Adapting to Change: The Emerging Role Of Traders In E&P
Published 20 May 2021
by David Stent, Content Manager, Energy Council
Financial activism has been a catalyst in shifting the approach to financing the oil and gas sector, with ESG demands creating risks that are often deemed unassailable to traditional lenders. The squeeze on the banking sector’s financing options has simultaneously suppressed oil and gas exploration and production activities, to the point whereby a supply dearth may appear in the coming years.
The limitations placed on both the banking and E&P sector have created a new opportunity for commodity traders, who themselves were squeezed out of their roles following the regulatory reconsiderations after the 2008 financial crisis.
Over the last decade, the role of trading houses has had to evolve to balance their fixed cost overheads with increased market volatility. And even though the sector is expected to see the $4.677 Trillion of trades in 2020 grow 25,5% to $5.870 Trillion in 2021 – there remains a sense of concern as to where the finance to fund trades will emerge from.
However, price fluctuations are anticipated risk in the cyclical oil and gas market, unanticipated are the incidents that leave financiers out-of-pocket and seriously scorned.
The financial reticence to engage with oil traders has been affected by the malfeasance of Singapore’s Hin Leong Trading, who was exposed to have fiddled the books and cheated the system on an industrial-scale. Much like the reticence that followed Bernie Madoff’s Wall Street Ponzi-scheme. These crimes cloud the entire sector who, by-and-large, maintain strict adherence to regulatory controls – but as one door closes, another opens.
In lieu of this finance, traders have taken on the role of providing capital to E&P operations – much like a family office or energy fund might, jumping upstream to lower supply risk.
Global Financial Crash to Hin Leong Trading: A Tale of Two Criminal Catastrophes
Following the post-2008 regulation of the capital markets and banking sector, there was a withdrawal from many providing commodity finance unable to stomach the risk. As some withdrew, others increased their share and their activity with major traders.
The result was a concentration of the commodity trading market towards the larger trading houses, as credit lines were cancelled and regulatory hurdles hindered smaller firms with unassailably high costs. However, the trading sector maintained an opacity to its operations and few outside oil and gas understood the mechanisms at play.
This trading environment was dealt a secondary blow following the Covid-19 pandemic and the actions of Hin Leong Trading Pte., one of the Asia Pacific region’s largest traders. In 2019, Hin Leong was only second to Glencore in their oil stock purchases in Asia.
As the virus spread, founder Oon Kuin Lim, doubled-down on his gasoline stock purchase, expecting China to contain Covid-19 much like the preceding viral outbreaks. Then, as prices tumbled, Hin Leong Trading could not fulfill the $3.5 Billion owed to lenders – collapsing the firm into bankruptcy and exposing the malfeasance at play.
Hin Leong’s central position as Singapore’s largest trading house created structural shocks, impacting the state’s tight-knit sector far beyond the monies owed. It owned and operated extensive bunkering services, had a fleet of 150 ships and barges, and facilitated the trades of many smaller firms.
It was soon revealed the company had falsified documents to acquire access to finance and attract investment, with a fraudulent understatement of $800 million in derivative losses and $2.1 billion in overstated derivative gains. Beyond this Hin Leong overstated asset values, fabricated fictitious gains and sales invoices, resold collateralized inventory and fuel cargo to those who did not hold the bill of lading.
As the pandemic took ahold of the global markets, Hin Leong’s lenders began to call in their debts as their Letters of Credit were not being honoured and the collateralized inventory had been ‘sold to raise cash, instead of repay debt liabilities’. In essence, it was a massive commodity-based Ponzi-scheme, and but one of a series of scandals that has rocked Singapore and Malaysia in recent years. OK Lim and two of his children now face in excess of 25 charges and over a decade in prison if they are successfully prosecuted.
And yet, painfully, this was the third incidence within the year for Singapore following the collapse of Agritrade International with $1.5 billion in debts, as well as Holong Trading who owed lenders just short of $500 million.
Too often financial institutions fail to regulate and/or monitor the dealings of the market movers, and when these failings are found out, their impacts reverberate throughout the world. Hin Leong played an oversized role in the oil price crash and has led to yet another reconsideration of trading regulations, as well as restrictions on access to capital for Asian oil traders.
ABN Amro has exited commodity finance altogether. Société Générale has closed their Asian commodity finance unit, while BNP Paribas has shut the doors on their Swiss trading unit. This appears to be a signal for the changing times ahead.
Alternative Models: Buying Up the Value Chain
Oil and gas traders have long-relied on the capacity to maximize their slender margins to obtain profits, and like other players in the wider industry, have had to diversify their business models to maintain relevance and profitability through the energy transition.
The diversification of portfolios has initiated withdrawal by IOCs from regional assets with high GHG emissions exposure, together and with the financial and public pressure to decarbonize has exposed a potential vacuum in the E&P sector. The financial pressures have restricted international lenders' capacity to fund new E&P ventures, creating an opportunity for market actors who have capital but do not face the restrictions and pressures of the energy transition to fill the void.
Traders saw an opportunity to develop alternative funding models, particularly structured credit investments on the secondary market that would monetize assets while maximizing optionality. By
providing access to this capital in conjunction with regional banks, trading houses could write-down the capital requirements and reduce the exposure to risk for the primary lender. A welcome consequence is direct access to oil and gas, thus removing one link in the fuel supply chain.
Then within the primary markets these trading houses have acted as a go-between the financing banks and major producers whose access to capital hasn’t been forthcoming. It has resulted in alternative capital arrangements that can negotiate a more regulatory-laden environment, while providing greater options for the traditional investors in the asset class.
It has been a considered approach that has seen trading houses begin to diversify their labour by hiring structured financiers from the likes of Goldman Sachs and JP Morgan, engineers and geologists from the IOCs and Oil Majors, and expanding into financial engineering. While this is a new chapter for many, these new-age traders appear to be developing successful E&P operations.
Transitioning Upstream, Against the Current
By expanding their activities beyond the trade the commodities and Midstream sector, trading houses have begun to influence the Upstream sector too. Vitol’s flagship E&P project is the Sankofa Gye Nyame field offshore Ghana, developed in conjunction with Eni, which they believe holds 500 million barrels of oil. Glencore have been developing projects in Cameroon, Chad and Equatorial Guinea, with Gunvor Resources similarly involving itself upstream in West Africa and Trafigura has announced an imminent expansion into the E&P sector.
Asian Upstream M&A has seen regional NOCs, more so than traders, fill the gap as they look to concentrate their resources and reduce operational expenditures. Moreover, ESG pressures have yet to take hold like they do in the West. Once the dust settles, we will see Asian traders dip into the E&P sector and pick up assets that international financiers and regional banks do not have an appetite for.
The relationship between financiers and traders has rarely been more fraught, untrusting and wary of the ramifications of massive miscalculations in trade volume. And yet, there is a burgeoning relationship among these two actors, as financiers seek capital owners willing to engage in upstream activities and defer some climate risk. As the concerns for E&P financing grow as the energy transition accelerates, traders could increasingly see themselves as ‘mini-majors’ exploring, producing and trading under one name just like the IOCs, just without public market constraints.