Geopolitical impacts on commodity trading

Answer

There are two types of commodities: soft and hard commodities. Soft commodities are agricultural products such as coffee, wheat and sugar. Hard commodities are products that must be mined or extracted such as oil, gold and other metals.

Commodities are raw materials needed for daily life and it is trade that moves the commodities from where they are produced to where they are consumed. Commodity traders may be involved in the production, transportation or processing of commodities, or they may be involved purely in making speculative investments in the commodity markets (eg, by entering into derivative contracts to ‘bet’ on commodity price movements).

Commodity markets are driven by economic principles of supply and demand and, in a globalised world, can be significantly impacted by geopolitical events. Commodity trading is typically a low-margin, high-volume business and, in order to maximise returns, commodity traders are often highly leveraged. As a result, commodity traders must take steps to manage the impact of geopolitical events on their exposures.

Geopolitical events and their impact on commodity markets

The term “geopolitical events” is used broadly to refer to political, economic and social events that influence international relations. Market commentators have noted that we are currently in a period of intensifying geopolitical risk and increasing tensions between world powers – a trend that looks set to continue.

Tensions are currently manifesting themselves in various forms across the globe, including international economic disputes, military conflicts and social unrest. Notable examples include: the US-China trade war; continuing economic sanctions against Russia; armed conflict in Ukraine; Brexit (including the possibility of a ‘no-deal’ Brexit); escalating tensions between the US; Saudi Arabia and Iran; large-scale protests and social unrest in Hong Kong; and ongoing political uncertainty in various nations in connection with recent or upcoming elections (eg, in Brazil, Nigeria, South Africa and India). 

Commodity markets react to geopolitical events in different ways but are primarily influenced by the impact of events on the commodity supply chain. Events such as conflicts, trade wars, social unrest and closures of important transport routes may result in difficulties in producing or transporting a particular commodity and, therefore, a shortage of supply and an increase in price. Further, uncertainty in the market around geopolitical events may create price volatility even where the production or transportation of an underlying commodity has not yet been affected. 

Case study: US-China trade dispute

The ongoing US-China trade dispute is one of the most significant current geopolitical events for the commodity markets. Since 2018, the US and China have each imposed new tariffs (currently ranging from 5% to 25%) on billions of dollars’ worth of goods produced by the other. Such tariffs have included a 15% levy on key Chinese goods entering the US (such as meat) and a 5% levy on US oil imports into China. While there have been some negotiations regarding a trade deal to end the dispute, both sides are threatening to impose further tariffs before the end of 2019. A separate but related phenomenon is the slowing of Chinese economic growth, in particular in its construction industry.

The slowdown of Chinese economic growth has meant a slowdown in Chinese demand for commodities. China has long been the world’s biggest consumer of industrial metals, but has recently been purchasing fewer industrial commodities, sparking concerns over a global oversupply. Meanwhile, the trade war appears to have contributed to general market uncertainty and the real value of global exports falling. The result has been increased price volatility for various commodities (including oil, gold, copper, tin, lead and nickel which have all seen price drops). With no end to either the slowdown or the trade war in sight, volatility seems set to continue.

Case study: tensions in the Middle East

The Middle East is a critical region for production of one of the most important global commodities – oil – and also home to several key strategic commodity transportation routes, such as the Strait of Hormuz and the Suez Canal. Increasing tensions in the Middle East have been a concern for commodity traders for decades, however, in recent months new dynamics have emerged, in particular the escalating tensions between the US, Saudi Arabia and Iran. Tensions have intensified as a result of the recent attacks on Saudi Arabia’s oil infrastructure, which Saudi Arabia and the US have blamed on Iran, and the US has further ramped up the already-tough sanctions it has imposed on Iran, including on its energy and financial sectors.

The events in Saudi Arabia and US sanctions on Iran have resulted in significant volatility in oil prices following a lengthy period of relatively low prices due to over-supply. Some reports have claimed that the recent attacks on the Saudi Arabian oil infrastructure disrupted the production of 5.7million barrels a day (which amounts to 5% of world output). Oil prices were up 15% on the day following the attacks and oil futures trading reached a record high. Shares in energy companies also rose. However, with Saudi Arabia restoring much of its production, the oil price has since fallen again. 

There have also been high-profile disruptions in shipping through the Strait of Hormuz (which transports a significant majority of the oil from the region). Further disruptions could have a significant impact on the transportation of oil (as well as other commodities), causing delays and failed deliveries that could have the effect of pushing oil prices (and the price of other commodities) higher.

Managing the impact of geopolitical events

For commodity traders, the impact of geopolitical events can be either positive or negative depending on their particular portfolio of investments (even if the event in question is widely seen as negative by global commentators). Commodity traders who are involved with the production or transportation of physical commodities may have some different concerns (such as failing to fulfil obligations in the event of failed deliveries) to purely speculative commodity traders, but fluctuating prices will often be a concern for both. 

Transaction structuring

Before any investment decision is made, most commodity traders will conduct significant due diligence into the relevant commodity/sector. If the commodity trader is sophisticated, this due diligence will likely be carried out with the assistance of technical advisers, including industry experts and lawyers who will assess the commerciality and legality of the opportunity, including the impact of any sanctions. Then, if a decision to invest has been made, the commodity trader will look to ensure that it receives appropriate legal protections in the transaction documents to deal with any risks identified during due diligence. Transaction documents may be based on industry standard terms (such as the Incoterms rules setting out the responsibilities of purchasers and sellers on delivery of goods), but lawyers may assist the commodity trader in negotiating bespoke terms such as appropriate financial tests, terms regarding timing for the passing of title and appropriate defaults.

Many commodity traders will also seek to hedge their investments at the outset. Commodity traders will often enter into offset hedges, which limit their exposure to price fluctuations. To do this, they purchase a ‘futures’ contract of an opposite but equal position for the same delivery date as the physical transaction. Other hedging products are also available for managing price risk, such as commodity swaps pursuant to which the commodity trader can swap a fixed price for a commodity with a floating price for the same or different commodity, or vice versa.

It is worth noting that not all commodity traders will be affected by fluctuating commodity prices and that hedging will, therefore, not always be a consideration. For instance, an oil trader who connects a seller and a buyer may simply sit in the middle and ‘arbitrate’ between the sell and buy prices – for that commodity trader, it makes little or no difference whether the price is going up or down as it takes no positive risk in the actual transaction.

Another key concern for many commodity traders at the outset, given that they are often highly leveraged, will be to ensure that their finance arrangements are sufficiently flexible to limit the risk of defaults under their loans if adverse events beyond their control occur which make it difficult for them to comply with obligations owed to their lenders. They will often take the advice of lawyers to agree appropriately tailored security packages, covenants and events of default with lenders, including relevant ‘cure’ periods.

Diversification and integration

In addition to structuring transactions to minimise risk, commodity traders will also look at their overall portfolios and may seek to manage the impact of geopolitical events by diversifying the commodities in which they trade or by sourcing the same commodities from different locations. This reduces dependency on particular commodities or regions, as a consequence of which the commodity trader is better able to withstand high-impact (but isolated) geopolitical events. In some circumstances commodity traders will even contractually agree that, in the event commodities due to be supplied to them, or which they are due to supply to purchasers, are unavailable due to events out of the parties’ control, obligations under the relevant contracts can be fulfilled by providing the same commodity, but from another source.

As an alternative to diversification, some commodity traders also use integration in the commodity supply chain (which, broadly, starts at commodity extraction and ends with the ultimate consumer) to manage their overall portfolios. This means that the commodity trader will purchase assets or take a role at various levels of the commodity supply chain, allowing the commodity trader to have greater control over the overall process and to insulate itself from the impact of events affecting one level of the supply chain only.

Catherine West and Nisha Raman are, respectively, associate and trainee solicitors at White & Case.