By David Sheppard
NEW YORK, July 29 (Reuters) – As JPMorgan Chase & Co
prepares to exit physical commodities trading, the spotlight is
turning to the future of the two banks that have dominated Wall
Street’s involvement in the natural resources supply chain for
30 years.
Goldman Sachs and Morgan Stanley two decades
ago became known as the ‘Wall Street Refiners’ for their mastery
of both financial and physical commodities.
But since 2012 Morgan Stanley has looked at selling its
commodity arm and Goldman has made moves to scale back its
physical operations.
Letters between the banks and the Federal Reserve, received
by Reuters under the Freedom of Information Act, show both banks
are in discussions on conforming or divesting activities that
fall outside the normal scope of commercial banks.
Goldman has been looking at selling its Metro International
metals warehouses firm since at least March, but it has also
publicly reaffirmed its commitment to its J. Aron commodities
business, where CEO Lloyd Blankfein started his career.
Morgan Stanley has been looking at a possible spin-off or
sale of its commodity arm since last summer, but with little
success. Recent moves suggest it may try to refocus on its vast
physical oil trading arm and exit peripheral markets like
Australian electricity.
The question is, in part, whether they will be able to
choose their own future, or will the Federal Reserve’s decision
to review the entire role of Wall Street in physical commodities
markets see regulators make the choice for them?
The past 10 days has seen unprecedented scrutiny of Wall
Street’s commodity trade, with a Senate hearing questioning
whether banks should be allowed to own pipelines, warehouses and
other commercial assets.
U.S. regulators and the Department of Justice have launched
initial investigations into the metals warehousing business of
banks and other big commodity traders, which have been accused
of driving up the price of aluminum by drink can manufacturers.
While JPMorgan cited the growing regulatory pressures as one
of the reasons it has decided to exit physical commodities
trading, it was not clear if it was influenced by the banks’
discussions with the Federal Reserve.
One person familiar with the matter said on Friday the bank
had decided the profits from commodities were too slight to be
worth the regulatory and reputational risks.
CEO Jamie Dimon has been trying to put the bank back on
course after a series of costly trading moves and regulatory
run-ins, including a potential $410 million settlement over
alleged power market manipulation.
“I don’t think it was any one thing, but a culmination of
things, that drove (JPMorgan’s) decision,” said Craig Pirrong, a
professor at the University of Houston and expert in commodity
markets.
“The legal and reputational risks, the Fed’s likely action
to constrain – if not eliminate – this sort of trading, the
increasing capital strains on banks, and especially the
political heat being directed at the industry. In the scheme of
things at JPMorgan, commodities just weren’t big enough and
profitable enough to be worth all this bother.”
LETTERS FROM THE FED
Goldman Sachs and Morgan Stanley may hold one advantage over
JPMorgan, as their long history of operating in physical
commodities as less regulated banks may provide them with
“grandfathered” ownership of assets like warehouses, pipelines
and storage tanks that other commercial banks aren’t allowed.
“I don’t think there is a necessary or clear link between
whatever the Fed’s position is on JPMorgan’s ownership of
physical assets – if, in fact, it is the Fed that is pushing
JPMorgan to divest – and the Fed’s position on Goldman and
Morgan Stanley,” said Saule Omarova, associate professor of law
at the University of North Carolina, who appeared at the Senate
banking committee hearing last week.
However, there are signs the Federal Reserve is still
reviewing this position, just two months before a five-year
deadline expires for Goldman and Morgan Stanley to conform their
business activities to the Bank Holding Company Act.
A Federal Reserve letter to the Goldman Sachs’ lawyers in
2012, obtained by Reuters, said that “specifically, Goldman
Sachs continues to engage in commodity-related activities and
indirectly controls (redacted) impermissible non-real-estate
investments that the Board has not authorized.”
The letter, dated September 19 2012, said the Fed was
granting another one year extension for Goldman as it had made a
“good faith effort to conform its impermissible activities” and
had “taken steps to restructure or divest its commodity-related
activities and its non-real estate investments.”
A Goldman Sachs spokesman declined to comment when asked
what assets or activities the Fed letter referred to.
It was not clear if the Fed was referring to Metro
International, which Goldman bought two years after converting
to a commercial bank during the financial crisis, and is now
looking to sell.
Goldman has already got rid of many of the physical trading
assets it owned in 2008. Last year it sold its power plant
business Cogentrix to private-equity firm the Carlyle Group. Its
U.S. power sales have fallen since then, according to regulatory
filings with the Federal Energy Regulatory Commission, and are
less than one sixth of their peak in 2005.
The bank may choose to focus on financial trading of
commodity derivatives and other products, one of its strongest
areas. It is already a much smaller player in global crude
markets than it was in the 1990s. Oil traders and Wall Street
rivals say it is rarely seen moving tankers of crude these days.
Last year it imported 5,000 barrels per day of crude oil to
the United States, mainly for a small asphalt refinery in
California, U.S. Energy Information Administration data shows.
JPMorgan imported 50 times more, or around 250,000 bpd.
Despite launching a metals trading desk in 2010 after its
purchase of Metro, it has struggled to compete against big
merchant commodity firms like Glencore Xstrata and Trafigura,
trading sources say. Two senior metals traders, Scott Evans and
David Freeland, left Goldman earlier this year.
Natural gas is the exception, where it has grown from a
small presence to be a top 10 physical gas trader in North
America since 2010, after its purchase of Nexen’s trading book.
Brad Hintz, a Wall Street analyst at Sanford Bernstein & Co
in New York and a former treasurer of Morgan Stanley, said that
regulatory pressures would probably lead to other banks
eventually following JPMorgan’s lead.
“The commodities business of the future will likely devolve
to its financing and risk management core and the banks will be
less active in the physical markets,” Hintz said.
“In the vernacular of the commodities market – Wall Street
will become “paper” traders.”
For Morgan Stanley, the situation may be more complicated.
It went deeper than any other bank into physical oil
trading, including acquiring its TransMontaigne terminal and
storage firm, which Forbes magazine estimates is the 17th
largest private company in the United States, with revenues of
more than $14 billion last year.
Morgan Stanley’s request to the Federal Reserve for another
year’s leeway, also released to Reuters by the Federal Reserve
under the Freedom of Information Act, consisted of eight heavily
redacted pages and 10 annexes. It is not clear what physical
commodity assets, if any, have been kept from public view.
A spokeswoman for Morgan Stanley could not be reached over
the weekend to answer questions over what non-conforming assets
were redacted in the Fed letter, and what, if any, assets had
been conformed or divested since.
What is known is that despite all the regulatory
uncertainty, TransMontaigne has pushed ahead with one of its
biggest physical asset investments ever, taking a 42.5 percent
stake in a $485 million oil terminal near Houston.
Two weeks ago, Morgan Stanley tied itself even more closely
to TransMontaigne, extending the majority of its oil terminal
leases with the firm indefinitely, according to a filing.
The bank remains by far the most exposed to the growing
pressure on banks in physical commodity trading.
PHIBRO PRECEDENT
For JPMorgan’s commodity division, it is not clear how the
next few months will go. Blythe Masters, one of the most
powerful women on Wall Street, will remain in charge of the
business and oversee the sale, but Morgan Stanley’s experience
may suggest it may not be straightforward.
While the bank has already sold more than half of its
electricity trading contracts, it still has a vast number of
physical deals and assets, including long-term supply and sales
agreements with two major U.S. refineries, and its Henry Bath
metals warehouse market has over 70 locations worldwide.
In an already crowded market, who would buy its assets?
“I doubt banks will buy. Which only leaves the physical
trading houses and some of these newly formed merchant traders
like Castleton and Freepoint,” said a trader at a Western
trading house in Singapore.
But there is one possible alternative.
In 1998, Citigroup said in a press release – reminiscent of
JPMorgan’s statement on Friday – that it was evaluating
“strategic alternatives” for its physical energy unit Phibro,
including a possible sale of the company.
The bank had absorbed the big energy trader in its merger
with Travelers Group that year, but banking regulations did not
automatically allow it to run the business given its dealings in
physical tankers of crude oil and pipelines of natural gas.
Five years later Phibro was still a part of Citigroup, and
the Federal Reserve granted approval for the bank to carry on
trading in physical markets – a landmark decision the Fed says
it is now reviewing. That approval opened the doors to almost
every other commercial bank on Wall Street getting permission to
trade physical commodities over the next five years.
Phibro was eventually sold to oil firm Occidental in 2008,
after public outrage over a $100 million bonus Citigroup was set
to pay to star oil trader Andy Hall, despite receiving a
government bailout.
Pirrong, the professor and commodities expert, said that
even if the banks do exit the physical business, they would
likely be replaced by other “financial” firms, like private
equity groups or hedge funds.
“Finance and commodities are inherently intertwined, and
will continue to be so,” Pirrong said.
“The identities of the financial firms that are involved may
change, but they will perform the same basic functions and
provide the same basic products and services that the banks do
now.”
(Additional reporting by Josephine Mason, Jonathan Leff and
Jeanine Prezioso in New York, Florence Tan in Singapore; Editing
by Michael Perry and Amran Abocar)
