Crisis Talk — with Christophe Salmon, CFO of Trafigura, on hedging oil’s biggest crash
As a crucial middleman in the oil business, Trafigura has had to cope with concerns about the creditworthiness of some of its counterparts, and unprecedented volatility in the oil price that saw the West Texas Intermediate (WTI) contract turn negative at the end of April. Christophe Salmon, the company’s chief financial officer, explained how the company has coped with the crisis, and how its funding approach, based on deep banking relationships and a secured financing structure, proved resilient to the chaos around it.
When did you realise how serious the crisis would be?
Let’s not forget that the virus crisis started in China much earlier than March 2020, when it reached Europe.
We have a strong presence all around the globe, and we could already see in January the impact of the virus. Our directly employed staff in China went off for Chinese New Year and did not come back to the office for more than a month.
With our team of analysts we saw, probably a bit earlier than others, that the virus issue in China was having a huge impact on the economy and was more serious than was realised in Europe. This gave us more time to think and to assess the consequences of the virus for the types of commodities we trade.
What were the main challenges for Trafigura?
The first challenge was, at a basic level, to make sure the company continued to run as a business. We are not an investment firm, we are trading physical commodities, moving goods from point A to point B, and that requires a lot of manpower in chartering ships, managing the finance, contracts and so on.
We needed to continue to run our business without impairing our risk management framework, and we can say now, two months into the lockdowns in India and Europe, that it is mission accomplished in that respect. It was a big effort from our business continuity teams — in our back office in India, for example, we had to make sure everyone had sufficient bandwidth to be able to connect directly into our systems and to maintain the integrity of our information technology.
The second challenge, though, was responding to the rapidly changing market conditions.
The commodity that has seen an extraordinary level of volatility has been oil. We have seen the oil price crashing with this combination of a shock in demand and a shock in supply. Opec+ turning on the taps to the market at the same time as global demand was crashing drove the price down very significantly. We have since seen a big effort from Opec+ to reduce supply, but then prices began to collapse again because everyone could see that the effort to contain supply was not at the level of the demand destruction.
All these changes in the space of perhaps eight weeks amounted to something that had never been seen before, and we reached the extreme point of the April maturity of the Nymex WTI contract turning negative one day before the maturity date.
Our job as a commodities trader is to balance physical supply and demand. This shock in demand has triggered a huge need for the market to absorb excess supply and to place this excess supply into storage. Companies like Trafigura and a few of our competitors have stored very significant volumes of crude oil all around the globe to respond to this shock.
The market has gone deeply into contango, and is incentivising physical players to store and sell oil on a forward basis, with the price difference covering the storage costs, and allowing companies engaged in this “cash and carry” strategy to profit.
Companies like Trafigura and a few other peers have done very well in this period by being able to absorb the shock.
How does that storage trade and the volatility in oil affect your funding?
Trafigura does not take any speculative position on outright commodity price. We are never long or short on the commodity we trade, we always hedge our market risk position on the flat price.
Practically speaking, if you have a quantity of crude oil which isn’t sold, we have a reverse derivative position on Nymex or ICE, which fully mitigates and balances any drop in the cash price of the physical leg.
A commodity trading firm is naturally long physical and short derivatives — when the oil price collapses, the derivatives market will transfer to you a lot of margin. So when the oil price collapsed, we received a lot of money back from the exchange. With this cash, we adjusted the loan-to-value of the inventories with our banks.
We have structured our financing so that banks finance the mark-to-market value of the inventory, with the mark performed typically every week.
So when the price goes down, we receive our margin first and we pay that to the banks over the week. It’s always easier when you receive the cash first, and you use the cash to amortise or adjust the value of your financing against the physical inventory.
When the market goes up, the process goes in reverse — we have to pay up front to meet a margin call on the derivatives, and get the money back from the banks the following week when the banks adjust their funding to the increased value of the inventory.
A physical commodity that’s properly hedged, properly insured and managed from an operational perspective can be seen as quasi-cash — that’s why the banks are comfortable financing 100% of it.
A second point, and probably a reason we had an easier life than others in the recent volatility, is that we need to deploy less working capital to finance the same volume of oil. A cargo of oil that was worth $70m in January, is now worth $30m — the same molecules, same crude oil but the value has more than halved.
The main pillar of Trafigura’s funding is to grant security to its banks over the inventories that the banks are financing — and that is the most robust type of funding you can have in place, because banks adjust their funding volumes based on the same value that drives your funding needs.
During these crises, a company like Trafigura always has a low level of utilisation of its credit lines — during the whole of the crisis in March and April we were able to maintain a significant liquidity position and low utilisation, because of the drop in commodities prices.
They say there’s no such thing as a perfect hedge — did that matter for you?
What we have left in our business is basis risk, due to the difference in correlation between the derivative contracts and the physical commodities we trade.
Sometimes the correlation between the hedging instrument and the commodity is not perfect. In the context of the Covid-19 crisis and the high level of volatility, we have seen an increase in our value-at-risk, but our VaR was kept at below 1% of our group equity.
Value-at-risk is there, but it’s an amount that’s small in the grand scheme of things.
How about counterparty risk?
We were doing well in this period, but some of our business counterparties were not — the airline companies, for instance, and some other big energy users.
So we have worked very carefully through our credit department and commercial division to make sure counterparty or performance risk was properly understood and properly measured and mitigated.
Two or three months after the beginning of the crisis, we have not had material issues in this period with counterparty risk. One can say that it is a matter of time. The conditions of our counterparties really depend on how long the virus crisis lasts — are we out for another one month, three months or six months? There is only so much pain that certain industries can sustain. We are, however, confident that the end of the lockdown, combined with significant stimulus from public policies, are limiting the downside for the global economy.
In the normal course of business, we try to mitigate risks as much as we can — we are very significant users of all the credit risk mitigants, you can imagine. CDS not so much, though, because the companies where the CDS market is available are only a tiny portion of the client base.
But we are very significant users of bank letters of credit, or silent payment guarantees from banks, and of insurance. Trafigura is a significant buyer of credit insurance in the Lloyds market in London.
In this crisis, we have tried to be proactive, and to mitigate the credit risk we have to take, and to decrease it. We have put more emphasis on getting down-payments from our clients, or having a letter of credit covering our next shipment.
How about your long-term funding approach?
Today, most of our funding comes from banks. Capital markets funding represents under 10% of our funding needs.
The benefit of this funding mix is that you can put a face to a name. For me, it is not “Bank XYZ”, it’s “Mr ABC”, where we have had a relationship lasting for years.
Especially during crisis times, the debt capital markets can be very volatile and very sentiment-driven. With banks, you have a person or a group of expert people to talk to, which in a stressful environment can be a much more reliable partner.
So we have no intention of changing this funding approach.
We have around 135 banks in our group, as one of our core principles in funding has been diversification. Each of these banks has their competitive edge — some banks are funding transactions in South America that others cannot because they don’t have any regional expertise. Some banks have expertise in the financing of metals in sub-Saharan Africa, and the others have not.
We try to find the right match between our needs and the bank’s expertise — that’s why we have so many banks around the world.
But we do have a core group of around 20 banks, which have a billion dollars or more of mainly secured self-liquidating facilities out to Trafigura, with whom we have an even more privileged relationship, even more of a partnership approach.
How did your banking group respond to the crisis?
Especially since the end of March, we have seen the cost of funds increase for some of these banks. The banks have seen huge drawdowns on corporate revolvers, mainly in dollars, and the non-US banks have seen an increase in their cost of funds to access dollars from their original currency through the cross-currency markets.
For a short period of time, perhaps two to three weeks, we saw a significant increase in cost of funds, which basically offset the drop in the Libor rate. The net effect for us was almost a flat price.
But the increased cost of funds for the banks was temporary — the mechanisms of the central banks to inject liquidity to banks and to the debt capital markets meant the funding pressure subsided. But there was a lag between the announcements and the execution.
Since the second half of April and [in the first half of] May, things have more or less come back to normal.
What about the issues we have seen with bankruptcies in commodity trading?
When these price movements occur, that is when you see a number of badly managed companies going under in our sector.
So companies that are either speculating, or lack the proper risk management frameworks, get into trouble. We have seen a number of bankruptcies of smaller regional players, especially in southeast Asia, and this has put a lot of strain on the banks, who will have to provide for these losses.
But they are looking to the large players like Trafigura as a kind of flight to quality. We have seen a stress on the bank side, not targeted at the leaders of the sector, but at the medium-sized regional players, who may have more difficulty accessing funding.
We expect an acceleration of the consolidation of the sector around the big players, but also an acceleration of the development of solutions such as blockchain in trade finance — we are working with the government of Singapore, the International Chamber of Commerce and a few banking partners on a blockchain solution to secure transaction and save cost.
Have your securitization programmes been affected?
We have a significant trade receivables securitization programme, which has been going for 16 years, and so it has been through a number of different economic cycles. To date there have been no defaults under these programmes — the fact that we deal with a commodity which is essential to our counterparts has been a good mitigant.
During the course of March and April, we have put in place additional credit monitoring for some of these obligors in the programme.
But we are a long-term player in our sectors, so our business counterparts which are here today will be there tomorrow — sometimes with a different shape, but they will be there.
So we wanted to make sure that we act in partnership with our end buyers. In a number of cases, that meant we had requests from some clients for deferred payment. In each case, we have had a very bespoke approach, depending on our analysis of the credit situation of the client, and the quality of the long-term relationship.
This was going on through March and April, but since the end of April we have not seen any new requests for payment deferrals — an acknowledgement that our clients have absorbed the shock, or found ways to monitor and manage their liquidity in an appropriate fashion.
What do you expect for the future of the oil industry, given recent market conditions?
What is likely to happen is a combination of bankruptcies in the exploration and production sector, and, as a consequence, mergers and acquisitions.
The last time when prices really went to the rock bottom — when Brent was at $12 and WTI at $11 — was in the late 1990s. During these years you had major consolidation. Total bought Elf and Fina, Chevron bought Texaco, same thing with Exxon Mobil.
Any period where there is a significant decrease in oil prices, you have M&A.
The big event of the past few years is the very rapid development of the US shale oil and gas production. Now, the production of US, Saudi Arabia and Russia are almost at the same level.
In the US, this is not one single company, it is multiple companies, and especially in the shale industry, you have multiple very small companies.
Some are going to go bankrupt and will be merged into bigger companies — probably some of the US oil majors will take the opportunity to consolidate the E&P sector.
How has Trafigura’s status as an unrated, private company changed how the crisis has affected you?
More than just being private, we are a partnership. Trafigura is an association of key partners — 700 people out of the 8,000 members of staff at Trafigura are shareholders in the business, and, when you think about it, this is the best system for alignment between management and shareholders. We think this is a key recipe of success.
Having said that, being private doesn’t mean opaque — we publicly release our financials twice a year, and the quality of our financials is the same as for listed companies.
The second point — we do not have a public rating, and we like to keep it that way. We have an implicit low investment grade rating, and that is what our core banks see in their internal models. We like to keep it that way because, at the end of the day, we are extracting most of our funding from banks which understand our business model rather than making credit decisions on the basis of a third party rating.
In addition, holding a rating could cause Trafigura to take more short-term-focused decisions in order to maintain a particular rating level, which would conflict with the group focus on long-term value creation.