The Hidden Plumbing of Commodity Finance

22:54And in that case, you're often talking to the warehouse directly. So you may say, the client may say, I'd like to release these five bags of coffee or one cappuccino to sell to this roaster. Is that okay? And our team is actually saying, yes, please release those. But that's on trust, what we call a trust receipt.

23:16Lewis Hart:And then they have to give us an account receivable to replace that within a certain number of days. Interesting. OK, so obviously in the backdrop of this conversation is the closure of the Strait of Hormuz. And we'll get to that in a second. But it does raise a question I sort of hinted at in the beginning. We all know that oil flows through the Strait of Hormuz and there's a futures market for it that allows some ability to reduce volatility or take out concerns. Pistachios also flow through the Strait of Hormuz. As far as I can tell, there's no pistachio futures. I just looked it up on the terminal.

23:50And I'm curious, first of all, A, do you do commodity finance for commodities that don't have hedging instruments? So one of my colleagues, this may shock you, is on the board of the Peanut Tree Nut Association. Is it actually called the Peanut Tree Nut? It's called the Peanut Tree Nut Association. It's a big trade organization, and we happen to finance— Peanuts aren't tree nuts, hence the name has to be segregated. Yes, you need peanuts and tree nuts in the title. It's very, very important, very specific. So we actually are active in lots of non-hedgible commodities, like cashews is a good example, pine nuts, pistachios less so, but all kinds of non-hedgible commodities that would probably surprise you.

24:32How does that change the calculus of commodity finance when that instrument doesn't exist? Yeah. So thinking about what's happening in the strait, first of all, we're not the largest player in the Middle East. I think more of the European banks, but certainly we're watching it closely. And I think what the media is really focused on is kind of the oil side of the story. So you keep hearing 20 % of global oil is trapped, the largest disruption in the history of the oil market. Those are all true. You see lots of activity in the price, although it's mostly in the front month, the front of the curve, not the back of the curve.

25:12What I think we're interested in actually in the lens of a commodity banker versus the lens of sort of an oil research analyst is how much capital is actually trapped, right? Because our business relies on turning over your balance sheet.

25:26Lewis Hart:The commodity merchant and the commodity banker, the fundamental principle is that self-liquidating nature. So you buy it, you sell it, you collect, and then you do it again. It's velocity of money. It's the velocity of the turnover. And right now, there is a lot of capital that's stuck in the strait. And I see lots of different reports. Is it something like 1 ,500 commercial vessels, some number like that? I think that's what the Pentagon said recently. That's a lot of working capital. So doing some rough math, that's tens of billions of dollars. Maybe it's more than$100 billion, but it's a massive number.

26:03Lewis Hart:And when all that gets trapped and you have potentially margin calls related to hedges on those inventories, that can really strain your liquidity if you don't have the right financing structure behind you. And that's why in these situations, you need a bank that understands your business. So if you were going to load an Afromax, which is like typically 700 ,000 barrels of oil, that's the capacity of an Afromax vessel. Before February 28th, the cost of that might be$40 million,$45 million. Today, it's more like$70,$75 million. And so overnight, the cost of your single shipment went up a significant amount.

26:48Lewis Hart:And how do you finance that? Back to the earlier point. You need a bank that can be flexible enough to write a line of credit that allows you to do financing under a certain guideline. So how are the banks actually handling this at the moment? Because on the one hand, like, OK, the cost of actually shipping stuff has gone up. On the other hand, the value of the underlying collateral, you know, assuming it's oil or maybe steel or something like that, has also gone up. But on the other hand, as you point out, balance sheets are probably a little more restricted if you have these huge sums that are already tied up because the ships aren't actually moving.

27:26Yeah.

27:27Lewis Hart:So I think going back to COVID and then Russia, Ukraine, first you had this huge supply chain disruption. We all remember images of container ships off the coast of Long Beach. Two years later, we had the Russian invasion of Ukraine and this huge disruption in natural gas flows from Russia to Europe. People didn't forget about those things. So companies went out and raised more capital so that they were ready for the next exogenous event. So I think - Sorry, when you say companies? Commodity merchants. Okay. Commodity merchants in this case, yeah. Commodity merchants specifically went out as a result of the volatility in those two events, raised more capital.

28:07Lewis Hart:So they're coming into this crisis well-funded. And so, so far things are working okay, actually. There's not evidence that things are breaking. If this lasts for months and months and months, who knows where it goes? But right now the system is functioning well, actually. The banks are supportive. The commodity merchants are dealing with the liquidity needs. They have enough liquidity. We haven't heard of any major issues yet, but it's a matter of time. And if the strait doesn't open sooner than later, then I think you could see big strains because there's so much trap capital there. What actually happens mechanically if I've financed a particular shipment and is now hypothetically stuck in the Strait of Hormuz?

28:55Like what conditions start to kick in? Yeah. So I think putting, if you're channeling your inner commodity banker, the first thing you're looking at is, is my collateral okay? Right? So if it's a shipment of oil, is, you know, the crew okay? Is the ship in the right place?

29:16Lewis Hart:Is it going to be at risk of, you know, being in a war zone and having impairment? Once you sort of get over that, you're looking at the insurance, making sure the insurance coverage is there. You're looking at what does the charter contract say between the merchant and the ship operator. And that's going to govern sort of who pays for this detention, voyage, frustration. There are different terms, but all those are going to be governed. Is voyage frustration an actual term? Yes. Frustration of voyage. Yes. And so this is, you know, demurrage is a common term. That's when the merchant is slow to load a vessel or slow to discharge a vessel.

29:56Lewis Hart:This is something a little different because this is essentially a war zone. The ships can't leave. And so it has happened historically, but it hasn't happened in a long time. And I know everyone is sort of looking at the contract, figuring out what the losses and costs are, and then figuring out who's responsible for what. It's not a single answer. It's case by case. But first you're looking at the collateral. Then you're looking at, does my client have enough capital to withstand this? How many months, days, you know, hopefully years could they withstand if this actually never opened?

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32:53Additional restrictions may apply. Please speak with a business banker for more information. JPMorgan Chase Bank, N.A., member FDIC. Game night rush or any night of the week, really. Genius keeps every order moving. From online ordering to your kitchen to the front counter. Big league reliability for any business. That's genius. Do you do like, you know, what would be the equivalent of workouts with clients? I mean, you know, here is clearly something that's not their fault. It's an exogenous shock and so forth. You probably would like to have that client be with you five years from now when hopefully the straights open in five years and so forth.

33:36And so you have like, OK, like here's money, some owe us. But this would be really stupid to put the screws to you now to collect that. Maybe they have the capital, could make the payment. But it would be very unwise in the long term to put the screws to the client to get that payment back given that life is long and so forth. Yeah. We operate under the principle that you don't put all your eggs in one basket. So supplier diversification is a really important part of commodity risk underwriting. And that means if a client has 100 % of their supply coming from one region, you might get a little anxious about that credit and say, maybe not for us.

34:13So typically there's enough diversification that a single ship or series of ships that are stuck in one place doesn't cause the company to kind of seize up.

34:26Lewis Hart:You know, there may be some of that out there, but we're not seeing that with our clients. I'm sorry, I want to just go back to something because I didn't understand. So you mentioned your colleague who's on the Peanut Tree Nut Association. Yes, yes. From the perspective of Brown Brothers Harriman, how does commodity banking or finance work differently for some of these more niche commodities where the client does not have the ability to go short to contrast the physical? Yeah. So you're always in non-hedgeable commodities, you're also measuring price risk. Yeah. typically in something like cashews as an example yeah they typically they cashew supply chain is super interesting by the way it starts typically in west africa it comes in something called raw seed it then gets shipped to southeast asia vietnam india and they extract this kernel and the kernel is what you eat and there's actually toxic liquid in between the shell and the kernel long story, but it's sort of a fun supply chain.

35:32Lewis Hart:And then it gets exported in edible form, typically from places like Vietnam. And so it's a very long supply chain. And typically what you're relying on there, because the price does move a lot, is a forward contract. And that forward contract may not be financially settled as it is in the futures market. It may be, I've sold this all to XYZ buyer at ABC price. Some maker of like sweets or something like that. Yeah, think about if you like cashews, if you go to your local grocery store, it's probably whoever sits in between your local grocery store and our client that is packaging and salting and all those things.

36:10So I was looking up the toxic liquid that comes from cashews and it's urish oil. I'm not sure I'm pronouncing that right, but the stuff that comes from poison ivy, which I am currently suffering from. So this is, yeah, this is interesting to me. That's really interesting to know. But it's interesting, too. Like, I remember when we were in Alaska, we were talking about some of the fishing that happens out there. How much fish goes to Asia for us to be processed? Oh, yeah, for processing, yeah. And it's really interesting to think from just like these pure commodity standpoints, how I imagine a lot of the value added, the supply chain is not actually accruing to the original origin of the commodity, but rather the entity that can do processing most efficiently through some combination of technology, environmental standards, labor costs and so forth.

37:01I imagine a lot of the value added in a, say, cashew comes there. Yeah. Yeah. I'd say a lot of the value is happening kind of in the midstream, to your point, in between the upstream, which would be the farm, for example, in West Africa, and the client at the end, the retailer. So that's definitely true. Interesting fact about the peanut tree nut market is that it's also full. I want to keep saying that. It's full of family businesses. And the other thing we do a lot of is work with family businesses. So you sort of look at this intersection of commodity trade finance, family business.

37:41Lewis Hart:And in the middle of those two overlapping circles is the peanut tree nut industry. Got it. Just going back to collateral, you know, one of the tropes or jokes that often gets brought up in commodities markets, it's like I put on a physical oil trade and like, oh, no, now I'm going to actually settle and take delivery of like 50 barrels of oil in my studio apartment or something like that. If you're in commodity finance, is taking delivery of actual collateral, like, is it a disaster for you the way it is for other investors? Or is it kind of that's what it's there for? These are all collateralized loans.

38:17Lewis Hart:Usually, you wouldn't take delivery if you didn't intend to. So usually, it means something went wrong. There are certain products where you actually buy the commodity physically with a contract to sell it back in the future. It's a form of inventory financing called a repurchase agreement. But typically, your goal is to manage the credit so it's a good company that doesn't default on the loan, and therefore, you avoid having to get out of the loan the second way, which is liquidating the collateral. So you try to avoid that at all costs. If you had to, the good news is you can typically sell it in the location where it exists.

38:55Lewis Hart:So if it's in a tank in Houston and it's X barrels of oil, you kind of say to someone else, hey, can I sell you this? It's sitting here and they'll quote you a price. So it's not as dramatic as actually arriving at our doorstep. And we try to avoid having to do that. That's part of our job. Something has gone wrong if we're doing that. But it has happened before over our 206-year history. Once again, going back to unhedgable commodities, and I ask this for a different reason, is one of the things, and it's sort of commodity-ish, one of the things that's very hot right now are a lot of people are hoping that compute futures are going to be a thing.

39:37And that people will trade capacity of an H100 NVIDIA chip in the way. And there are some nascent efforts. And I don't know if this is going to take off. But I'm curious, like, if there are any intuitions that we can build based on existing markets of what types of commodities lend themselves to financialization that way. So we don't have – we have oil futures and we have cotton futures. We don't have pistachio futures. Is there anything that we can look at and say, yes, this type of market lends itself to financialization on an exchange whereas this one doesn't? so as in our minds we can help try to predict whether this will logically apply to something like compute futures.

40:18Yeah. So if you look at the origin of the futures market, it was really designed to help farmers manage their price risk. So think of a grain farmer in Iowa planting. This is what they teach you in the textbook. The farmer and the hedge and all that. Not the onion farmer. But if you look at the properties of the commodities, I think it's a few things. One is how homogenous is the product.

40:40Lewis Hart:So the more heterogeneous the product is, the harder it is to standardize into a financial contract. Two is volatility. If there's no futures market and it's moving all over the place, there's going to be a lot of demand from a producer, from an end user for a futures market. So actually memory chips and compute are extremely volatile right now. We've been thinking a lot about whether that's a good candidate for a futures contract. And if you're a fab that's producing chips right now, you love the price you're getting, right? I mean, maybe you've sold some of it forward below the market, but as you're kind of rolling your contracts, it's very profitable, right?

41:22Lewis Hart:And could you lock that in? On the other side, if you're an electronics consumer of chips, you'd love to be able to hedge that price and hedge your consumption. So I actually think it's a great candidate for the futures market. Whether it takes off, I'm not sure, but I know some of the exchanges are spending a lot of time on this right now. I don't know when this particular episode is coming out. We're recording on May 27th, but very soon at our live show, we will have an episode dedicated to hearing from one company that is trying to create a compute exchange and futures market, basically. So that'll be interesting.

42:02Yeah, I'm very interested in this question.

42:04Lewis Hart:I think part of the big story with compute, by the way, that's under followed is copper. So I think everyone talks about power, you know, and power is really important. And there needs to be lots of power capacity in order to build the AI revolution. Copper is as important. And you see copper prices at record highs, largely because of how much copper data centers are consuming because of all the electrical capacity that needs to be in that infrastructure. Do commodity financiers, do they have good insight into trends in commodity prices just by virtue of being able to see actual supply and demand on the ground?

42:44Lewis Hart:In general, our philosophy is we don't know where the price is going. So we try to be price agnostic, But you can't help but notice trends, see things early. And one example would be in 2020 when COVID hit, you just saw freight prices skyrocketing. I think well before the market, you saw things like steel going up quickly and those prices being passed down the supply chain. So you definitely can see things that kind of feed into like the PPI, ultimately the CPI. When you live upstream the way we do in kind of these metal energy ag supply chains, you often see things first and before they actually get transmitted into the economic data.

43:28Lewis Hart:Now, it's just one side of it. So it may not be conclusive, but it certainly provides us with lots of interesting information. There's not a trucking future trucking capacity futures market, but it occurs to me like, OK, here is a situation in which you have this sort of idiosyncratic moment. And then it probably wouldn't have made sense. I don't know. Actually, trucking like is it in your mind? Like, could that eventually be a candidate for? Yeah, because you have these explosions of price. And so in the explosion of price moment, probably everyone's like, oh, I wish I could hedge this. Right.

44:03But then you don't really know. is this a permanent fixture or is this just a post-COVID thing where there was a one-time price readjustment? Because if it's a one-time price readjustment, you don't really need a futures market. And we don't really know like from memory, is this like a one-time price readjustment or is this a new permanent fixture of the memory landscape? But answering that question would be an important part of whether it's worth it to build out a futures market. But I'm just curious, like in the post-COVID environment, were there people kicking around the idea of freight futures or something like that?

44:34Yeah, and there are - Because it's like everyone wakes to this volatility. There's not super liquid, but there are tanker contracts you can buy. Yeah, I just noticed this cape size, but it looks like there's almost no liquid. Yeah, there's not. The bid ask is pretty wide, but people do try to make markets. So dry bulk freight, you can go long or short. Trucking, I think, is a good candidate for it. I think because trucking in a lot of ways follows the diesel market, because the biggest kind of variable cost of trucking is - So there's already an assumption to hedge that.

45:01Lewis Hart:A little bit. It's not perfect, but it's pretty highly correlated. Tracy hinted at this. Were onion futures to be legalized? Would onions themselves? So you've mentioned - Now we're just doing hypothetical futures markets. You mentioned there are two conditions, the high price volatility and homogeneity of the underlying commodity. Yes. Would onions meet the conditions such that were they to be legalized, they would be a good candidate for financialization? Well, one thing I'd worry about with onions is perishability. Yeah, right. You know? So I think putting onions in a warehouse, if you had a physical settlement process, could be a little dangerous, you know, because you can only store them for so long.

45:49Yeah. But onions, they are pretty homogenous as far as I know. I mean, maybe I'm missing like a specific - Well, purple onions, green onions, white onions. So there's some basis risk. You know what my favorite onion is? The Texas 1015. Do you know what that is? No. I've never heard of that. What is that? Yeah, it's a type of yellow onion that I think was created at Texas A &M University. It's really sweet and tasty. Sounds fake. No, no. I mean, it's like any other— It sounds like Texas A &M propaganda. No, believe me, I would be the last person to advocate for Texas A &M propaganda. No, look up Texas 1015.

46:21It's a really nice onion. Man, I've got big onion growing plans this year. Oh, my God. It's the official state vegetable of the state of Texas, according to Google's AI overview. So I have no idea if that's true. No way. I'm going to have to try this. Yeah, they're good. They're good. All right. Well, we're learning all sorts of things in this conversation. I just want to go back to the idea of seeing some trends before they kind of burst into the public consciousness. So one of the reasons I was tracking a ship last week was because it was going with its payload of fertilizer. It was going from Saudi Arabia's Yambou port to Bangladesh.

46:57So basically they had trucked a bunch of fertilizer from the like Gulf side of Saudi Arabia over to the African side of Saudi Arabia. And we're going round. Are you seeing any new like trade routes being established as a result of what's going on in the Strait of War?

47:14Lewis Hart:Yeah, totally. Great question. I think we saw that starting actually with the Houthi issue in the Red Sea. And if you think about voyages, for example, from Shanghai to Northern Europe, take that route, which is a pretty big route, they used to go through the Suez Canal. Suez Canal kind of closes because ships are not comfortable taking that risk. Suddenly, they're now routing around the Cape of Good Hope. And back to my point on kind of this age of bottlenecks and disruption, that's adding 10, 15, maybe more in terms of shipping days, which adds to the working capital requirement, adds to the cost, the day rate on the ship, the insurance.

47:57So absolutely seeing a lot of that.

47:59Lewis Hart:And I would guess if the Strait of Hormuz conflict continues for a lot longer, there's going to be a lot of creativity in terms of how to discharge cargoes from those ships. get them to safer ground and then export them in some other way. I would imagine if I were Saudi Arabia, I'd be thinking about building pipelines, going the other direction. I'm sure that's happening all over the Middle East to try to avoid the strait. Even if it does subside, I think people are still going to want to find alternatives because we've realized how reliant we are on this one choke point. All right, Lewis Hart, thank you so much for coming on all thoughts.

48:38That was so much fun. It was great to be here. It was a lot of fun. That was fun. That was really, really interesting. Learned about Urshal. The onion question was good.

48:46Lewis Hart:Yeah, that was good.

49:00Joe, I always enjoy those commodity discussions. I feel like I learn a lot of things like that Urshal is also found in cashews. I had no idea. And it sucks when it gets on your skin because you've been gardening. I also learned that there's a peanut tree nut association. I learned about that. Why didn't they call it like ground nut tree nut association? Are there just like not enough popular ground nuts? Is peanut a ground nut? That's what I thought. I have no idea. Doesn't it grow on like? I have no idea. No, I did think I love that conversation. I guess, you know, Now, as you said, there's a sort of romantic, exciting element of commodities that's very real.

49:41I mean, and it still exists. The fact that you're having to reroute trade flows in real time. Yeah, you're seeing new trade routes established. You know what I want to do an episode on is Asian food processing. Because it's really interesting to think about commodities are grown all over the world, or agricultural commodities in particular are grown all around the world. but essentially where more and more of our food come from East Asia, even though we don't think of East Asia as being a big agricultural powerhouse per se. Well, the Alaska fish stat blew my mind when we heard it last year. Also, okay, so I just Googled this.

50:21I feel like we've been doing a lot of like searches during this conversation. That's actually a sign of a good episode. But apparently peanut is just another word for groundnut. I always thought peanut was a type of groundnut, But it turns out they're just like interchangeable terms. Yeah. So in Asia and India, they'll talk about groundnut oil, which is just peanut oil. Interesting. We're learning a lot. There you go. And one other thing I wanted to say is, you know, it's becoming a cliche at this point. But Lewis was talking about the idea of all this capital tied up in the Strait of Hormuz, right?

50:54And like, it's OK now, but in a few months. But the longer it goes on, like, the more problematic it becomes. And this seems to be, like, the overriding theme of this entire shock, right? Well, you know, it's interesting. Yes, absolutely. Because we're recording this May 27th. So tomorrow will have been the three-month start of the war. Yeah. I don't know when this episode is coming out. But it's also interesting to think that, you know, a couple months ago, when we were doing commodity episodes, we would say like the exact time of the episode, like I was recording this at 1030. Right. But now it just feels like this is just this interminable thing that's part of the background.

51:35We're actually so deep into it that it's just like, yeah, it's probably going to be closed a year from now too. And it just feels like, it has this feeling of permanence that now it suddenly becomes, yeah, I suppose things could change by the time this episode comes out, but it almost feels like it probably won't. We've definitely stopped doing the minute by minute timestamp. Okay, shall we leave it there? Let's leave it there. This has been another episode of the Odd Thoughts podcast. I'm Tracy Allaway. You can follow me at Tracy Allaway. And I'm Jill Weisenthal. You can follow me at The Stalwart.

52:04Follow our producers, Kerman Rodriguez at Kerman Armand, Dashiell Bennett at Dashbot, Kale Brooks at Kale Brooks, and Kevin Lozano at Kevin Lloyd Lozano. And for more Odd Laws content, go to Bloomberg.com slash OddLots. We have a daily newsletter and all of our episodes. And you can chat about all these topics 24-7 in our Discord, Discord.gg slash OddLots. And if you enjoy Odd Lots, if you like it when we talk about the non-existent onion futures market, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free.

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