By John Kemp
LONDON, Dec 6 (Reuters) - Deutsche Bank's decision to quittrading in most commodity markets is another sign of the excesscapacity across the commodity-trading sector and likelyforeshadows further consolidation over the next two to threeyears.
Deutsche, rated one of the top five commoditybanks globally, will cease trading in energy, agriculture, basemetals, coal and iron ore, while retaining its precious metalsbusiness and popular index funds.
Deutsche is not the first to scale back. In 2012, UBS announced it would stop trading most commodities otherthan gold and index funds.
Earlier this year, JPMorgan Chase and Co announcedit was putting its physical commodity businesses up for sale,following pressure from the U.S. Federal Reserve.
Morgan Stanley and Goldman Sachs are alsoexploring a sale for parts of their physical trading operations.
Other major banks such as Barclays and BNP Paribas have sharply reduced elements of their commoditytrading and financing businesses in the last two years.
Headcount on the commodity desks of the 10 investment bankswith the largest commodity businesses has fallen by a fifthsince 2011, according to industry analysts at Coalition.
Revenues for the commodity banks are expected to be under $5billion this year, down more than half from $12 billion at theend of the last decade, Coalition said in a recent report.
It is fashionable to blame regulations introduced followingthe 2008 financial crisis for making commodity tradinguneconomic and causing banks to retreat.
In reality, the trading units had become unprofitable, astoo many banks, trading houses and hedge funds were chasing toolittle business from investors and end-users.
The number of banks, merchants and hedge funds operating incommodity markets has continued to grow over the last threeyears, even as commodity prices have peaked and begun to fall,and investors have scaled back money allocated to the sector.
"The decision to refocus our commodities business is basedon our identification of more attractive ways to deploy ourcapital and balance sheet resources," Colin Fan, co-head ofCorporate Banking & Securities at Deutsche Bank, said in astatement on Thursday.
"This move responds to industry-wide regulatory change andwill also reduce the complexity of our business."
SHRINKING PROFITS
Pressure on profits is visible across the sector.
Like commodity prices, the trading business has always beenstrongly cyclical.
The price of most commodities peaked between 2007 and 2011and is now flat or falling. Traders inevitably insist theirbusinesses are designed to make money in both rising and fallingmarkets. It is much easier, however, to make money during acyclical upswing.
Price volatility is also crucial to traders' returns.Volatility creates opportunities for traders to enter and exitpositions and is an important source of profits for theiroptions-writing desks. But measured over any timescale, from oneday to one month and one year, the volatility in commodityprices has fallen to its lowest since the mid-1990s.
Dealing spreads, the difference between bid and ask prices,are another important source of revenues. As prices havestabilised following the 2002-2011 upswing, however, spreadshave tightened significantly.
On the London Metal Exchange's benchmark three-month coppercontract, for example, the bid-ask spread has shrunk from $10per tonne in 2008 to $1.25 currently, a dealing spread of lessthan 0.02 percent on a $7,000 commodity. The spread on theflagship aluminium contract is just 50-75 cents per tonne, or0.04 percent.
Institutional and private investors are no longer allocatingnew money to commodities, and in some cases have reduced theirexposure to the asset class.
Assets under management in big commodity-focused funds, suchas Pimco's Commodity Real Return Strategy Fund, Schroeder'sAlternative Solutions Commodity Fund, and the California PublicEmployees Retirement System (Calpers) commodity programme, havebeen sharply reduced over the last two years.
As a result, there is less client money to manage, lessclient trading activity, and fewer maturing positions to rollover, all of which has bitten deeply into revenues for the majorbanks and swap dealers.
For the time being at least, the slowdown in trading onbehalf of financial investors has not been compensated by anincrease in hedging on behalf of producers and consumers.
The hedging market looks saturated. With the price of majorcommodities such as copper, oil and natural gas moving in narrowranges, it has proved difficult to find new groups of customerswho are not already hedging in order to expand the size of themarket.
TOO MANY DEALERS
Even as demand for commodity trading services hasstabilised, the number of traders and intermediaries hascontinued to grow, intensifying competition, which is one reasonthat spreads have shrunk and volatility has fallen.
The number of banks, dealers, hedge funds and otherintermediaries active in commodity markets grew sharply in theboom years, and has continued to increase even as prices havestabilised.
The number of hedge funds and other money managers withreportable positions in derivative contracts linked to U.S.light sweet crude oil (WTI) rose from just over 200 in the firsthalf of 2008 to over 300 in much of 2009, 2010 and 2011.
New specialist commodity trading firms such as Freepoint andTrailstone have been set up by refugees from the big banks,while others such as BTGPactual have ramped up their tradingoperations.
Italian oil major Eni has been bulking up its owntrading business to compete with major swap dealers such asShell and BP.
The result is intensifying competition for a largely staticpool of business. In this context, increased pressure fromregulators on some of the commodity trading banks has been thelast straw.
If the commodity trading units had continued to be hugelyprofitable, it is likely the major banks would have tried toretain them and simply borne the increased compliance costs.
But as profit margins have shrunk, commodities have become aniche and non-core business for many banking giants. The returnshave not been worth the complexity and level of regulatory riskinvolved in managing them.
In the next two to three years, the commodity trading sectorfaces a shakeout that will eliminate some of the excess capacityand restore a higher level of profitability for thoseinstitutions that remain.
The shakeout is likely to favour traders with strong balancesheets and a long-term commitment to the commodity business,such as Vitol, Glencore and Mercuria,specialists like Freepoint, as well as the trading arms of themajor oil companies such as Shell, BP and Eni.
The losers seem set to be the commodity desks at the bigbanks, which have neither the scale nor the specialisation tosurvive, as well as some hedge funds and institutional moneymanagers, for whom commodities are non-core business lines.
