A physical oil trade shock for banks

High fuel prices, tightening credit conditions and unprecedented market imbalances threaten to stymie investment banks looking to fatten their oil trading profits by expanding into physical markets.

Morgan Stanley, which has run a large global book trading physical distillates like jet fuel and diesel for more than a decade, last month put its Asian fuel oil trading business on ice, barely a year after entering the market.

As the only investment bank with a well-established foothold in the physical oil market, Morgan's exit appeared more likely the result of turbulent conditions than a lack of expertise or will, oil traders said.

But it highlights the uphill struggle that peers such as JP Morgan, Merrill Lynch or Barclays Capital face in cracking the market for physical oil, which requires a commitment to capital-intensive storage facilities, long tanker voyages and a large, specialised back office.

"It's a sign of the times when even the most experienced top-tier banks are having difficulty in getting success in an industry they already know so well," says Ong Eng Tong, who consults on storage and trading projects in Singapore.

It wasn't supposed to be like this.

A year or more ago, markets were buoyant, cash was cheap and more banks were tip-toeing into physical markets in an effort to challenge Morgan and Goldman Sachs' position as Wall Street's biggest energy traders. The two made an estimated $5 billion (Dh18.36 billion) trading energy and commodities last year.

The freshman class of investment banks looking to cross over into physical oil trade are seeking new revenue sources to boost profits on their big derivatives trading desks.

While Morgan sought to keep ahead of the pack with a deal to supply and market products on behalf of independent European refiner Ineos, Barclays has entered the physical fuel barge market in Europe, and actively trades diesel and crude oil.

TOUGHER TIMES

But things have changed in the oil market and outside it.

The uneven deterioration in the global economy has knocked many physical markets for a loop.

Strong industrial growth in China and India, for example, and a shift towards diesel cars in Europe, pushed diesel prices to an extraordinary premium to lacklustre petrol.

A glut and poor demand earlier in the year, drove residual fuel prices to their deepest discount versus crude on record – before resurging over the past two months as supplies took a turn for the worse and consumption in the Middle East jumped. The rally in oil prices to nearly $150 a barrel last month, double from a year ago, drove up the cost of shipping cargoes or storing crude in tanks, while credit conditions tightened. Without owning a piece of energy infrastructure to fall back on – such as Morgan Stanley's United States coastal distillate storage tanks – proprietary physical trading became a bigger challenge.

"This kind of knowledge gives you an appreciation of how to look for opportunities to make money when you trade, be it physical or the paper," said a veteran oil trader. "You can be more durable, if you take the time to learn the whole business or at least participate in it at some level, because if you don't you will fall like sand."

CREDIT PINCH

Investment banks from Wall Street to Tokyo have been badly battered by the US sub-prime crisis, which could see losses for the industry snowballing up to $1 trillion, squeezing liquidity desperately needed to keep new businesses running.

"Because of the current credit constraints, banks are forced to change their strategy by putting more focus on businesses or regions that are more established," said a senior banking executive with a top European bank.

The surge in oil prices over the past six years means that trading a single 30,000-tonne cargo of petroleum now requires a $30 million letter of credit, eating into credit lines. In 2002 the same cargo would have required only $8m.

Although companies can use back-to-back transactions to offset some of the credit required for letters of credit, it is still more capital intensive than trading futures contracts on which they have to meet relatively small margin requirements.

Even in derivatives markets some banks are finding the going difficult, especially as choppy conditions trigger margin calls.

French bank BNP Paribas shut its relatively new Asian oil derivatives trading desk in Singapore earlier this year while Dutch-Belgian bank Fortis shifted its trading team to Houston in the US just months after establishing its Singapore desk.

While few have yet thrown in the towel in their effort to crack the physical market, doubts are already growing about whether the timing may simply be wrong.

"If not for the credit crisis there may have been a better chance of success for newcomers looking at entering physical trading," said Ong. (Reuters)