Noble Group, Its Risk And Its Circularity With The Energy Commodity Prices by Navigating the Commodity Markets with Freight and Spreads

The link between lending, credit, liquidity and price is a less-understood aspect of commodity trading.

It is fundamentally wrong to compare lending risks in commodities with lending risks in any other businesses.

Bank lending is modeled on negative skew (frequent small gains and infrequent large losses) while the shape of the normal distribution in commodities has positive skew, the opposite.

A bank underwriting loans on commodities to a large pool of customers and collects the interest and fees until the day one very large customer defaults on their loans (think of the big E, Enron Corp) and everything they’ve earned over the years goes up in flames [Standard Chartered’s TCF people have hazardously learnt it].

For Economists, the loop between a bankruptcy risk scenario at a commodity trader and its trickle-down effect on energy prices is called circularity.

Geeks like me who have perhaps spent too much time in risk have theorized that:

  • Tail-risk ( the risk of an asset or portfolio of assets move more than 3 standard deviations from its mean) can build-up in the energy market because of idiosyncratic risks and adverse selection.
  • The commodity market will act as a belt between the bankruptcy risk and prices, transforming the idiosyncratic risk and the unwinding of its trade positions into market risk units.
  • The subsequent liquidity effect will bring energy and commodity to their limit-down and spread differentials will widen.

In the physical market when an entity is selling a commodity on a fixed price contract to a trader, and there is a credit default, they may have to liquidate that contract on the open market.

If the price of the commodity has dropped significantly, the company or the bank financing the trade has a marked-to-market loss.

Noble Group

The VaR (Value at Risk) framework to assess the potential loss in value of a commodity trading portfolio on any given day is used at Commodity houses where profit and losses are calculated daily “marking-to-market”.

Rising volatility ? and increased correlation trigger a timing-bomb on every other trader’s internal VaR regardless of if they have bilateral trade or not with Noble Group, constraining their internal liquidity and prohibiting their trade exposure limits.

That a commodity trader is long a commodity and short in the derivatives market doesn’t absolutely alter margin calls in the real world.

Recently, a mid-tier trader has reported a one-day $50M loss in the PnL sheet due to the ebbs in only just one day in the oil market.

Lending in the commodity market is also achieved with repos (repurchase agreements) where both the spot and forward price are agreed now on a commodity (more likely on a metal), and the difference between them implies an interest rates.

The collateralization of the loan is achieved by selling the security temporarily to the bank.

Repos create a liability on a balance sheet of the trader but a bank can also combine a repo with a swap so the trader exposure remains “off-balance sheet” and only the MTM variation stays on its client balance sheet.

This arrangement, although extremely advantageous for credit rating and financial presentations doesn’t offset increased financial risk for the borrower.

It is the unwinding of these trades that is potentially worrying on the LME markets…

The big N funds its long-term commodity contracts and liabilities with short-term papers exposing the company to rollover-risk, the risk that a trader can be refinanced only on highly disadvantageous terms or either simply not refinanced.

Since they are financing their bonds payments with short-term borrowing at a positive spread, when the debt cannot be refinanced at an interest rate below the bond yield, a negative cash flow and losses will result.

These risks are tied together and this is just fascinating.

A) When creditors withdraw credit or change the terms on which it is granted, the trade book has to be unwound and/or positions are no longer profitable and the trader realize mark-to-market.

B) Because of losses, trade counterparty increase collateral requirements, raising the cost of financing of holding a long position on a commodity or hedging in the OTC market.

“The decrease in trade and other payables was due to: “in the money” Oil Liquids futures contracts rolling off with corresponding decrease in cash margin liabilities to brokers which are included in trade and other payables; and the tigthening of the Group’s uncommited unsecured credit lines.”

Noble Group Q1-2016 Presentation p.10

C) A risk reluctance is first reflected in the higher credit spreads.

Banks become more reluctant to lend.

Brokering counterparties in derivatives ask collateral to take the other side of the trader.

Counterparties in billateral commodity contracts also ask collateral or refuse to open Letter of Credit instruments (L/Cs).

Working capital is in jeopardy and negative operating cash flows result.

Noble has lost US$1.5 billion in bank lines. Trade and other payable has decreased by US$1.271 billion with approximately 50% due to the tightening of the Group’s uncommitted unsecured bank lines which resulted in a reduction in the availability of term letters of credit”.

Noble Group MD&A Q1-2016  p.18

D) In a liquid market, the trader make offer to the trade, offering creditors 70 cent on the dollar with a debt-equity swap.

E) However in an illiquid asset market, the banks force the trader to raise cash by liquidating illiquid assets at distressed to meet an immediate demand for cash- it’s the trader who is taking the losses, working for the banks.

December 2015: In a fire-sale, Noble Group has sold its 49% stake in its agribusiness segment to Chinese state-owned enterprise COFCO for US$750m.

The stated book value of Noble Agri’s was US$1.34 billion and after having announced the deal, Noble disclosed that it will book a non-cash loss of around US$546m due to the difference between the carrying value of Noble Agri and realized sale.

F) Realized Losses on the Trade, on the Assets and negative cash outflows put further the commodity trader in the red.

Noble Group

Noble Group Q1-2016, SGX release P.8 Statement of Cashflows

G) The report of losses raises more awareness about their Solvency (having a positive amount of equity (Asset greater than Liabilities).

[A) B) C) E) F) G) are all ticked with Noble Group Ltd].

Since commodity houses management is comprised predominantly of traders who are predisposed to defending their books, they might be also reluctant to recognize losses at market valuations they considered “below fundamentals” or because of Adverse Selection (protecting information on certain aspects could have made an entity less attractive at a point in time).

Liquidity and Solvency are linked by asset value and the gain and losses of the trading position on commodity contracts.

The idiosyncratic point about noble group is about whether Noble Group is overvaluing assets and booking large profits on long-term supply deals before it received any cash from the transactions.

Noble Group

The consolidated Balance Sheet of Noble Group Ltd for Q4-2015, shows that a drop of less than 19% in the assets value would render this commodity house insolvent.

[As of Q1-2016,using Noble’s risible net assets of $3,4B (booked equity) it was -23% and using the market equity value it was only  -10%].

“I actually had a spreadsheet that tracked the impact of every one of our structured finance deals on our credit rating. It showed how the deals allowed us to be rated BBB+ when we were really a BB- company.” -Andrew Fastow, CFO ENRON in an interview with the Ivey Business Journal 1

Enron Corp, “the big E” who was once the world’s largest energy trader is often dispatched to a distant past as an anomaly with no bearing on how trade houses operate nowadays.1 The Lemons come from the trees.

Advised by Investment Bankers and Asset-Backed Securities Structurers who have left banking to enter commodity trading after 08’, the big N uses a plethora of finance transformations to get “exposure on commodities”.

Noble Group Ltd. is more akin to an exchange-listed “Financial asset trader” betting on the value of assets in commodity than a “Commodity Merchant” and consequently the marginal effect of disadvantageous financing terms is particularly strong and negative on the company.

The cliché ” cheap credit is the lifeblood of traders” is an understatement for the circularity between operating cash-flows and financing cash-flows at this entity.

Lately, Fitch has joined Moody’s and Standard & Poor’s in cutting the Hong-Kong trader to junk.

In a late twist, Noble has relied on a combination of short-term credit trade credit facility and record commodity backed-loans to finance its activities.

Commodity backed-loans are short-term in nature, their access can disappear rapidly like it occurred during the subprime crisis for other types of asset-backed loans.

Noble has reduced its trade revenues but increased RMI (ready and marketable inventories).

These RMI are considered as cash equivalent in the SGX-listed trader’s net debt calculation and for their liquidity headroom purpose but not as cash equivalent for its enterprise valuation.

It is quite regrettable that they can get away with this murder.

The big N has covered credit issues.

They cannot reduce the size of these commodity-backed loans backing those RMI without weakening their coverage and getting downgrade further by  Standard and Poor’s and other credit agencies- they have simply no liquidity headroom [relative to bank covenants and collateral commitments].

As a 1st-class U.S trader recalled :

“It is  not uncommon for a 5 days trip to take 2 weeks due to storms… Sometimes the vessel can spend a number of days going backwards  due high winds and heavy sea but in the case of Noble Group-they’ve spent months going backwards, the mothership has lost propulsion.

You can plug patches after patches to fix the holes of a rusted hull but at some point can another ship really come to rescue a sinking ship ”

There’s more than one tree in a forest. Commodity traders accounting and economic dealings will get more scrutiny.

In the coming weeks Noble Group’s assertions will be put to the test.

Because of liquidity effects, it is also not outside the realm of possibility that the bankruptcy risk of a major trader will have also have a trickle-down effect on energy and commodity prices.

Simon Jacques

Credits:

  1. Enron Explained, Ivey Business Journal

© 2016, Navigating the commodities markets with Freight and Spreads