Traders or Commodity Finance Banks ? Part IV- Glencore Exotic Risks

Traders like Glencore build desks to profit from perceived anomalies. Lately, they have started to see risk arbitrage in finance.They  engage them by managing the exotic risks, actively transferring them to another party instead of warehousing them. 

(Reuters) – Glencore is seeking to raise $550 million from investors via a debt issue guaranteed by oil from Iraqi Kurdistan in an attempt to secure a big slice of the high-risk – and high-reward – market in a region at war with Islamic State.

Kurdish oil has been targeted by European traders over the past two years, during an industry downturn, since Erbil began selling oil independently from Baghdad. It has been relatively cheap due to the potential for supply disruptions and threats from Iraq’s central government to sue anyone touching the crude.

…

Now the company is seeking a much bigger role in the region, but wants to split the risks by selling debt notes to be repaid with Kurdish oil income, according to a prospectus seen by Reuters.

Technically, the money would be raised by a special-purpose vehicle, says the document which has been sent to a small number of investors and hedge funds who specialize in high-risk, high-yield investments and emerging markets. The debt is nonrecourse, meaning Glencore will not be liable should problems occur.

Glencore’s planned five-year note would carry an interest rate of 12 percent, according to the prospectus. That contrasts sharply with its other borrowings – it is currently buying back bonds carrying rates of 2.5 percent to 3.125 percent.

The company is also seeking a 36-month grace period before it starts repaying the debt in monthly installments, another reason why investors might expect a high return.

“You can argue that in a way it is not Glencore but Kurdistan who is paying that interest rate as it is the ultimate borrower,” said one industry source close to the deal.

…

MILITANT ATTACKS

While Glencore and rivals have loaned money to Erbil, sources have previously told Reuters, they have never publicly acknowledged such deals for fears of confronting the Iraqi central government, which says the Kurds have failed to respect deals to transfer agreed volumes of oil to Baghdad.

….

Such transactions do occasionally face setbacks like in the case of Moroccan refiner Samir, where several trading houses including Glencore lost hundreds of millions of dollars last year.

Glencore said it would hold a minimum of 10 percent of the notes at all times following the issue.

 

Figure 1: A Pre-Pay arrangement depicted by Jacques, S and Simondet, A. (2016)

 

Figure 2: The illustration of the Glencore pre-pay.

What are the two fundamental difference between the prepay arrangements in figure 1 and 2 ?

1. The apportionment of the risks presents some significant differences.

2. The perceived anomaly that the trader aims to capture.

 

THE APPORTIONMENT OF THE RISKS.

Considering that the “winner” is a non-recourse with a 3 yrs grace period.

Who is the party bearing most of the risks under this scheme ?

A) The Trader

B) Banks

C) Investors

_

RISK-ARBITRAGE

“The world’s largest commodity traders have noted and Arbitrage between Credit and performance-based Finance.”Jacques, S and Simondet, A. (2016)

The perceived anomaly that the trader aims to capture in figure 2 is the delta of risk sophistication between the investors & the financial institutions, no longer an arbitrage between credit and performance.

We note in the Glencore pre-pay- point (2) that the investors are the lender, not the banks .

Who would argue that investors are more sophisticated than specialized banks at pricing, trading and managing credit, commodity and country risks ?

“Such transactions do occasionally face setbacks like in the case of Moroccan refiner Samir, where several trading houses including Glencore lost hundreds of millions of dollars last year”.

This is negative skew: frequent small gains and infrequent large losses-e.g the classic directional predicament of a call/put seller.

“Glencore expects to enter into a new 5-year agreement with the government of Kurdistan to buy its crude, with deliveries rising from one cargo in January, to two in February-March, four in April and six from May onwards”.

“Six cargoes a month would represent a quarter of overall exports from Kurdistan and would be worth over $1.7 billion a year at today’s price of around $40 per barrel for Kurdish oil, and more than $8 billion over the course of five years.”

“The debt is non-recourse, meaning Glencore will not be liable should problems occur.”

The trader makes a loan at t=0, at t=1…n is receiving one, two, three, four cargoes per month and collect the interest until 6 large cargoes default and significant portion of the interests collected over the course of the 5-year agreement goes up in flames in the SPV… (The investor has met the 3rd moment of the distribution…)

EMBEDDED CALLABILITY

The offering defies the law of physics and “As it is” it would be unacceptable for a lender.

-Non-recourse (Glencore offloads the risk).

-offers a return of 1200bps p.a but with a 3 years grace period.

-Finally the trader is planning to hold at least 10% of the issue.

Glencore will indeed participate in its own issue but tactically, what is ultimately profiled above is a synthetic callable note.

–

Jacques S.

Advising the producer, processor and end-user in North America.

Commodity trading and finance

Navigating the commodities markets with Freight and Spreads © 2016

Citation format:

Jacques, S  (2016)“Traders or Commodity Finance Banks ? Part IV– Glencore Exotic Risks”, http://wp.me/p3k7lL-5rJ , Navigating the commodities markets with Freight and Spreads , November 26, 2016.