By John Kemp
LONDON, Dec 6 (Reuters) - Deutsche Bank's decision to quit trading in most commodity markets is another sign of the excess capacity across the commodity-trading sector and likely foreshadows further consolidation over the next two to three years.
Deutsche, rated one of the top five commodity banks globally, will cease trading in energy, agriculture, base metals, coal and iron ore, while retaining its precious metals business and popular index funds.
Deutsche is not the first to scale back. In 2012, UBS announced it would stop trading most commodities other than gold and index funds.
Earlier this year, JPMorgan Chase and Co announced it was putting its physical commodity businesses up for sale, following pressure from the U.S. Federal Reserve.
Morgan Stanley and Goldman Sachs are also exploring a sale for parts of their physical trading operations.
Other major banks such as Barclays and BNP Paribas have sharply reduced elements of their commodity trading and financing businesses in the last two years.
Headcount on the commodity desks of the 10 investment banks with the largest commodity businesses has fallen by a fifth since 2011, according to industry analysts at Coalition.
Revenues for the commodity banks are expected to be under $5 billion this year, down more than half from $12 billion at the end of the last decade, Coalition said in a recent report.
It is fashionable to blame regulations introduced following the 2008 financial crisis for making commodity trading uneconomic and causing banks to retreat.
In reality, the trading units had become unprofitable, as too many banks, trading houses and hedge funds were chasing too little business from investors and end-users.
The number of banks, merchants and hedge funds operating in commodity markets has continued to grow over the last three years, 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 based on our identification of more attractive ways to deploy our capital and balance sheet resources," Colin Fan, co-head of Corporate Banking & Securities at Deutsche Bank, said in a statement on Thursday.
"This move responds to industry-wide regulatory change and will also reduce the complexity of our business."
Pressure on profits is visible across the sector.
Like commodity prices, the trading business has always been strongly cyclical.
The price of most commodities peaked between 2007 and 2011 and is now flat or falling. Traders inevitably insist their businesses are designed to make money in both rising and falling markets. It is much easier, however, to make money during a cyclical upswing.
Price volatility is also crucial to traders' returns. Volatility creates opportunities for traders to enter and exit positions and is an important source of profits for their options-writing desks. But measured over any timescale, from one day to one month and one year, the volatility in commodity prices 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 have stabilised following the 2002-2011 upswing, however, spreads have tightened significantly.
On the London Metal Exchange's benchmark three-month copper contract, for example, the bid-ask spread has shrunk from $10 per tonne in 2008 to $1.25 currently, a dealing spread of less than 0.02 percent on a $7,000 commodity. The spread on the flagship aluminium contract is just 50-75 cents per tonne, or 0.04 percent.
Institutional and private investors are no longer allocating new money to commodities, and in some cases have reduced their exposure to the asset class.
Assets under management in big commodity-focused funds, such as Pimco's Commodity Real Return Strategy Fund, Schroeder's Alternative Solutions Commodity Fund, and the California Public Employees Retirement System (Calpers) commodity programme, have been sharply reduced over the last two years.
As a result, there is less client money to manage, less client trading activity, and fewer maturing positions to roll over, all of which has bitten deeply into revenues for the major banks and swap dealers.
For the time being at least, the slowdown in trading on behalf of financial investors has not been compensated by an increase in hedging on behalf of producers and consumers.
The hedging market looks saturated. With the price of major commodities such as copper, oil and natural gas moving in narrow ranges, it has proved difficult to find new groups of customers who are not already hedging in order to expand the size of the market.
Even as demand for commodity trading services has stabilised, the number of traders and intermediaries has continued to grow, intensifying competition, which is one reason that spreads have shrunk and volatility has fallen.
The number of banks, dealers, hedge funds and other intermediaries active in commodity markets grew sharply in the boom years, and has continued to increase even as prices have stabilised.
The number of hedge funds and other money managers with reportable positions in derivative contracts linked to U.S. light sweet crude oil (WTI) rose from just over 200 in the first half of 2008 to over 300 in much of 2009, 2010 and 2011.
New specialist commodity trading firms such as Freepoint and Trailstone have been set up by refugees from the big banks, while others such as BTGPactual have ramped up their trading operations.
Italian oil major Eni has been bulking up its own trading business to compete with major swap dealers such as Shell and BP.
The result is intensifying competition for a largely static pool of business. In this context, increased pressure from regulators on some of the commodity trading banks has been the last straw.
If the commodity trading units had continued to be hugely profitable, it is likely the major banks would have tried to retain them and simply borne the increased compliance costs.
But as profit margins have shrunk, commodities have become a niche and non-core business for many banking giants. The returns have not been worth the complexity and level of regulatory risk involved in managing them.
In the next two to three years, the commodity trading sector faces a shakeout that will eliminate some of the excess capacity and restore a higher level of profitability for those institutions that remain.
The shakeout is likely to favour traders with strong balance sheets 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 the major oil companies such as Shell, BP and Eni.
The losers seem set to be the commodity desks at the big banks, which have neither the scale nor the specialisation to survive, as well as some hedge funds and institutional money managers, for whom commodities are non-core business lines.