Clarity on April 2015 Commodities Trading

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Trading places Evolving trends Trade flows Perspectives on selected A look at the main trends affecting An analysis of the evolution of ­international trading locations commodity trading ­commodities trade flows

Transforming with agility 2 Clarity on Commodities Trading

CONTENT

Clarity on Commodities Trading

EDITORIAL CHAPTER II

03 Transforming with agility 28 Evolving trends

04 Highlights 30 Survival of the fittest: navigating through ­turbulent markets

CHAPTER I 34 Agile transformation: how business and IT transformation is changing 06 Trading places 38 A new policy for an age of transparency 42 Geared for change: regulations trends

08 Switzerland: a powerful trading hub on a solid ­impacting the commodity trading sector foundation 46 Taxing times 12 Houston, Texas: an energy powerhouse 50 Market trends 16 London: setting the standard 20 Dubai, United Arab Emirates: a trading legacy CHAPTER III 24 Singapore: a premier commodity hub 52 Trade flows

54 Iron ore 56 Copper 58 Soybean 60 Crude oil

64 PINBOARD

65 CONTACTS & IMPRINT

1 2 Clarity on Commodities Trading

EDITORIAL

Richard Sharman Head of Commodities Trading

Transforming with agility

Commodity trading companies today operate in a highly Companies that will succeed will have flexible cost structures, competitive and dynamic environment where change is one clear entry and exit strategies and most importantly should of the few constant factors. Complexity of doing business be prepared to expect the unexpected. is being increased by changes in regulation, business models and trade flows. With this publication, KPMG wants to illustrate the growing importance of the commodity trading sector to the global With a world population expected to grow almost 40% economy. By focusing on the main trends affecting commodity by 2050, the middle class rising in emerging countries and trading and the perspectives of our specialists on the develop­ the continuation of industrialization, there is a structural in­ ments visible in various trading hubs, we want this to be the crease in the demand for commodities. While trading com­ next piece in your transformation journey. panies have an essential role to play to link this demand to new sources of supply, this will require investments in infra­ structure and global coverage. At the same time, trading companies need to maintain agility as external factors are creating unforeseen changes in trade flows, currencies and commodity prices. Richard Sharman

3 HIGH- LIGHTS

TRADE FLOWS

In response to infrastructure investments and urbanization in natural resource- poor economies (especially China), international trade of commodities has increased significantly over the last ten years. As Chinese economic growth has begun to slow down, excess supply is putting pressure on commodity prices, and is realigning the supply flows of key commodities such as iron ore, copper, and coal. Commodity producers, traders, and consumers alike are all reconfiguring their strategies to deal with this new reality.

TRADING TRANSFORMATION CONTINUES

Commodity trading companies are operating on a larger part of supply chains with the aim to improve their operating leverage.

REGULATIONS

The flood of regulations aimed at the financial sector is also impacting the commodities sector, both directly and indirectly. Given the diversity of regulations and the pace of change, companies will need to assess the impact themselves and come up with an adequate response.

4 Clarity on Commodities Trading FINANCIAL INSTITUTIONS EXITING PHYSICAL COMMODITY TRADING

Regulatory changes, increased capital requirements and reduced trading oppor­ tunities have forced many financial institutions to leave commodity trading. These exiting financial institutions provide opportunities for trading companies to fill the gap.

HIGH- STAKEHOLDERS’ COMMUNICATION

As a consequence of utilizing new sources of capital and opening up to ­external investors, commodity trading companies will have to embrace a more transparent and open dialogue with stakeholders.

AGILE IT OPERATIONS

To reduce complexity and costs, there is a trend towards IT integration. LIGHTS At the same time, IT needs to be more flexible and adaptive to changes, a strategy the trading industry is familiar with.

TAX

Increasingly, countries face international competition trying to entice businesses based on attractive tax rates. The current wave of international tax reform is creating uncertainty over the tax position of existing business structures.

GOVERNMENTS FACILITATE STRONG TRADING CLUSTERS

The decision where to establish a business is not only driven by competitive tax rates. Companies also consider infrastructure, legal systems, regulations and the quality of the workforce. Successful trading clusters show that governments strategically create favorable conditions for trading companies.

LONG-TERM TRENDS

Resource restriction, climate change and behavioral changes will drive techno­ logical developments focused on energy efficiency, recycling, localized energy generation and food production.

5 CHAPTER I

TRADING PLACES Perspectives on selected international trading locations

Change is one of the few constants. This is the common message from our specialists when they observe developments in various trading hubs. Commodities traders are under pressure to continuously revisit their role in the supply chain and reassess the value they add to markets. In fact, this need is not limited only to companies. It applies equally to the countries in which the traders operate. Countries compete to attract businesses and employment. They do this primarily by offering attractive tax rates, robust legal systems and good infrastructure, as well as on the basis of labor costs and standards of living. These qualities can vary in attractiveness as trade flows, currencies and commodity prices change – sometimes instantly – having potentially significant implications for where a business deems to be an appropriate base.

6 Clarity on Commodities Trading

7 8 Clarity on Commodities Trading SWITZERLAND A powerful trading hub on a solid foundation

Switzerland has a long tradition of being one of the world’s leading centers of commodities trading. There is a hub of diverse companies active in and around the commodities industry, including banks that specialize in the financing of commodities trading, companies providing inspection services, shipping companies, insurance companies, law firms, escrow agents and consultants. It is in the interest of Switzerland to maintain the strong fundamentals of the industry, specifically its attractiveness as a business location from a tax, infrastructure, regulation and quality of living perspective.

9 CHAPTER I TRADING PLACES

Reijer Barendregt, addition to other factors that contrib- are well trained and specialized. KPMG in Geneva ute to Switzerland’s appeal as a busi- Switzerland’s strategic location in ness location, such as the availability Europe, ideally situated between of well-trained personnel and a gener- American and Asian time zones, ally high standard of living, the coun- makes it possible to trade with Asia, try’s sophisticated and stable financial the Middle East, and the continental system makes it particularly attractive US on the same day. The country’s as a commodities trading center. modern infrastructure, good transpor- Commodity traders must be able to tation system and flexible employment he building blocks rely upon the availability of special- laws are further arguments that favor The reasons for ized financial service providers that of- Switzerland as a center for commodi- Switzerland’s major role fer highly sophisticated financing and ties trading. in global commodities arbitrage products tailored to the spe- T trading include a stable cific needs of the commodity industry. As a business location for commodities and predictable political, economic, A Masters in International Trading, trading, Switzerland faces international and legal environment, a competitive Commodity Finance and Shipping competition from places such as corporate taxation regime and a busi- program ensures that new workers Singapore, Dubai, China, the United ness-friendly regulatory climate. In come into the market every year who States and the United Kingdom.

10 Clarity on Commodities Trading

However, with its attractive effective country’s reputation have also affected Reform III and the ongoing dialogue statutory corporate income tax rates, the commodity trading industry. This with the EU on corporate taxation. binding advance tax rulings, an exten- has resulted in a background report on Based on the current draft of the legis- sive network of tax treaties (with close the commodities industry to the atten- lation, it appears that Switzerland will to 90 nations), investment protection tion of the Swiss Federal Council. The be able to maintain a competitive tax agreements (over 100), a VAT rate of Swiss Federal Council expects all regime. 8% and a competitive personal income companies to conduct tax system, Switzerland still remains themselves responsibly very attractive. and with integrity, to Switzerland recognizes the comply with human rights, environmental importance of the commodity Being adaptive to change and social responsibili- trading industry for its Recent referendums (specifically the ty standards but is re- Stop Mass Immigration Initiative, the luctant to produce in- economy and will protect its referendum on limiting the highest sal- dustry-specific ary in a company to twelve times the regulation. The recom- interests through effective lowest salary and the referendum on mendations highlight regulations that will executive pay) and the decision of the the need for improved Swiss National Bank (SNB) to stop its transparency concern- strengthen the industry to currency intervention may somewhat ing derivative trading, undermine the idea of a stable and pre- money laundering, tax create a level playing field. dictable political, economic, and legal evasion, physical com- environment. However, these events modity trading, finan- should be seen as a response to the cial flows from resource extracting Concerns around transparency, referen- instability that surrounds Switzerland, companies to governments and prod- dums and the strength of the Swiss which inevitably affects the open uct flows. Commodity trading compa- franc should not affect Switzerland’s economy of Switzerland. Another in- nies, fully aware of the stakes, have competitiveness. Ultimately, Switzerland terpretation of this could be that it is engaged proactively in the voluntary is competitive because of its underlying precisely these responses (and ongoing improvement of their governance. To strengths, such as a highly specialized dialogues) that demonstrate the ensure a level playing field, Switzerland workforce, an excellent banking system, strength and the flexibility of the will engage itself to have the regula- competitive taxes and a high standard of Swiss economy. tions it will implement align with reg- living. In the end, these fundamentals ulations implemented by other major matter. Switzerland’s reputation has recently financial centers. been a bit more tarnished as concerns have been raised about the lack of transparency of Swiss-based banks, The fundamentals matter which have been under fire for several There is currently no evidence of com- years for allegedly helping clients panies moving away from Switzerland evade taxes. Concerns regarding trans- in droves. Much will also depend on parency and the damaging effect to the the framework of the Corporate Tax

11 12 Clarity on Commodities Trading

HOUSTON, TEXAS An energy powerhouse

Dominating Houston’s industrial landscape, energy is vital to the city’s economy. With many of the world's largest energy trading companies either headquartered or having major trading offices in Houston – BP, Shell, Chevron, Vitol (to name but a few), the city thrives on its commodities business. Oil, gas and refined products take pride of place in an industry that spans both financial and trading activities. An extremely large physical commodities community completes the mix.

13 CHAPTER I TRADING PLACES

Brian O’Neal, executives. There has also been consid- subsequent emergence of shale pro- KPMG in Houston erable investment in related industries duction methods, both of which have such as chemicals, technology, and ad- added to the city’s fortunes. Indeed, vanced manufacturing. George Mitchell, the “father of frack- ing,” was a major contributor to Houston area business, residential de- Deregulation and shale: velopment, and arts communities. reinvigorating the city’s fortunes Energy trading in deregulated markets Having gone through difficult times in remains strong in Houston, and there he commodities business the 1980s because of its dependency remains considerable interest in shale achieved critical mass in on the energy industry, Houston’s plays, even at low prices, primarily Houston many years ago. economy diversified over the next two due to ongoing infrastructure invest- In addition to those di- decades. Even so, Houston is once ments and the effect that increased T rectly involved in the en- again well served by the energy sector. supply has on downstream industries ergy business, an entire service indus- Much of this success can be attributed such as chemical manufacturing lique- try has sprung up – from engineers to to the postderegulation merchant ener- fied natural gas (LNG) exportation. financial accountants to business gy boom of the early 2000s and the

14 Clarity on Commodities Trading

A future burning bright cause for concern at energy trading So what does the future hold for the Prospects for the city’s energy indus- companies as well as associated indus- corporate landscape? try are aided by the fact Texas has tries that rely on oil and refined prod- The combination of low oil prices and made great strides to be a busi- ucts (e.g. oil field services, drilling highly leveraged midtier producers ness-friendly state, particularly in companies, engineering firms, etc.). means consolidation can be expected terms of taxation and regulation. Depressed oil prices cause capital to gather pace from late 2015. Once Corporate law and taxes are condu- needs to come to the fore. As a result, existing hedges expire, sustained oil cive, with relatively low corporation organizations along the value chain are production at USD 40 per barrel could tax and the lack of a personal income looking to become more flexible. Many cause considerable financial difficul- tax drawing businesses and talented energy traders in particular are looking ties and drive multiple companies to professionals to the state. A certain de- closely at their business models. seek relief in asset sales and divesti- gree of forward thinking has also tures. Larger players are already played its part. The late 1990s closely observing such small saw a heavy investment in com- If trading is squeezed by businesses, considering possible munications and infrastructure asset purchases and entity acqui- by Houston’s government. And low market liquidity, sitions in the near future. of course its sheer proximity to As far as the bigger picture is natural resources should not be and capital situations concerned, there is a clear shift underestimated. Such factors restrict proprietary trad- in global energy dynamics as a mean the future remains bright. result of the US’s mass exploita- ing, we may see a number tion of shale deposits. With mod- erate pricing expected to endure Some challenges persist of companies shift their for some time, impacts will be Energy in Houston faces com- focus towards asset felt across multiple industries mon challenges, though few are and global populations. uniquely attributable to the city ownership, optimization, Houston’s history with the indus- itself. In speaking to executives try, ability to carry through mar- across energy trading companies, and tax-advantaged ket lows and highs, and concen- a common concern is the ability corporate restructuring. tration of talent mean it will (and cost) to keep pace with reg- continue to exert significant in- ulatory change. As the industry fluence on this changing market moves towards greater transpar- environment. ency, many businesses are investing Even taking these challenges into ac- Houston remains extremely attractive heavily in compliance with an evolv- count, continued investment in capital as a commodities hub. Continued de- ing regulatory landscape. projects and human resources can be velopment is expected across crude oil, Environmental regulations are also a expected. Especially as the overall US gas and refined products. The industry key concern for the industry’s execu- infrastructure for oil refining, com- will continue to evolve – as it has for tives. In addition to well-publicized modity transportation, and power gen- decades – and is working hard to en- opposition to hydraulic fracturing, a eration and transmission is expected to hance its risk management and capital number of ongoing updates to environ- lag behind future needs. A lion’s share management approaches. All in all, the mental regulations are addressed and of future investment is likely to focus city remains an extremely exciting planned for by Houston’s top energy on Houston, given the concentration of place to do business – with a future full companies on an annual basis. major energy players here and the vast of enthusiasm and, well … energy. The falling price of oil is also a major existing pool of skilled resources.

15 16 Clarity on Commodities Trading LONDON Setting the standard

From the City coffee houses that gave rise to some of the world’s first stock exchanges in the 17th century to the Brent Crude benchmark that emerged in the 1970s, London has played an important role in the evolution of commodity trading. London continues to set the standard today through global benchmarks for metals and oil as well as by having the largest natural gas market in Europe.

17 CHAPTER I TRADING PLACES

James Maycock, thriving ecosystem of match buyers and sellers in the OTC KPMG in London trade and finance market. It has exchanges and trading As a world financial houses specializing in industrial metals, center, it is the place agricultural commodities and energy A that market participants futures. Events such as International come to structure, fund and hedge their Petroleum Week and London trades. London sets itself apart as a hub Metal Exchange Week bring industry for trading commodities from other players together every year. trading centers in Switzerland and Singapore thanks to a high density of The city’s cosmopolitan character and the industry’s key institutions, events cultural offerings attract skilled per- and people. The city is home to major sonnel from all over the world who fill commodity brokerages that actively a diversity of roles within commodity

18 Clarity on Commodities Trading

trading. A London address still holds directives re- prestige value for company owners. In garding capital Traders accordingly have new addition, investors and traders from requirements, is other countries are drawn by the ease that many opportunities to match supply of doing business in the UK: barriers banks have and demand throughout to entry are low, assets are safeguarded abandoned oth- by the rule of law and the political sys- erwise profit- the energy supply chain, using tem is stable. able commodi- ty trading lines shipping and storage. due to the un- Weighing the EU relationship and certainty sur- new regulation rounding the additional costs they may Market watchers see more potential Market observers are monitoring sever- impose. Although the liquidity gap left for vertical integration within the in- al variables in the current political envi- by the banks has not yet been filled, this dustry. In the North Sea in particular, ronment. The UK is gearing up for a seems to be a short-term issue. The where assets are mature, new players closely contested election in May 2015. larger question on the minds of all including fund managers are also tak- Amid the broader political uncertainty market players is the ultimate financial ing the opportunity to diversify their in the short term, a key issue in the up- burden of the coming regulatory and portfolios as more established oil com- coming election is the UK’s relation- tax schemes. panies move to new frontier territories. ship with Europe – especially with a potential yes/no referendum in 2017 – Given the increasingly global nature of as well as the impact of EU regulation Finding opportunity in current energy markets as well as financial and the emergence of a more joined-up ­market dynamics markets, London appears well posi- approach from regulators across borders Whilst foreign currency risk looks set tioned to profit from its location at the more generally. to become a longer-term trend global- confluence of capital flows, talent -mi A raft of regulatory measures followed ly, with central banks continuing to gration and broader trends in business. the 2007-2008 financial crisis in re- experiment with interest rates and sponse to calls for more transparency quantitative easing, commodity traders and oversight. One effect of such regu- in London are accustomed to manag- lation, including MiFID II (the EU ing foreign currency exposure since Directive on Markets in Financial they have always done their business Instruments), REMIT (the EU in dollars. Regulation on Energy Market Integrity and Transparency), EMIR (European Volatility has returned to the commod- Market Infrastructure Regulation on ity markets in the form of weak prices OTC derivatives) as well as various and shifts in global energy sources.

19 20 Clarity on Commodities Trading

DUBAI, UNITED ARAB EMIRATES A trading legacy

To understand Dubai and its strategic focus on commodities trading, look at aspects of its past to see how central this business is to Dubai’s success. Dubai began as a village centered on fishing and pearl trading and grew on the back of this trading legacy. However, as Sami Al Qamzi, Director General, Department of Economic Development (DED), says: “While retail trade has always played an important role in Dubai’s growth, it has undergone a major transformation and modernization in the last ten years. Trade has and continues to be one of the key pillars in the overall structure of our local economy and a main driver for its growth with the rising curve in trade volumes as an indicator of the success of its developmental strategies.”

21 CHAPTER I TRADING PLACES

Luke Ellyard, Emirates with over 9,000 registered has become an attractive place to do KPMG in the Lower Gulf companies under license. Ahmed Bin business, with Western markets shifting Sulayem, Executive Chairman of trade and financial flows from the West DMCC, is quoted on their website as to the East. This also has to do with the saying: “Trading will always be a key massively increased regulatory burden component of Dubai’s vision of be- of conducting commodity and deriva- coming a dynamic and diverse econo- tives businesses in Western markets. my, and the gateway to the emerging markets of the Businesses are also aware that ommodities trading as Middle East. As an interna- they can go more directly from a strategic government tional commodities hub, initiative DMCC plays an important production in the west (Africa and At the heart of this role in the evolution and South America) or north (Russia) C growing trade is economic growth of Dubai.” to consumption in Asia. Dubai’s commodities industry. In 2002, as a central strategic govern- ment initiative, the Dubai Multi A location central to global­ Dubai, with its first-world infrastruc- Commodities Centre (DMCC) was es- commodities flows ture and ideal geographic location, is tablished with a mandate to provide In addition to this strategic focus on ideally placed to play its part in these the physical, market and financial in- trade, Dubai’s success is in part due to flows. frastructure required to set up and op- its central location. It is midway be- erate a thriving commodities market- tween East Asia and western Europe, place. This was seen as vital for Dubai as well as Central Asia in the north and Now established as a global player to be a global gateway for the com- Africa in the south. At a time when the in gold, diamond and tea trading modities trade. Today, DMCC is the the European and the American econo- In particular for gold flows, Dubai has largest free zone in the United Arab mies are growing only sluggishly, Asia been able to capitalize on both its

22 Clarity on Commodities Trading

proximity to the key consumer mar- including world-class air and port counter parties (CCPs) are considered kets of India and China and its value free-zone facilities. Other attractive a key element of the infrastructure in as a trade hub and channel from the factors, such as Dubai’s strong securi- the financial system of any economy, international market to its ultimate ty and good customs, combined with integral in managing risk within the fi- destinations. It is currently the world’s the rest of the infrastructure, make nancial system, and European Market leading physical gold market with over Dubai a place where cash and physi- Infrastructure Regulation (EMIR) is 40% of the world’s gold passing cally settled ETD and OTC commodi- focusing on the financial security of through the emirate, with some giving ties contracts are viable options for CCPs, the integrity and capability of Dubai the nickname City of Gold. global as well as local businesses. The CCP management, capital and struc- This is also true for flows in other available skill set is constantly im- ture. Broadly, EMIR requirements for commodities, such as diamonds. proving, meaning that companies es- capital and structure are becoming DMCC has grown exponentially in tablishing themselves in Dubai can benchmarks within the industry and the terms of diamond trading in recent find (or easily import) the skilled labor Emirates Securities and Commodities years. Diamonds are following the they require. Telecoms and associated Authority, the federal regulator, is like- West-to-East. The Dubai Diamond trading technologies are also constant- ly to adopt these standards in new reg- Exchange now has over 600 precious ly improving. Where once they may ulation. This would be beneficial for stones and diamond companies and is have been viewed as a deterrent to set Dubai because it will give global insti- one of the top three diamond trading up shop in the region, this is no longer tutions increased confidence in the centers in the world. Tea is reversing the case. regulatory environment, reduce risk the West-to-East pattern, shifting fur- within well-capitalized CCPs, and ther west. The UAE is the world’s therefore give institutions added com- largest reexporter of tea with a 60% Positively countering the geopolitical fort in engaging with local CCPs. share of the market. Again DMCC and regulatory challenges faced These positive regulatory steps, pro- plays a key role in global tea trading Given Dubai’s location, it is impossi- viding a regulatory environment in and logistics. Both diamonds and tea ble to ignore the rise of religious ex- many ways equivalent to Europe, sim- are now established because of what tremism in the Middle East and Africa. ply enhance Dubai as a location in Dubai can offer to this global com- The region has its fair share of politi- which global entities are happy to con- modities flow. cal tension. However, Dubai is part of duct commodities business. the UAE, which has a reputation for being a low-crime and politically sta- Other factors contributing to the ble country, considered a safe haven So what does the future hold success for people and money flows from the for Dubai? Dubai has two main commodities ex- rest of the region. One of the six key themes in the re- changes: the Dubai Gold and Another aspect that cannot be ignored cently published city’s vision for 2021 Commodities Exchange (DGCX), lo- is the fall of the oil price. However, is that it will aim to be a “Pivotal Hub cated in the DMCC, and the Dubai since the formation of the UAE in in the Global Economy.” Dubai has Mercantile Exchange (DME). The 1971, Dubai has transformed itself also been awarded the World Expo for DME is located in the Dubai from an oil-and gas-dependent state to 2020 which will be held under the International Financial Center (DIFC), a broadly diversified economy based on theme “Connecting Minds, Creating a financial free zone designed to pro- international trade, banking, tourism, the Future” and is projected to attract mote financial services within the real estate and manufacturing. Oil has 25 million visitors, 70% from over- UAE, which is regulated by the Dubai played a progressively diminishing role seas. Both of these projects are central Financial Services Authority. It is the in the emirate’s economic profile. In to Dubai’s growth over the coming main energy-focused commodities ex- 1985, the oil sector contributed just un- years and reinforce the view that change east of the Suez and home to der half of Dubai’s GDP. By 1993 that Dubai will continue to focus on devel- the world’s third largest crude bench- figure had fallen to 24%, and now it is oping its role as a trading center in the mark, the Oman Crude Oil Futures under 5%. Perversely for its location, world of commodities flows. Contract (DME Oman) which is estab- Dubai has the potential to gain from It is hard to imagine where the Dubai lished as the crude oil benchmark for the rise in trade flows expected from commodity industry will be in ten the region and historically established the falling costs of transport fuel. years, but assuming flows and capital markets for Middle Eastern crude oil continue to move to the East, regula- exports to Asia. From a regulatory perspective the tion, systems and infrastructure reach However, whilst the DMCC as a free challenge is the economic fallout from operational maturity, and the market zone acts as a focal point for commod- 2008, which is now affecting how the continues to develop at the pace of the ities trading, there are many other fac- derivatives business is conducted in last ten years, it will be an exciting tors contributing to the success, and between economic areas. Central place to be!

23 SINGAPORE A premier commodity hub

Singapore’s evolution towards becoming one of Asia’s premier commodity trading hubs has been a carefully crafted process. Through government pragmatism, proactivity and foresight, Singapore is jostling with Hong Kong and Shanghai to become Asia’s chief commodity trading hub.

24 Clarity on Commodities Trading SINGAPORE A premier commodity hub

25 CHAPTER I TRADING PLACES

Hak Bin Pek, markets of the West and energy-de- trading. In agriculture, it sees about KPMG in Singapore mand centers of the East. 20% of global trade and ranks second It has emerged as the world’s third – behind Switzerland – for metals and largest transshipment port, largest bun- minerals. It is, nonetheless, the gov- ker market and boasts a reputation for ernment’s cultivation of an attractive maritime and logistical proficiency. Its business environment that has cata- deep-water berths can accommodate lyzed the “little red dot” into a global Suezmax, Panamax oil tankers and commodity and financial powerhouse. very large crude carriers (VLCC), sup- ocated along the cross- plementing the development of a large, roads of busy sea-lanes and well-integrated and sophisticated Business haven supported by a natural downstream supply chain. A key competitive advantage Singapore deep-water harbor, has over Southeast Asian rivals is that it L Singapore has long facili- Supported by world-class infrastruc- is both a trading and banking hub, with tated Asia’s rising appetite for com- ture, it is perhaps little surprise that both growing hand in hand. modities. Indeed, Singapore sits strate- Singapore handles approximately 15% The city-state’s physical and paper gically between the traditional supply of the world’s physical crude oil market has flourished because the

26 Clarity on Commodities Trading

positioning themselves in Singapore, Corporation (SLNG) offers Storage & providing innovative sources of invest- Reload Services (S&R). ment and, in some cases, are likely to opportunistically acquire distressed In conjunction with support for a more assets. transparent and liquid LNG market comes support for the same in the Against a backdrop of low and volatile electricity markets. Currently, the crude oil prices, physical traders are Energy Market Authority is providing pursuing contango trading strategies incentives to electricity producers to by storing oil in anticipation that crude facilitate a futures market, with the in- commodity market has long had ac- prices will rise in the future. tention to provide a mechanism for cess to a trade finance platform, sup- Singapore’s storage capacity, com- hedging risk, as well as providing a ported by transparency and a robust bined with vast storage developments platform for potential new entrants. ­attitude to the rule of law. in Pengerang, Malaysia and The implementation of innovative fis- Batam, As demonstrated in several other cal incentives has drawn a stream of Indonesia, has international trading companies to set resulted in the international markets, the end up shop in Singapore. Malacca Straits goal of more transparency and becoming the The “Global Traders programme” world’s largest ­liquidity is greater competition, (GTP), established in 2001, offers a oil trading hub, corporate tax rate of 10% to traders. surpassing the which itself exerts downward Companies can qualify for a 5% rate if Amsterdam, pressure on prices – a boon for they commit to hiring local Rotterdam and Singaporeans and make significant use Antwerp consumers. of Singapore’s banking and financial (ARA) region. services, among other criteria. In a rel- These develop- atively short time, the GTP has con- ments have resulted in prices moving Whilst Singapore provides an excel- tributed substantially to the country’s beyond a Free-on-Board (FOB) lent platform for a regional commodi- economy and has been a critical factor Singapore basis, towards a broader ties trading center, it also faces certain in its ascendance as not just a regional, FOB “Straits” basis. The extra storage constraints and limitations such as the but also as a global commodity hub. will enhance trading flexibility and constraint of land, lack of indigenous boost liquidity for the oil commodity resources, high labor costs and short- industry in Singapore. age of talents in some disciplines. Unfolding market trends The global commodity industry is con- The successful companies tend to be tinuously evolving, involving a vast Long-term developments the ones who are able to capitalize on number of players across a broad sup- Asia, particularly after the Fukushima Singapore’s advantageous position but ply chain. In the last few years, a mix accident in 2011, is anticipated to be also from the greater ASEAN market of financial players have left and en- the core LNG demand market, with and resources as a whole. Those who tered the sector. demand expected to rise threefold over leverage on innovative technologies the next 20 years. and effective supply chain manage- In the face of capital requirements, ment across the region will be able to stress-testing measures and generally In light of relatively high natural gas benefit most from the ASEAN region. poor performance, a number of large prices vis-à-vis the US and Europe, investment banks have sold their phys- calls for the creation of a transparent The good news is that Singapore is ical assets and exited physical trading and liquid LNG regional spot market sitting in the middle of such a high- plays. By contrast, as the oil and gas have intensified. Singapore, which growth region; companies that make industry braces itself against weak opened its first LNG Terminal in 2013 the right planning and strategic prices, and cash flow constraints and has plans to build a second, has approach will often be rewarded. mount, M&A opportunities have well-established ambitions to position emerged in Asia. The region is witness- itself as the region’s chief LNG trad- ing a raft of private equity and hedge ing hub, leveraging its mature com- fund players seeking entrance into the modity trading infrastructure. Indeed, market. A number of these are as of 2015, Singapore LNG

27 CHAPTER II

EVOLVING TRENDS

28 Clarity on Commodities Trading

Governments and regulators have a lot on their plates. Particularly as they seek to manage financial stability and avoid future economic crises. The way in which financial markets function – and the fast pace at which they change – adds to the difficulties. A wealth of new regulations have been proposed in the aftermath of the 2007 – 2008 financial crisis. Too many of these regulatory responses reflect the old state of affairs and the countries’ attempts to manage national interest in light of historical trends. If a level playing field is to be achieved, a more coordinated global approach is needed to the regulation and taxation of international businesses. Some key developments such as Dodd-Frank and EMIR are aligned to a certain extent. For taxation, the BEPS action plan is providing international direction through the OECD. Furthermore, a series of private initiatives are being undertaken to develop standards that have truly global reach. The Extractive Industries Transparency Initiative (EITI) is one such example, aiming to enhance the transparency of commodity trade flows on a global basis. Businesses must develop their own strategies to respond to these changes. To draw a parallel with digital disruption, organizations are increasingly moving away from traditional detailed strategy and planning approaches, towards a more flexible approach. This is necessary due to the sheer speed with which change occurs – meaning that organizations have months to respond, rather than years. Commodity trading companies tend to be very agile, with a track record of being able to respond quickly to change. Many are investing in physical assets, infrastructure and logistics to support their trading operations. In doing so, they are removing supply bottlenecks and extending their control over the supply chain in the quest for more sustainable, higher profit margins. The risk is that their extended reach will come at the expense of agility. With this in mind, successful companies may well be the ones that manage to achieve flexible cost structures, clear exit strategies and are well prepared to expect the unexpected.

29 CHAPTER II EVOLVING TRENDS SURVIVAL OF THE FITTEST NAVIGATING THROUGH TURBULENT MARKETS

30 Clarity on Commodities Trading

2014 saw steep falls for certain key commodities (such as crude oil and soybeans), while extending the decline in oth­ ers (iron ore, coal, copper, wheat, etc.). Traders have also been working in a lower-volatility context, making directional plays such as cash-and-carry oil trades scarcer. Against this backdrop, trading firms have looked to strengthen core plat­ forms, increase supply chain efficiency (to increase trade margins), and selectively invest in assets that enhance their position in the supply chain or provide access to long-term price upside (such as in upstream mining or energy assets). Resource companies have been affected by the lower-price environment, with smaller players becoming vulnerable due to the reduced profitability on weaker balance sheets. With 2015 opening with prices still low, major players are now looking at where and how to play in the new context.

LOW PRICING DRIVING Altona), coal and aluminum markets, the opportunity the lower asset prices STRATEGIC AND TACTICAL where production costs and logistics are presenting to acquire or joint ven­ OPPORTUNITIES costs are key pivots to viability. In oil, ture with struggling smaller miners or increased volumes on the market (in upstream oil production companies Continued weaker pricing in iron ore, the face of the Saudi production push) and add them to their core operations. aluminum, coal, and the recent slump have led to US new oil rig count de­ in crude oil pricing have been driven by creasing in early 2015. The opportunities in upstream opera­ a combination of large volumes of sup­ tions are traditionally not a core focus of ply coming online as well as weaker We expect the current situation to trig­ commodity traders who prefer to own demand from China, whose economy ger a significant wave of consolidation assets tied to logistics, which enhance has driven the major shifts in commod­ in mining as well as oil and gas. The their end-to-end trading margin, and ity flows over the past decade. The weak pricing over 2014 is expected to avoid flat price risk exposure. However, weaker pricing is now driving industry persist in the near future and will put traders with a positive long term view consolidation and shutdown of produc­ continued pressure on midsized re­ of the prospects for global economic re­ tion facilities. Rio Tinto expects 85 source firms with relatively high pro­ covery are now looking for ways to play mtpa of iron ore supply to come off duction costs. As such, companies an expected rebound in commodity the market in 2015, principally from with available cash reserves (e.g. sov­ prices over the medium term, and if higher-cost Chinese mines, but also ereign wealth funds, top mining com­ ­upstream assets can be used effectively from troubled smaller Australian mines panies, Chinese resource companies) to construct a solid yet hedged position, (such as Fortescue). Similar situations or structured financing (e.g. physical they will move on appropriate assets. can be observed in the copper (e.g. traders) are likely to take advantage of

31 CHAPTER II EVOLVING TRENDS

PRODUCERS UPSTREAM TRADING PROCESSORS DOWNSTREAM CONSUMERS

• UPSTREAM OIL • INTEGRATED TRADERS • INTEGRATED REFINERS • INTEGRATED TRADERS • POWER COMPANIES (EXPLORATION AND (MAJORS AND NOCS) (MAJORS AND NOCS) PRODUCTION) • INDEPENDENT • PETROCHEMICAL • LARGE INDEPENDENT REFINERS • LARGE INDEPENDENT FIRMS • COAL MINES TRADERS TRADERS • TRADING REFINERS • DOWNSTREAM OIL • UPSTREAM GAS • INTEGRATED • INTEGRATED FIRMS AGRICULTURE FOCUS • GAS FRACTIONATION AGRICULTURE FOCUS • ORE MINES • INDUSTRY • MIDSIZE AND SMALL • COAL WASHING • MIDSIZE AND SMALL • SOFT COMMODITY NICHE TRADERS NICHE TRADERS PRODUCERS • METAL SMELTERS

• MILLING/GRINDING FOR SOFT COMMODITIES

PHYSICAL TRADING COMPANIES USE LOGISTIC AND PRICING CAPABILITIES TO SOURCE, STORE AND SHIP COMMODITIES

SOURCING AND TANKER/CARGO OWNED AND LEASED KEY CUSTOMER OFFTAKE AGREEMENTS CHARTERING STORAGE CAPACITY CONTRACTS

As opportunities appear on the market, Temasek now controls 80% of Olam, houses have flexed their balance sheets new players such as private equity the listed agriculture-focused trader. to step into the void – to the point that funds, sovereign wealth funds, and Where trading houses are creating JVs some have considered acquiring banks. hedge funds are participating in invest­ to enter upstream assets, they structure ments, thereby limiting trading house transactions with offtake agreements, exposure. Current examples are Cargill which provide them with proprietary ac­ RESOURCE-HEAVY TRADERS along with Permira recently seeking to cess to product flow, allowing them to FOCUSING ON CORE OPERA- invest in value-added animal feed busi­ create more complex trading structures TIONS, BANK REGULATION ness Nutreco, Carlyle joining up with with a greater degree of optionality. DRIVING EXITS Vitol in oil storage or Mubadala partner­ ing with Impala (Trafigura) in port opera­ A further effect of the low prices has Given the past year’s poor results and tions. Although announced transactions been to trigger an increase in prefinanc­ next year’s weak projections, an­ are more in processing and logistics, a ing by traders, whereby they will lock in nouncements of reductions in costs number of attempts to transact in up­ a significant volume of offtake at fixed and decreased budgets for capital out­ stream assets have also been brokered. pricing. This allows them to establish a lays have flooded the mining market. In addition PE firms have invested equi­ floor for access to product, secure sup­ Conjecture has run rampant with the ty in trading houses, such as KKR in ply and provide much-needed cash to more extreme example of Rio Tinto’s MCS Capital and Oaktree in Hetco, sig­ the production or mining firm to finance announcement that it had been infor­ naling the increasing trend of commodi­ working capital, and continue with ex­ mally approached by Glencore to ty traders looking for new sources of ploration or other capex programs. The gauge interest in a possible merger. long-term capital to increase their busi­ increase in prefinancing is also a conse­ A tie-up would indeed release huge ness reach. In a more extreme version quence of the retreat by banks from synergies and cost reductions, espe­ of this trend, the Singapore wealth fund structured trade finance, and trading cially relating to both companies’ coal

32 Clarity on Commodities Trading

assets in Australia. Given recent stock Given the flat trading conditions of the CONCLUSION prices, however, such a merger would last two years (with very low volatili­ be difficult in the short term – the mar­ ties), traders have sought to increase In summary, commodity prices are kets will be watching and speculating their share of all commodity trades, still heavily reliant on the dynamics heavily from April 2015 when discus­ increasing the volume of physical and of the Chinese economy, but struc- sions can begin again. Furthermore, paper products traded to maintain their tural changes in key industries, such we expect continued divestment of absolute margins. Increasing control as the US oil and gas or Australian noncore assets as resource compa- of the logistics chain is providing im­ iron ore sectors, have also triggered nies respond to low commodity pric- proved operating leverage to take significant shifts in product flow, es, depressed share prices and the advantage of this increase in scale in whose impact is influencing the resulting demands of investors. trading operations. markets. Where anticipated, these Along this vein, another area of strate­ shifts are allowing major traders to The market is also seeing the in­ gic investment is gaining control of benefit from strong sourcing and creased divestment of physical com­ ports with expected growth of com­ marketing positions. Where traders modity trading arms by banks as fi­ modity flows. These are being seen as are following the market, we are nancial institutions are exposed to key to developing long-term delivery seeing traders performing strategic increasing scrutiny by regulators. cost advantages for traders across reviews of their noncore assets, Even prior to the US Senate’s release most commodity classes, including with the larger, more diversified of its findings on Wall Street banks’ softs. Trafigura has demonstrated this traders mothballing assets and/or involvement with physical commodity by joining forces with Mubadala focusing on cost reduction while trading, Mercuria acquired a position Development for a controlling stake in waiting for commodity prices to in- of J.P. Morgan’s physical commodi­ Brazil’s iron ore-focused Porto Sudeste crease. The smaller, less diversified ties business. Morgan Stanley is re­ terminal. Glencore has similarly acquired resource players will be forced to launching the sale process of its oil a 50% stake in the Barcarena port in consider selling their noncore (or trading and storage business (follow­ northern Brazil from ADM to increase high-cost) assets at relatively low ing the attempted sale to Rosneft), their presence in soybean trade. prices. Look for private equity and which signals major banks’ exit as Soft commodity traders will continue other financial investors to enter the key players in the physical commodi­ to expand their presence in port infra­ M&A market searching for bargains in ty trading market. Banks will retain structure such as terminals, jetties the hope of commodity prices rising instead their role in certain areas of and storage facilities, particularly in in the future. Traders will continue financing and thereby reduce costly developing markets. to pick up logistical assets in order regulatory compliance. to extend their scale advantages Refining facilities have attracted less in key product platforms. Resulting attention as excess supply has, on the from these trends is an expected ENHANCING THE VALUE CHAIN whole, created unfavorable conditions reshuffling of assets in favor of the for owners of these assets. This has larger, more financially sound traders Commodity trading companies have been evident in the sugar market, and new market entrants looking continued to seek opportunities to where Brazilian sugar refineries have for bargains. strengthen their value chains through been difficult to sell. In addition, oil re­ acquisitions. We expect to see deals fineries, particularly in Europe, have sparked by traders’ desire to own stor­ seen margins squeezed, as lower de­ age facilities, as most expect commod­ mand, low pricing and higher relative ity prices to rise from their current levels costs reduce their appeal especially in in the foreseeable future (reflected, the face of a revitalized US refining for example, in crude oil’s contango sector, which has become a net ex­ forward price curve). Most oil storage is porter once more. Traders have strug­ still captive (i.e. owned by oil majors), gled with many refined product cate­ and given the capital efficiency initiatives gories and are rethinking their Bryan DeBlanc, KPMG in Zurich, and in place in those companies, we can positions across these desks for 2015. James Carter, KPMG in Geneva expect more storage to be released Going forward, this could result in in­ to market, particularly in regions where creased mothballing of unprofitable re­ demand has softened, such as Europe’s fineries or much lower valuations for ARA terminals area. any transactions.

33 CHAPTER II EVOLVING TRENDS AGILE TRANSFORMATION HOW BUSINESS AND IT TRANSFORMATION IS CHANGING

34 Clarity on Commodities Trading

The commodity trading industry is facing increased competition and higher demand for value-added products and services. This leads to increased cost pressure and a general urgency to transform the business. Many organizations are cleaning up their environment aiming at more efficient IT. However, those cost reduction initiatives alone do not address the overall need for IT to become more flexible. A new pattern is evolving that profoundly changes the way of business and IT transformation.

35 CHAPTER II EVOLVING TRENDS

TODAY TOMORROW

IT PROJECTS SOME, BIG MANY, SMALL

TIME TO LIVE 2 - 3 YEARS 2 - 3 MONTHS

SOLUTIONS BIG APPLICATIONS SMALL APPLICATIONS

GOVERNANCE CENTRALIZED DECENTRALIZES (ONE SIZE FITS ALL) (ONE PLATFORM FITS ALL)

PRINCIPLE BUY BEFORE BUILD FLEXIBILITY BEFORE EFFICIENCY

Many organizations in the commodity In this approach, the strategy clearly good news. This way you are able to trading industry are challenged with a states the direction and focuses on the identify the real winners and move complex and heterogeneous IT archi­ benefits to be achieved (“why”). This efforts in the right direction. It requires tecture and with a number of large sets the scene for an ideation process, an environment, though, that effectively “big-bang,” high-cost and low-value IT which identifies and prioritizes “what” evaluates ideas and treats “failed” projects. To reduce costs, application exactly should be done. The best ideas projects as a necessary step in an landscapes are harmonized, reducing are moved towards pilot stage, tested overall learning process. redundant systems and moving to­ and, if the benefits are not there, dis­ wards central solutions. The scope of carded. This does not mean that the IT projects is reduced but budget over­ strategy is less important. It aims to ENTERPRISE ARCHITECTURE runs remain. instead reduce the effort and time of (EA) – BUILD SMALL TEAMS, Experience shows organizations can planning every detail before moving ALIGNMENT WILL FOLLOW move to a more flexible and beneficial to the real transformation. As a result, way of transforming their business steering can effectively be done on a Alignment of business and IT is one of through three key processes. quarterly rather than a yearly basis. the evergreens of the past with many challenges and many efforts to ad­ dress them. Enterprise Architecture STRATEGY AND PLANNING – PORTFOLIO MANAGEMENT – (EA) is one of the disciplines aiming to DON’T MAKE PLANS, ALLOW 25% OF YOUR close this gap. Many organizations EXPERIMENT ON IDEAS PROJECTS TO FAIL have put a lot of sweat and tears into establishing EA in their organization Organizations are increasingly Some of the ideas planned in an agile and only a few have realized real bene­ moving away from the traditional organization will not make it to the final fits. Looking at the technology side of approach of detailed strategy and stage and will be canceled after piloting. EA, it is now time to really make IT as planning followed by one large Given the amount of project overruns a service happen and realize many of transformation, towards a more and large projects that fail after years the hypes we have seen in the past flexible approach. of implementation today, this is actually (service-oriented architecture).

36 Clarity on Commodities Trading

TODAY TOMORROW

ENTERPRISE WIDE PLANNING PILOT-SPECIFIC TEAM ARCHITECTS PER LAYER: COVERING ALL LAYERS:

BUSINESS

BUSINESS INFORMATION INFORMATION

APPLICATION APPLICATION

TECHNOLOGY TECHNOLOGY

Facing the business side of EA, the and covers (at least) the business strat­ can respond quickly. Strategies that alignment of business and IT will be egy, business front office, digital move away from the traditional ap­ driven through establishing smaller technologies and software development. proach of detailed strategy and plan­ teams. Those teams will make the plans ning towards a more flexible approach (i.e. architect the enterprise) in close Step 2 – the bigger picture: put the are common in the commodity trading collaboration and there will naturally team in a room, align the objectives and industry. From this perspective an IT be a much smaller gap between them. direction and give them time to ideate. strategy that is similarly agile would This will increase competencies of clearly make sense. EA in the business where it belonged Step 3 – the reality check: validate all along. the ideas and assess the current capa­ With increasing experience of small bilities of your IT to fulfill pilot candi­ teams doing pilots and stronger in­ dates. volvement of the business, the shift LEAD THE CHANGE – FOUR KEY from “big bang” IT projects to small STEPS WE ENCOURAGE YOU Step 4 – the pilot: push towards pilots and successful solutions might just TO TAKE (minimal viable products), using a green- ­become a reality. field approach, and test the results. Successful organizations have managed to drive the conversation of agile transformation, engage It is in the genes of commodity trading the business stakeholders and companies to deal with constant communicate the change within change, as markets are volatile and Markus Steinbrecher, the IT organization. Of the many changes in trade flows, currencies and KPMG in Zurich different approaches, four key commodity prices can incur instantly. steps prevail: As changes are happening so quickly companies need to react fast. Step 1 – the team: build an A-Team that Commodity trading companies are understands the agile transformation very agile and have proven that they

37 CHAPTER II EVOLVING TRENDS

38 Clarity on Commodities Trading A NEW POLICY FOR AN AGE OF TRANSPARENCY

On 18 November 2014, Trafigura announced its new policy to support the Extractive Industries Transparency Initiative (EITI), the global standard for improving transparency of revenues from natural resources, and to disclose its payments for oil to governments that are members of the EITI. Through these decisions Trafigura took an important step towards improved trans- parency in the global commodity trade.

39 CHAPTER II EVOLVING TRENDS

THE EITI STANDARD

At the EITI Global Conference in Sydney, in May 2013, the EITI Board adopted the EITI Standard, a result of years of consultations and negotiations. The Standard took the EITI from being a relatively narrowly focused revenue transparency mechanism to a wider platform for reforms of natural resource management. The Standard requires that each country publish an annual EITI Report that contains, among other things, infor­ mation about the legal and fiscal provisions relevant to extractives, organization of state-owned enterprises (SOEs), production, license allocations and registers. The Standard contains recommendations on contracts disclosure and a provision on the disclosure of oil sales by SOEs. The EITI Board may refine the Standard further to result in the approval of a common set of reporting guidelines applicable to both trading companies and SOEs.

40 Clarity on Commodities Trading

The commodities trading industry RESULTS OF TRANSPARENCY section 1504 in the Dodd-Frank Act plays an important role in feeding in the US and the EU Transparency the global market with oil, gas, While the EITI has been successful in Directive requiring that extractive minerals and metals necessary for bringing transparency to the extractive companies with publicly listed shares economic development. This much is sector, one of the key challenges and instruments report payments to widely appreciated. What is often ahead is to ensure that the wealth of governments, by project. The EITI con­ less obvious is the key role these data generated by the EITI is under­ siders there to be complementarity trading companies play in providing stood, analyzed and used to encourage between these reporting requirements revenues to governments of re- change and improvements in the ex­ and the EITI. Having company data in source-rich countries. Acting often tractive sector. Some early examples of stock exchanges in the US and Europe is as an intermediary between export- how the EITI is being used to initiate welcome but needs to be complement­ ers and importers of crude oil, for reforms include: ed by the EITI bringing transparency example, an oil trading company • In Chad, the government has estab­ to government data and engaging stake­ transfers not only oil from one lished revenue recording and moni­ holders in the producing countries country to another, but also signifi- toring systems after EITI reports themselves. cant amounts of capital from the oil identified inadequate record keeping consumer to the oil producer. systems. The EITI is increasingly becoming a fo­ • In Ghana, closer scrutiny of royalties rum where companies, civil society and Until recently, the proceeds from the transferred by the central govern­ governments meet to reach compro­ sale of these resources went unno­ ment to the local level has led the mises that further a common agenda of ticed and were not publicly recorded in government to develop guidelines transparency and accountability in the most countries. Such secrecy breeds for the utilization of local revenue management of natural resources. abuse, corruption, mismanagement, and to open separate bank accounts With the increasing global focus on resentment and sometimes conflict. that facilitate revenue tracking. transparency in the trading of oil, gas This is why a commitment to disclose • In Myanmar, the EITI has become a and minerals, it is time for commodities payments to governments will be an platform for conversations on needs trading companies to join this debate. important act of industry leadership by for reforming state-owned enterpris­ the trading sector. This is also the rea­ es and how to manage the revenues son why the EITI is calling on trading from oil and gas sustainably. companies to step up and join the • In Mongolia, the EITI has helped har­ global effort towards more transparent monize and enforce auditing practic­ commodities trading. In this way, they es across government agencies con­ will contribute in deepening stakehold­ tributing to strengthening public ers’ understanding of the cost of se­ financial management. crecy, and in furthering the debate to­ • In Nigeria, the government is devel­ wards more responsible disclosure. oping a new calculation model for Bringing transparency to the interac­ royalty payments from oil after the tion between trading companies and EITI identified a US$ 2 billion under­ resource-rich governments is a neces­ assessment. sary step if we are to ensure that citi­ Jonas Moberg, Head of Secretariat, zens benefit from the resources that Extractive Industries Transparency Initiative (EITI). belong to them. A common set of MANDATORY DISCLOSURE comprehensive and practical reporting guidelines will ensure a level playing There have been extensive debates in field for the trading industry and a re­ recent years about mandatory disclosure sponse to the increasing global de­ requirements for oil, gas and mining mands for reporting, transparency and, companies in the US and Europe. ultimately, accountability. This refers to legislation, particularly

41 CHAPTER II EVOLVING TRENDS

GEARED FOR CHANGE REGULATIONS TRENDS IMPACTING THE COMMODITY TRADING SECTOR

42 Clarity on Commodities Trading

ON 19 NOVEMBER 2014, THE UNITED STATES SENATE’S PERMANENT SUB- COMMITTEE ON INVESTIGATIONS (PSI) PUBLISHED A NEARLY 400-PAGE-LONG REPORT ON WALL STREET BANKS AND THEIR INVOLVEMENT IN PHYSICAL COMMODITIES TRADING AND STORAGE ACTIVITIES. HOW DO SUCH REPORTS AFFECT REGULATORS?

While one can disagree about the warehouse financing. Potential regu- facts and results as they are present- lations could have a direct or indirect ed in this report, what cannot be de- impact on the commodities sector. nied is the fact that such reports and However, there is still some leeway if public hearings increase the pressure such challenges are addressed pro- on regulators to come up with new spectively, leveraging existing frame- regulations addressing risk manage- works. The commodity trading sector ment, behavior and conduct, mixing is well aware of the status of current banking and commerce as well as discussions on regulation and trans- safeguards in general. Some constit- parency. However, the pace at which uents could argue that existing and some of these changes occur has future regulations are mainly geared accelerated and should not be under- towards financial institutions. estimated. It has to be assumed that However, such a view would proba- regulators have learnt their lesson bly be shortsighted and ignore the from the recent financial crisis and commodities sector’s dependencies are under pressure to respond. on financial institutions to provide How could regulations have direct or trade finance services along the value indirect repercussions on commodity chain from preexport financing to trading companies?

43 CHAPTER II EVOLVING TRENDS

COMMODITY TRADING COMPANIES DIRECTLY OR INDIRECTLY AFFECTED BY KEY REGULATIONS

REGULATIONS REGULATORY CHANGES IMPACT ON COMMODITY DRIVEN BY SEVERAL TRADING COMPANIES INSTITUTIONS

Deleveraging of banks’ balance sheets Reduced access to financing • Maximum leverage ratios • Less availability of letters of credits • Minimum target capital requirements • Difficulty to raise syndicated and • Minimum liquidity ratios structured loans Central banks • Credit valuation adjustments • Increasing costs across all trade Basel Committee ­finance products ECB Regulation of OTC derivatives FED • Central clearing and reporting Complexity and cost intensity of BoE • Capital and margin requirements trading activities are increasing • Reporting to central trade repository • Systems and processes given new Financial regulatory • Daily market-to-market/collateral reporting requirements authorities needs • Working capital requirements SEC • Trading on organized trading venues ­(clearing fees, margin, collateral) FCA • Position limits • Increasing compliance requirements FINMA • Regulatory oversight/interventions (monitoring, investigations, compli­ BaFin ance framework, AML, sanctions) Regulation of European power and Policy makers gas markets Changes due to banks’ exit/spin-off European Union • Prohibits market abuse in the whole­ commodity trading United States sale market • Less market making, reduced ­hedging tools Limits to banks’ trading activities • Banks to spin off commodity trading • Ban of proprietary trading (financial, units and sell physical assets physical) • Potential limits to banks ownership/ control of physical trading assets (e.g. storage)

44 Clarity on Commodities Trading

CAPITAL AND LIQUIDITY including a provision dealing with miner­ balance sheet, market, credit and oper­ REQUIREMENTS FOR als exported from the Democratic ational risk perspective but increasingly FINANCIAL INSTITUTIONS Republic of the Congo and neighboring also from a reputational, conduct, legal (BASEL III AND IV) countries. and compliance risks perspective, which are harder to capture given their Regulators are forcing banks to de­ qualitative nature. A “wait and see” leverage their balance sheets by MARKET CONDUCT, strategy may not be the right ap­ increasing capital and liquidity require­ TRANSPARENCY AND proach. Instead, it is a good idea to ments, which will impact the availabili­ CONSUMER PROTECTION prospectively enhance and implement ty of financing. Even in countries (MIFID II AND REMIT) governance and control frameworks to where banks are currently able to use address reputational, conduct, legal risk-based models to calculate capital REMIT, the Regulation on Energy and compliance risks beside market, requirements, developments in Basel Market Integrity and Transparency, an credit and operational risks early on. IV suggest that the favorable EU regulation influencing electricity Annual testing should be considered impact on capital requirements from and gas products, aims to reduce in­ in order to ensure operating effective­ using risk-based models is likely to be sider trading and market manipulation. ness and to reassess the design of limited going forward. Another trend Another EU regulation, MiFID II such governance and control frame­ that can be observed is the increased (Markets in Financial Instruments works. It is further recommended to focus on leverage ratios rather than Directive 2), is mainly geared towards actively manage transparency require­ capital as leverage ratios are less vul­ financial institutions providing invest­ ments by implementing self-regulatory nerable to underlying risk models and, ment services by for instance reducing measures that can be based on exist­ as such, are supposed to provide a exemptions, increasing the scope of ing initiatives but should be further better comparison among financial in­ products covered and tightening developed and geared towards the stitutions across different jurisdictions. reporting requirements. MiFID II com­ commodity trading sector. The ultimate pliments other regulations such as aim of such counteraction is to not in­ REMIT and EMIR in the EU and could crease the pressure on governments REGULATIONS COVERING OTC therefore have both direct and indirect and regulators to introduce more DERIVATIVES AND CONFLICT impact on commodity traders. stringent laws and regulations beyond MINERALS (DODD-FRANK AND Switzerland has responded to these what is currently on the horizon. EMIR) acts (EMIR and Dodd-Frank OTC Derivative regulations) by developing In the US, Dodd-Frank, and in particular its own Swiss Financial Market Title VII, has increased regulations cov­ Infrastructure Act (FinfraG). ering OTC derivatives with the ultimate Ralph Dicht, aim to enhance transparency by intro­ KPMG in Zurich ducing organized trading facilities, cen­ WHAT NEXT? tral clearing, central margin and central reporting, to name only a few corner­ The pace of new and potential regula­ stones of the regulation. In the tion has increased, regardless of European Union, EMIR (the European whether such new regulation impacts Market Infrastructure Regulation) is the commodity trading sector directly the EU equivalent to Title VII in Dodd- or indirectly. The pressure on regula­ Frank. While the objectives are more tors is higher than ever. Major stake­ or less the same, there are differences holders such as financial institutions in complexity and cost to comply with are directly impacted by a wave of such regulations. Besides this, the regulations. Specifically banks will have Dodd-Frank Act goes further by including to consider the counterparties/clients several “miscellaneous” provisions, they do business with, not only from a

45 CHAPTER II EVOLVING TRENDS

TAXING TIMES 46 Clarity on Commodities Trading

The tax framework has been playing a role when it comes to business location. In view of the recent developments at the level of the OECD (in particular on Base Erosion and Profit Shifting, short BEPS) it is worthwhile to take a look at what may be of particular concern for the commodity trading industry in the area of taxation.

The G20-OECD project on BEPS is an and taxpayer profit shifting. The ambitious action plan encompassing OECD aims to provide governments 15 areas that are perceived to have with coordinated domestic and the greatest potential for abuse by international instruments to prevent ­international companies. The goals of international companies from paying the plan are to identify concrete strat­ too little or no taxes. egies for addressing tax base erosion

47 CHAPTER II EVOLVING TRENDS

ALIGNING VALUE CREATION Rewards that previously would have Looking ahead, traditional commodity WITH LOCATION OF PROFITS flowed contractually to risk-bearing trading structures may no longer be locations (i.e. for providing access to appropriate. For example, a central­ The BEPS action plan seeks to address at-risk capital) may flow to key people ized trading model – with a single scenarios where multinational groups functions post-BEPS. The same is true central trading entity that provides can unfairly reallocate profits between for rewards flowing to assets. The trading support and financial capital different tax jurisdictions. In particular, OECD’s near-final guidance on trans­ and earns the majority of group prof­ BEPS targets situations where risks fer pricing for intangible assets down­ its, and a network of trading service and the resulting rewards are not plays the value attributed to legal providers in key locations earning rela­ aligned with value-creating substance ownership of intangible property (e.g. tively low returns – may no longer be – by which the OECD means signifi­ trademarks, patents) and ensures straightforward under BEPS, especially cant people functions. It also requires value is attributed to the individuals where there are deemed to be key de­ a review of overall value chain pro­ managing particular assets. cision makers in the trading operations. fitability in determining entity-based profitability. Of particular focus going This change is significant. For com­ As many commodity traders rely on forward will be aligning the value modity trading companies, much of derivative and physical traders who creation process – and specifically the substance that creates value lies often operate on a global basis across the location of key employees – with in its people – its traders and the staff such locations as Switzerland, London, the location of profits. who set overall trading strategies, New York, Houston and Singapore, it negotiate long-term supply or customer is critical to review significant people contracts, manage risk, and determine functions against the creation of value asset investments. across the entire group value chain.

48 48 Clarity on Commodities Trading

In summary, the current wave of international tax reform is creating uncertainty over the tax position of existing business structures. The G20-OECD action plan on BEPS will create significant uncertainty in tax outcomes, which could lead to more tax disputes and threaten the effectiveness of existing commodity trading operating models. As we move into the new post-BEPS world, tax executives of commodity trading companies should among others assess existing structures and consider whether they could defend them against sub­ stance-based challenges, monitor the impact of international tax changes on commodity trading operations in both OECD and non-OECD jurisdictions and consider advance pricing arrangements to reduce transfer pricing risk. As long as the commodity trading company’s business sub­ stance is real and well-documented, its related-party pricing practices are sound and comprehensive tax compliance pro­ cesses are followed, the centralized trading operation model would likely remain effective in a post-BEPS world.

To read more on this topic, please consult our recent global report: Commodity trading companies – Meeting the challenge of tax and regulatory change.

For many traders, comparison of the Under these proposals, international Stefan Kuhn, tax outcomes for existing business companies would have to disclose in­ KPMG in Zurich models in a pre- and a post-BEPS formation such as revenue, profits, lo­ world may lead to very different results. cation of employees and assets, cash tax payable and flows of royalty, inter­ est and other payments between ju­ risdictions. This will draw the focus to TAX TRANSPARENCY AND those jurisdictions that receive large COUNTRY-BY-COUNTRY payments and have transactions with REPORTING high-risk (i.e. low-tax) jurisdictions.

In light of perceptions that interna­ Complying with these detailed report­ tional companies are able to abuse ing rules will be a substantial compli­ the current system, in part due to the ance burden. The rules will also likely lack of information shared between lead to more questions and challenges tax authorities on a taxpayer’s global from tax authorities as they seek to presence and profitability, the OECD understand how the local share of the and domestic governments are ex­ overall group reward was determined. pected to insist on country-by-country reporting in the near future in order to facilitate this sharing of information between tax authorities.

49 CHAPTER II EVOLVING TRENDS SIGNIFICANT TRENDS AFFECTING COMMODITIES TRADING

CURRENT TRENDS LONG-TERM TRENDS

• Banks moving out of commodity trading • Population and income growth key drivers • Correlation between commodities ­behind growing demand reducing after­ high correlation during • Technological developments and ­super cycle behavioral changes will cause • Diversification will increase optionality unpredictable shifts in markets • Investments in infrastructure required to unlock new resources and markets

ENERGY • National oil companies extend trading • Prices, technology and policies drive ­activities changes in fuel mix • Refining margins in Europe structurally • Economies become less energy-intensive under pressure ­relative to GDP • Pressure on prices due to new sources • Embedding of environmental costs in ­ of supply energy prices • Improved efficiency structurally • Carbon capture and storage (CCS) to lowers ­demand for transport fuels offset carbon emissions • Increased access to resources due to • Natural gas will gain market share ­technological developments • Convergence of natural gas prices globally • Shale gas production will expand in other ­regions outside the US • Localized energy generation • Policy changes cause unpredictability for ­renewables

50 Clarity on Commodities Trading SIGNIFICANT TRENDS AFFECTING COMMODITIES TRADING

CURRENT TRENDS LONG-TERM TRENDS

METALS • Slowing growth in China • Increasing reliance on recycling for supply • Urbanization continues of metals • New supply arriving due to past • Change in application of materials will ­investments spurred by high prices cause shift in demand • Reduction in capex of investments • Top suppliers high market share • Prices are approaching bottom of the cycle

AGRICULTURAL • Real crop prices down from recent • Technological developments will drive peaks but to stay on a higher plateau increase in supply COMMODITIES • Production growing in developing countries • Politics continue to plan an important • Price incentives for investment in role in agricultural production agriculture have increased • Climate change may affect production • Unpredictability due to weather conditions • Africa increasingly seen as an • Investments in infrastructure needed opportunity for investment • Changing consumption patterns

51 CHAPTER III

Trade flows

52 Clarity on Commodities Trading

China’s rapid industrial expansion has driven an extraordinary increase in its demand for all metal ores over the past decade (from USD 7.2 billion in 2003 to USD 148.8 billion in 2013 according to International Trade Center statistics). In the race to meet this demand, mining companies have responded by ramping up their production capabilities around the globe.

At the same time, other BRIC and emerging economies enjoyed swift economic development, fueled in part by the growth in commodities demand. As they have done so, they have developed their own domestic need for commodity resources.

Demand for metals has abated as Chinese economic growth has begun to slow. Early 2015 has seen Brazil and Russia facing recession, leading to a fall in demand for many resources relating to construction and industry. Such resources include iron ore for steel, aluminum, and energy resources to drive production. The ongoing sluggishness of economic recovery elsewhere, especially in Europe, has failed to help pick up the shortfall. Of the major economies, only the US (which has a considerable resource base) has shown real improvement.

This situation has left many producers in a position of excess production, with oversupply of iron ore, copper, coal and aluminum, among many other commodities. As smaller miners and energy producers struggle in a low-price environment, a sizeable rebalancing is presently under-way, which is expected to lead to consolidation through a mix of mergers, shutdowns, and buyouts. This is combining with a drive by top mining groups such as Rio Tinto, BHP, Glencore and others to expand their market shares.

The impacts on commodity flows are still working through the system. Global commodity supply and logistics chains have undergone substantial re- alignment over the past decade to feed China’s growth. While these chains will remain in place, they may cater more to those largest corporate players who can ensure their role as a key strategic supplier. The reversal of energy imports into the US over the past four to five years has meanwhile shifted flows of crude oil from countries such as Nigeria, which has had to find new markets (e.g. India). Elsewhere, the political situation in the Ukraine is affecting Russian gas exports to the benefit of Qatar, which has seen its LNG exports rise even further (a 5.4-fold increase in volume between 2003 and 2013).

In the soft commodities market, the main product impacted by these global trade trends is soybean, the export volume of which has almost doubled between 2004 and 2014. China now imports more than 60% of the world’s soybeans. Sugar has been impacted by an overcapacity in the processing/ refining stage, with many Brazilian refineries operating at a loss. Abundant sugarcane supply has been influenced by the increasing capability of farmers across the globe to develop large-scale sugar plantations. Developed economies, where sugar consumption is highest, have seen flattening import demand, with the UK dropping from first place in 2004 to seventh in 2013. China now ranks as the leading importer, increasing its intake by nearly four times between 2004 and 2013.

53 CHAPTER III TRADE FLOWS Iron ore trade in 2014 Major trade flows (in million tons exported)

Source: Trade Map, International Trade Statistics, International Trade Center (ITC).

Principal exporters 1.6 2.4 2.7 1.8 of iron ore 8.6 4 12.5 2.6 7 2 4.7 2.3 2.6

3 6.1 6.3 10 6.6

CIS (Russia) Sweden Canada Total: 22.9 Total: 23.7 Total: 40.2

54 Clarity on Commodities Trading

Australia grew nearly twice as fast as the global export market in USD terms (15.4 x versus 8.4 x), and faster in volume terms, increasing market share from 27% to 48% from 2004 to 2013, leveraging its strategic position relative to China and other Asian markets.

Brazil maintained its second position, but saw production volumes flatten from 2011.

China increased its share of volume of global iron ore imports from 31% to over 65% from 2004 to 2014 (208 million tons to 933 million tons).

Key iron ore export destinations

China United Kingdom

Japan India

Republic of Korea Hong Kong, China

Chinese Taipei Germany

Indonesia Saudi Arabia

Netherlands Finland

Argentina Poland

France Czech Republic

Slovakia Austria

Turkey Others

3.4 3.5 10.6 15.3 1.9 13.8 50.8 1.1 4.6 15.8 3.4 19.5 4.7 30.8 76.8 39.3 4.6 6.3

4.9 8.7 93.5 179.9 578.7

5

Ukraine South Africa Brazil Australia Total: 40.8 Total: 67.1 Total: 344.4 Total: 724.6

55 CHAPTER III TRADE FLOWS Copper trade flows evolution in the past ten years Main producers exporting to consumer markets (from 2004 to 2014 in 1,000 tons sold)

Key copper export destinations Copper is an increasingly fragmented production market; the top four exporters held 73% market China Spain share in USD terms in 2004, which has dropped to 61% in 2013. Japan Chile

India Canada Chile is the leading exporter of copper ore and con­ centrates (32% market share in USD terms in 2013), Republic of Korea Germany together with Peru (14%). Australia, Indonesia, and Brazil US more recently Canada and the US combine to take ­another 25% of the market. The next seven exporting Philippines Others nations generate 19% market share. Mexico

Source: Trade Map, International Trade Statistics, International Trade Center (ITC).

507

448 333

248 326

225 195 94 123 37 287 32 119 13 110 221 186 15 61 5 17 13 24 2 10 271 144 4 22 0.3 5 155 3 74 0.8 4 2004 2014 2004 2014 2004 2014 Total: 161 Total: 423 Total: 58.1 Total: 433 Total: 1,805 Total: 1,454

Canada US Indonesia

56 Clarity on Commodities Trading

3,111

2,597

1,983 1,293

754

1,107 339

494 686 462 585

243 216 1,241 162 491 273 171 346 136 831 188 198 148 454 266 95 533 58 131 398 37 77 100 54 94 2004 2014 2004 2014 2004 2014 Total: 1,184 Total: 2,189 Total: 1,607 Total: 3,849 Total: 2,065 Total: 9,458

Australia Peru Chile

57 CHAPTER III TRADE FLOWS Soybean trade flows evolution in the past ten years Top three producers exporting to consumer markets (from 2004 to 2014 in 1,000 tons sold)

Key soybean export destinations The top two soybean exporters, Brazil and the US, held 77% market share in 2013, in line with the 78% Others Netherlands they held in 2004.

Japan Germany Soybean exports have increased by 3.7 times in Spain Turkey value (1.8 x in volume) in that period, driven by demand from China. Chinese Taipei Mexico

China US In line with other commodities, China now imports over 60% of global soybean exports. Indonesia Bangladesh

Egypt France

Thailand Italy

Source: Trade Map, International Trade Statistics, International Trade Center (ITC).

58 Clarity on Commodities Trading

31,343

32,664

9,403

5,678 3,562

3,288 1,989

1,818 3,569 2,120 3,120

1,470 2,000 9,988 1,636 1,630 1,244 6,156 1,542 1,059 1,062 862 7,103 6,601 4,342 5,960

551 503 275 149 229 146 166 122 957 706

2004 2014 2004 2014 2004 2014 Total: 6,520 Total: 7,782 Total: 19,247 Total: 45,691 Total: 25,603 Total: 50,170

Argentina Brazil US

59 CHAPTER III TRADE FLOWS Crude oil imports evolution in the past ten years for Europe, China and the United States

European countries monthly crude oil imports 2004 – 2014 Million BBL per month

75 France 70 Germany Italy 65 Netherlands 60 Spain 55 UK 50 45 40 35 30 25 20

Jan 04 Sep 04 May 05 Jan 06 Sep 06 May 07 Jan 08 Sep 08 May 09 Jan 10 Sep 10 May 11 Jan 12 Sep 12 May 13 Jan 14 Sep 14

Source: The JODI (Joint Oil Data Initiative) Oil World Database

60 Clarity on Commodities Trading

US monthly crude oil imports, production, refinery intake 2004 – 2014 Million BBL per month

600 Refinery Intake 500 Imports Production 400

300

200

100

Jan 04 Jul 04 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14

Significant shifts in oil trade flows in the last five years have contributed to current low-pricing environment.

Major market shifts as US shale oil production has reduced reliance on imports, especially from West Africa, but also Venezuela.

Saudi Arabia’s increased production has added to a ­situation of oversupply, leading to dramatically lower prices per barrel.

Key decline in import volume for major European markets such as France and Italy.

61 CHAPTER III TRADE FLOWS Crude oil imports evolution in the past ten years for Europe, China and the United States

China monthly crude oil imports, production, refinery intake 2004 – 2014 Million BBL per month

350 Refinery Intake 300 Imports Production 250

200

150

100

50

Jan 04 Jul 04 Jan 05 Jul 05 Jan 06 Jul 06 Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14

China has increased its share of global oil imports from 5% in 2004 to 13% in 2013, while the US has maintained its position as top importer with 16% in 2013, down from 26% in 2004.

China’s oil import strategy has prioritized a balanced portfolio of supplying nations, which benefits the role of major oil traders.

62 Clarity on Commodities Trading

China’s crude oil imports by source 2013

Source: EIA, FACTS Global Energy, ITX, The Handbook of Global Energy Policy

12% 19%

2% 2%

3%

4%

China’s total crude oil imports for 2013 4% 2.26 billion barrels 14%

6%

8% 9%

9% 8%

Saudi Arabia Iran Venezuela Kuwait Others

Angola Oman Kazakhstan Congo

Russia Iraq UAE Brazil

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