April 14, 2022
Since Russia invaded Ukraine on February 24, prices for a variety of commodities, including energy, food, and metals, have seen some of the biggest increases since the 1970s. These price movements have been exceptional both in its size and in its speed.
The movements have also been notable for the amplitude of the shock in different commodities. While volatility in commodity markets is not unusual, rapid and correlated price increases across many different types of commodities at once are much more rare.
In addition to the invasion of Ukraine, these moves coincide with international sanctions on Russia and have put pressure on financial sector intermediation in global commodity markets.
Recent evidence of risk management shortcomings on the London Metal Exchange (lack of monitoring of large positions, suspension of trading, and reported pressures on multiple clearing members in nickel trading) is another concern.
Ongoing developments in commodities should be monitored for possible impacts on financial conditions in general.
Commodity Prices and Trading: Potential for a Negative Feedback Loop?
Key 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 must look further to finance the commodities they store, ship, trade and/or process.
In addition, entities involved in commodity trading and production often hedge their exposures using derivative markets, primarily futures and options, to hedge against unexpected or extreme price swings. Traders and producers are generally required to do so by covenants on their bank loans to reduce the risk of default.
Derivative hedges for companies that are long the underlying commodity are generally known as offsetting “short” positions, that is, the derivative position protects against a drop in the price of the commodity. These hedges, however, have liquidity implications for the companies that use them.
Specifically, although the two positions offset in an economic sense, the cash flows do not offset. For example, a commodity trading company might buy a physical commodity and then also spend cash on a derivative hedge against falling prices. However, if commodity prices rise, the derivative position taken to hedge against a price drop loses money. Margin calls from the derivative counterparty may follow, requiring the trader/producer to provide additional hedge financing and further drain cash.
More generally, global commodity financing needs increase significantly as prices rise. When commodity prices rise rapidly, not only do goods prices rise, but also the associated price volatility increases the size of margin calls (Table 1). Rapid price increases across a variety of products mean that trading companies need additional credit to finance not only the goods they buy, but also the margin they must put up.
Liquidity strains associated with hedging margin calls may encourage companies to trade more derivatives. To hedge against further increases in commodity prices, companies can purchase commodity options with higher strike prices (the price at which an option can be exercised) to generate cash inflows to offset margin calls in their short commodity futures positions.
For example, while some of the growth in out-of-the-money options on oil may reflect market views about the future path of prices, some of this activity may also come from companies seeking to minimize liquidity stresses associated with other options. derivative positions. (Box 2). In essence, the company that normally seeks to position itself against a loss also takes the opposite position (to limit gains) in order to reduce potential cash flow stresses associated with its hedging activity.
In this environment of growing financing needs for raw materials, banks are the main source of credit for companies that sell raw materials. There are some reports of banks downsizing and unwilling to increase their exposure to these companies. While commodity trading companies so far seem to have obtained the necessary credit to continue their trading activities, the recent situation highlights some vulnerabilities.
A pullback in credit to some commodity trading firms could leave the rest unable to meet demand for commodity trading, which could create a negative feedback loop that pushes commodity prices higher.
How International Sanctions on Russia Affect Global Commodity Financing
International sanctions on Russian entities complicate global commodity market funding markets in two ways. First, banks may be reluctant to provide financing to commodity trading companies involved in the procurement, storage, or distribution of Russian commodities. This may be due to broad sanctions, the potential for sanctions to be expanded due to reported atrocities against civilians or a further escalation in Russia’s war against Ukraine, and the reputational risk associated with this brokering. Commodity companies can also decide to self-sanction their activities related to Russian raw materials.
To be clear, the intention of the international sanctions is to negatively affect the intermediation of the Russian economy and, in turn, to stop the conflict in Ukraine.
Second, there is a risk that international sanctions could be extended to include foreign affiliates of Russian state-owned commodity producers (such as the UK-domiciled trading affiliate of Gazprom or affiliates of the integrated oil company Rosneft). , which are engaged in the sale, trading or distribution of raw materials outside Russia. .
Like commodity trading firms, these companies may be active in both the physical commodity and derivatives markets. Their inability (or even unwillingness) to meet physical delivery or related obligations could leave non-Russian counterparties, including European utilities and refiners, at a loss.
Such a situation could manifest itself in the European utility sector in a similar way to what happened to some electricity producers during the February 2021 freeze in Texas. Some Texas electricity providers were forced to make expensive spot market purchases of natural gas used in power generation or were unable to produce and deliver the electricity they had sold in the derivatives market. (These risks may provide some context for a recent decision by the German government to take control of a local Gazprom subsidiary.)
US Surveillance of Global Commodity Market Brokerage
Monitoring the evolution of intermediation in the commodity markets is essential for at least three reasons:
- First, price or counterparty shocks could trigger a negative feedback loop that causes commodity prices to rise even higher. Further increases in commodity prices exacerbated by financial stress could lead to demand destruction while raising actual and expected inflation.
- Second, a sharper rise in global commodity prices due to intermediation challenges could weigh heavily on risk assets and increase volatility, leading to an abrupt and significant tightening of financial conditions.
- Finally, because commodities are largely settled in US dollars, companies rely on US and foreign banks for dollar financing to fund both their physical commodity purchases and associated derivative hedging positions. Since foreign banks’ commodity financing is typically denominated in US dollars, disruptions in commodity financing can affect offshore dollar liquidity (Table 3).
In response to the strains to date, a European energy trade group has called for facilities backed by the European central bank that could provide emergency liquidity to energy markets. If a further shock to commodity prices were to 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; Companies active in commodity markets would be wise 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.