Antony Jenkins is currently cleaning house for the third time in three years as the need to cut costs and improve returns persists.

So what’s on the chopping block?

A Look Into Barclays Services

While Barclay’s has declined to reveal the precise details of its reduction plan until tomorrow, the areas where the bank is expected to scale back will likely include “credit trading, emerging markets, securitization, structured credit and equity derivatives”, and may also involve the selling of its commodities index business.

While staff reductions are expected in the bank’s global commodity operations involving base and precious metals, agriculture and energy trading, the impact on employment is going to be quite small, given that only 160 employees are employed in the offices that will be affected.

Services catering to the producers of metals, agricultural and energy products will most assuredly be continued, as these have long been a mainstay of Barclay’s business, as explained at the bank’s website (cited from below).
Only certain exotic offshoots will likely be scaled back. Areas to be shaken out will likely include:

Coal markets: Barclays will most likely retain its “price risk management” services to “companies exposed to the global thermal coal market”, offering “a wide range of financial instruments in the main export and import hubs”, catering to “a range of coal producers, utilities, cement producers and steel mills across the world” by helping them “remove price uncertainty and lock in favourable prices for future periods” – services which remain in high demand.

What will likely be cut in this area is the “Commodity Index Linked Note whose performance is directly linked to the price movements of coal”, and some “dry bulk shipping” services.

Agricultural markets: Also retained will likely be Barclays’ “extensive platform of commodity risk management and financial services solutions across a broad spectrum of agricultural products” from grains to softs to fertilizers, offering “competitive pricing and liquidity to corporations, funds and investors along with innovative hedging strategies and market insight”.

What could be cut from this sphere are some exotic investment structures such as swaps, exotic options and commodity linked notes, which are part of the index products most banks have been eliminating.

Oil markets: Barclays will likely continue as “a market maker in financially-settled instruments on both exchange and over the counter indices for crude oil and refined products globally”. The bank has long been “a clearing member of the Intercontinental Exchange and the New York Mercantile Exchange” providing “clearing and execution services”, and is unlikely to give up such valuable services to such a prominent client base, which includes “producers, refiners, consumers and a wide range of intermediaries”. Barclays “comprehensive knowledge and understanding of all areas of the petroleum markets” and “expertise in managing, structuring and implementing risk management programmes” are renowned among “clients with petroleum exposure”.

What will likely be scrapped in this space are swaps and the bank’s “complex indexation formulae”.

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Base and precious metals markets: As a “long standing member of the London Metal Exchange” and “the member with the highest credit rating” within the group, Barclays will undoubtedly continue in its prominent role as one of the five participants in the daily gold fix which sets trading price for gold among banks. Its invaluable credit rating enables the bank to offer “longer dated structured solutions” which cannot be easily obtained elsewhere, and will most likely be continued.

Barclays is also likely to continue in it prominent role in precious metals warehousing, having invested heavily in its own “precious metals vault in response to growing client demand for precious metal storage”, a service which remains highly profitable.

Cuts will likely involve swaps, exotic options, and “derivative structures, including commodity linked investor products and yield enhancements NYMEX/Comex”.

Power and gas markets: Given the recent turmoil in the gas and electric power markets throughout Europe due to escalating tensions in Ukraine, Barclays’ prominent position in the “UK, US, French, German, Dutch, Belgian,

Spanish and Nordic power markets and the UK, US and Belgian gas markets” will undoubtedly be preserved, if not expanded.

As a member of “NYMEX, EEX, Powernext, APX and Nordpool exchanges” and “one of the largest players in the European power and gas markets and an active trader on exchanges across Europe in both exchange traded and OTC products”, Barclays “position, in-depth market knowledge and strong credit rating” allow it “to structure long-dated and complex risk management solutions in a difficult market place” – services which are only increasing in demand as government energy plans face an increasing need for radical overhauls.

Environmental markets: As a consequence of such changing energy strategies, one area of Barclays’ operations that may be slashed considerably could involve the trading of emission “allowances and project credits”, which the bank facilitates for industries operating under such emission credit plans as the EU Emissions Trading Scheme (ETS), Clean Development Mechanism (CDM), Joint implementation (JI), Regional Greenhouse Gas Initiative (RGGI) and the California Emissions Trading System (AB-32).

While California’s emission credits trading plan should remain unaffected, European emissions trading plans could undergo thorough re-evaluations given the anticipated changes to the region’s energy strategies. The increased need for energy self-sufficiency will likely result in the easing of restrictions on shale oil and gas operations in Europe, and may also necessitate the easing of emission control standards across the entire industrial sector.

Although the trading of emission credits is not going away completely, there may be less demand for some of the products and services associated with the practice for some years. Some of Barclays products including “financial swaps against market indices allow access to price exposure without delivery” and “bespoke swap products that allow clients to monetise their CER limits while maintaining their compliance positions” could see decreased demand and may be scaled back or eliminated.

Effect on Average Investors

It is unlikely that any reductions by Barclays Bank of its commodities services will affect average investors, since most invest in ETFs and producer stocks, which Barclays is not involved with. Such downsizing of commodity trading operations also isn’t an omen of the death of commodity investing. The grains, metals and energies will always be available for trading, and will continue to provide investors with periodic opportunities for generating returns.

Barclays’ house cleaning simply reaffirms how banking institutions continually reassess their commodity operations to optimize the use of their capital, as they re-shift their focus onto their most efficient programs. This provides us little investors with an example of how we too should be periodically reexamining our own holdings to ensure our portfolios are continually optimized for their efficient use of capital.

Are we keeping track of which of our holdings are winning, and which are losing? Do we periodically book the profits from our gainers and perhaps switch our laggards for other choices? If the big banks aren’t exempt from such tweaks, then neither are we little investors to neglect performing a good spring cleaning to ensure our portfolios never stray from our long-term investment objectives.

Joseph Cafariello