In an HC Insider podcast recorded in February this year, HC Group’s Managing Partner Paul Chapman and Kevin O’Reilly, an expert in commodity markets, reviewed the role the investment banks played in developing the global commodity markets.
Goldman Sachs and Morgan Stanley started in the commodities business with hires from the physical commodities industry. This experience was acquired either through acquisition, such as Goldman’s 1981 purchase of family-owned commodity trading company Jaron, or directly soliciting talented industry individuals. These banks became successful by mixing their bank finance, risk management, and derivatives-savvy talent alongside their commodity industry hires (who fixed cargoes, served load to the electricity grids, and delivered gold bullion to accounts at the Bank of England). In this article, O’ Reilly reviews the history of the investment banks in commodities, their impact on developing commodity talent, and their hiring challenges for the future.
Breeding Grounds for Success
The repeal of the Glass-Steagall Act in 1999 boosted investment banks' growth plans, allowing them to expand their capital bases and enter many new markets, including commodities. As a result of this, their need for talent grew exponentially. Light regulation, limitless capital, large pay packets, and almost unlimited commercial possibilities attracted commodity industry professionals in Asia, Europe, and the US. Graduate trainees now had a new, if not yet fashionable, commodities department to rotate through on their bank training programs.
Banks are typically breeding grounds for success, centers of financial innovation, and up until 2008, were an excellent environment for risk-takers. Bank commodity businesses grew massively during the 2000s. They became the most sought-after business group for a graduate trainee and had little trouble attracting trading talent from established supermajors, deregulated utility players, and traditional multinational commodity companies. In effect, some banks had become asset-light physical merchants themselves, and none more so than Morgan Stanley, which had a significant footprint in the United States energy markets, storing heating oil in New Haven, transporting refined products through its pipeline company TransMontaigne, and operating over 100 ships through its shipping pool subsidiary. The industry professionals taught the bank’s junior staff the nuances of their physical markets, building deep talent benches that mixed cutting-edge finance and commodity trading.
As profitability grew, the first real war for commodity talent began amongst the big financial players. Well-known and very successful trading and structuring talent from the desks of Morgan Stanley and Goldman Sachs were lured to the newer entrants through enormous compensation packages, material management responsibility, and impressive-sounding titles. An executive director from Morgan Stanley was suddenly a managing director at JP Morgan and their global commodities head. Similar staff poaching from Jaron allowed Credit Suisse and Lehman Brothers to make a splash in the commodity world, if only for a limited time.
Merchants Commodity Traders
The first war for talent was short-lived. After the 2008 global financial crisis (GFC), the talent battles were no longer centered on the banks. The subsequent 2010 Dodd-Frank regulation of banks and financial institutions severely hampered their ability to operate in the way they had before due to increased regulatory, reporting, and capital charge burdens.
Despite playing no part in the GFC and delivering multibillion-dollar profits in 2008, they were subjected to the same rules as the rest of the financial community. Further punishment came via the infamous 2014 Senate hearings that forced the banks to divest all their physical assets. Banks became banks again (and don’t do any commodity trading while you’re at it!)
While the banks thrived during the 2000s, the lesser-known commodity merchant traders expanded their operations. Similarly, hedge funds and investors also took an interest, particularly when crude oil hit an all-time high of §147 USD-bbl in July 2008. Hedge funds have often turned bank traders' heads with the lure of a hassle-free life focusing on the markets - instead of non-trading-related work such as peer reviews, corporate social activities, and relentless compliance training videos!
Commodity merchants became the big winners in the commodity talent wars after 2009. They avoided the most onerous regulations (by not being too big to fail or by being domiciled in jurisdictions outside the United States and the UK). They were able to continue trading, speculating, and developing operating models that spanned the entire commodity supply chain. The merchants became the destination of choice for the bank commodity talent. They attracted the brightest and best right across the talent pool, acquiring deep derivatives, financing, and sales knowledge.
The banks could no longer offer extensive, multi-year bonus guarantees and had higher than ever proportions of yearly compensation granted in deferred banking shares, which had performed disastrously in 2008 and would languish near the lows for several years.
The banks’ reputations were hurt after the GFC. Whether the younger self-conscious generation of talent of the day wanted to work in a bank became a legitimate question. Those formerly from the commodities industry either returned and used their skills to develop new markets in renewables trading or found a home with a hedge fund.
With most corporate planning operating within five years – if not shorter – institutional knowledge was lost through staff attrition. Most banks lost at least an entire business cycle’s worth of commodity talent.
Today, merchant traders have graduate training schemes and spent the last decade recruiting the best commodity talent from banks. They have benefitted massively from an era of near-zero interest rates allowing them to finance ever-larger trades. More recently, despite the COVID-19 pandemic and the Russian invasion, volatility rates reached new highs, and record yearly profits have continued to be made.
Volatility is usually a commodity trader’s best friend. Still, extreme price shocks have led to commodity exchanges making unprecedented capital and margin calls for the hedges of the merchant traders’ arbitrage positions. The recent nickel market chaos is the most visible example on the London Metal Exchange in March 2022. The merchants’ trades make economic sense, but the mismatches between daily variation margin calls on their futures positions versus the terminal cash flows of the physical trade settlement have led to alarm bells ringing in the commodity trading community, with several players floating the idea of bailouts.
A moral hazard arises when self-serving commodity merchants who have benefited from the banks being squeezed out through regulation start asking for taxpayers’ money. While participating and adding liquidity to markets, merchant commodity traders are not helping bona fide end-users and producers of commodities to hedge their exposures and secure certainty of cash flows and their operations. Is this important to today’s socially conscious young graduates?
In contrast, the bank commodity desks of the last 30 years provided industry, corporates, and transport with hedges and structured finance solutions that allowed for cheaper borrowing rates, security of future cash flows, and natural resources (mines, farms, power plants, solar plants, and wind farms) development. In short, they created certainty by helping people. That help led to job creation, prosperity for many, and community development.
The current crises gripping the energy and food markets today could pave the way for a swift return of the banks to help calm markets, leading to lower prices and inflation. For the first time in a generation, commodities and inflation pose a severe threat to everyday life, and in times of trouble, governments have looked to the banks for help.
In another recent HC Insider podcast with Jeff Currie of Goldman Sachs, Currie talked about insufficient capital allocated to the commodity space. Money needs to flow freely to where it is required. Historically, money comes from banks. But the banks will need to attract trading and structuring talent back (from the merchants and industry again) to make this happen on a much larger scale. Over time, they will need to develop the junior talent too. The scene could be set for a repeat of the last cycle seen in the 2000s.
The Energy Transition
The energy transition represents another global challenge that the young are keen to take up arms and fight for. In the HC Insider Podcast, I argued that the banks could help with the great energy transition.
The energy transition needs capital and the accompanying hedges to make renewable projects and developments viable. Banks are also the ideal marketplace for the nascent but growing voluntary carbon offset markets. The demand for voluntary carbon offsets will come from businesses that are customers of the banks.
Being at the center of the carbon offsets discussion can help banks rehabilitate their reputations. The carbon offset industry is attractive to today's graduates and veterans who know how to nurture markets. It is a segue for the banks to return to some level of commodity engagement and attract the talent needed to help tackle the challenges we face now and in the future.
Despite strict regulations, the banks have plenty to offer. They remain hubs of ingenuity and great places to develop careers. Since the GCF, they have become more client-focused, community-oriented, and self-aware.
Hedge funds, merchant traders, and traditional industrial participants are great places to work. But with the continued strong bank performances of the last few years and the vast opportunity for the energy transition, employees at these entities might once more be enticed towards the commodity banking sector for (most) of the same reasons they were nearly 30 years ago.
Many of today’s graduates are too young to remember the anger at those same banks in 2008-2009. They might look at them more favorably given the prominent role they can play in making the environment a better place, taming inflation, and feeding the world.