Commodities can be defined as being typically mass-produced goods which are sold and delivered in bulk such as agriculture, metals, minerals, and energy derivatives that are typically all natural resources and/or raw materials with supply, price, and logistics volatility. Significant investments are required for energy and mining assets, agriculture typically has less CAPEX, but are subject to weather risks and diseases. Commodity finance creates volatility for the processors as they are exposed to price volatility on their raw materials and may not be in the position to adjust the sale price of their products as quickly.
The place and time of production of commodities is commonly different from the location and time of use. Physical trade will always need to take place and the logistics timing is one of the major risks as the price of any commodity can change drastically over a 2-month travel period.
The main players involved in commodity trade finance chain are the producers, traders, and end-use processors. Commodity trade finance is the financing to bridge the purchase of the commodity till the sale of the commodity to the end processor, typically utilizing letters of credit.
The management, history, financial position, and the type of commodity will determine one of the following structures:
Transactional trade finance: A trader enters into a purchase agreement with a supplier for a commodity and simultaneously sells the same to the buyer. The trader requests to its bank to finance the purchase on the understanding that the sales proceeds will pay for the financing. If approved, the buyer and sellers’ banks will both require several pieces of documentation (quality certificates, logistics documents, insurance, etc.) to proceed. This type of trade finance is very straightforward, easy to liquidate, and less risky for banks. However, the paperwork can be grueling, so banks typically have minimum dollar values to make the effort worth their time.
Borrowing bases: This structure allows a lender to finance against a pool of capital assets (inventory, receivables, alternative cash flow, etc.) that are provided as collateral. This value serves as the limit for drawing credit on the facility. A far less laborious and costly process for the banks when compared to transactional.
Working capital: These facilities are provided on the known credit strength, a guarantee, and/or alternative collateral in addition the borrower having a very established relationship with lender. This is the least intensive for the lender and borrower.
Structured trade finance: These are bespoke structures offered to finance less common trades where the tenor of the credit exceeds the asset conversion cycle. A trader may be required to provide prepayment(s) to a producer. The prepayments are then repaid by assigning the future cashflow. Tolling is fascinating as the trader will supply raw materials to a processor and choose to offtake the processed material in place of a pre-processing sale. Some major oil companies prefer this method as they can reduce their carbon footprint by not owning a refinery. The lender will finance the purchase of the raw material against the assignment of the proceeds from the processed material.
Disruptions: The global spread of Covid-19 and the fraudulent activity in the 2020 Asian commodity trading space has led to significant turbulence in the commodity finance market, many banks have permanently left the market. The remaining lenders’ still have appetite for medium to large traders in the sector remains, but new entry players without strong balance sheets have few options. However, crises like these present opportunities for new types of liquidity providers such as credit funds. 3rd party technology will play a greater role in diligence, inventory management, and general account processing. It’s ultimately incumbent upon both the lender and borrower to have transparency and a team effort to source knowledge and risks, neither party wins in a bankruptcy.
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