Banks: Commodities Are The Hanging Judge

by: Andrew Hecht


The commodity bear is taking no prisoners.

Even the big boys are suffering.

Oil-related debt could get ugly.

Banks - a commodity noose around their necks.

Commodity prices are screaming deflation.

Banking is not the business it used to be. In the U.S. and Europe, regulations in the post-2008 era have increased and compliance costs and capital charges have put a leash on the over exuberance that led to the global financial crisis. Risk taking in terms of trading, a profit vertical that had been all the rage in the pre-crisis days, has taken a back seat to lending, the traditional business of the banks around the world.

Lending is a tricky business; it depends on the ability of the borrower to repay debt. Banks protect themselves with collateral. A property is the collateral for a home loan. As we learned in the sub-prime mortgage crisis six years ago, when the value of real estate drops and borrowers could not meet the monthly payment, the banks were stuck holding the bag. That created a slew of individual defaults that added up to a crisis and losses for many lending institutions that had to turn to governments for bailouts.

In the world of commodities, banks finance production projects. The projects themselves serve as collateral for the loans. Whether it is an oil-producing property, a copper or gold mine or any other commodity-related project finance deal, the bank depends on the borrower to extract and sell the raw materials. Banks around the world have been active in these types of transactions. Commodity producers had been making lots of money until recently; they had no problem servicing the debt that financed exploration and output of raw materials. In 2015, this changed and in 2016, it appears that many loans on the books of banks are giving the financial institutions around the world more than a bad case of indigestion.

The commodity bear is taking no prisoners

There are many reasons why commodity prices have moved lower. China, the world's number one commodity consumer, has experienced a slowdown in their economy as the nation shifts from a heavy manufacturing model to a consumer-based economy. The dollar is trading at a much higher level than in May 2014. As the reserve currency of the world, the dollar is the pricing mechanism for commodities. Therefore, there is an inverse relationship between the dollar and commodity prices. The decade-long bull market in commodities that occurred between 2002 and 2012 caused producers to increase output. This led to increased inventories as supply moved higher than demand. Oversupply has caused prices to fall. In crude oil, oversupply has caused the price to drop from over $107 in June 2014 on the active month NYMEX crude oil futures contract to the $30 level recently. Copper has declined to half the value it was trading at in 2011. Almost all raw material prices have moved lower.

One result of the commodity bear market is that producers of raw materials have seen profit margins shrink or in some cases disappear totally. As many of these companies use banks to finance their operations, the ability for them to service debt has decreased. As commodity producers do not pay their debts, the banks wind up holding the bag as they did in the sub-prime mortgage crisis. The collateral that supports the loans has declined in value as commodity prices have decreased, in many cases dramatically. The only difference between the mortgage crisis and current lending problems is that the former was ubiquitous and characterized by multitudes of small defaults that added up to a massive number. When it comes to the inability of commodity producers to repay loans, it is a relatively small number of defaulters; however, those individual defaults are massive.

Glencore (OTCPK:GLNCY), one of the biggest commodity producers in the world, was one of the worst performing stocks in Europe in 2015. While the company has worked diligently to trim their massive debt load and cut expenses, they continue to owe banks lots of money on commodity project financing deals. Shares of other major raw material producers have declined alongside falling prices. Commodities are cyclical assets and the market is currently entrenched in a secular bear market. This has created a thorn in the side of the institutions that finance this sector and while they hold liens and collateral, the commodity-producing assets themselves, the value of those assets has declined.

Even the big boys are suffering

Bank earnings reflect the swoon in commodity prices. The major U.S. banks are all suffering.

Bank of America (NYSE:BAC) is trading close to 52-week lows and the lowest level since 2013.

Shares of JPMorgan (NYSE:JPM) have moved lower thus far in 2016. When the Chinese central bank shocked markets by devaluing the yuan on August 24, 2015 JPM fell to the lowest level since 2013.

Wells Fargo (NYSE:WFC) is trading close to 52-week lows. These are not only the major U.S. banks that are suffering, Zions Bancorporation (NASDAQ:ZION) holds 7% of its loan portfolio in energy-related loans. Shares in ZION are trading close to 52-week lows. In Europe, the condition of the banking community is even worse.

The European economy continues to be problematic and the ECB's program of quantitative easing continues to attempt to stimulate growth. Recently, fears of problems with the loan portfolios held by Italian banks grew when the ECB requested more details on the non-performing loan portfolios of the nation's three major financial institutions. Shares of these banks tanked on the news and one of those banks, UniCredit (OTCPK:UNCFY), lost a third of its value. Germany's largest bank, Deutsche Bank (NYSE:DB), reported a record loss in 2015 last week. Their shares are down over 25% so far in 2016. Another major German bank, Commerzbank (OTCPK:CRZBY), has seen its shares decline by over 20% in 2016. Credit Suisse (NYSE:CS) reported its first full-year loss since 2008 last week. Credit default swaps on many of these European banks have gone through the roof recently. Credit Suisse took a huge write-down pertaining to its acquisition of DLJ way back in 2000. This could be a move designed to clean the decks and lower the bar so low for future earnings.

In England, Standard Chartered Bank and HSBC (NYSE:HSBC) have both passed stress tests but both are struggling with the slowdown in China and the new rules and regulations imposed on almost a daily basis by the Chinese government.

Shares of HSBC have moved to 52-week lows and are at the lowest level since 2009. The bank recently said that they are going to curb mortgage provisions to Chinese nationals looking to buy property in the United States. HSBC had been very active in this market.

The bottom line is that major banks and financial institutions around the world are suffering, their shares are dropping and they have been reporting losses. Even Goldman Sachs (NYSE:GS), one of the strongest financial concerns on earth, is trading close to 52-week lows.

Oil-related debt could get ugly

Crude oil traded down to lows of $26.19 per barrel on January 20. Since then, it has rebounded back above the $30 level, however, this is a far cry from where it was trading less than two years ago when the price was over $100 per barrel.

The monthly chart of the price of NYMEX oil is not a pretty picture for those involved in the oil business, nor is it good news for the banks that finance them. As hedges roll off, the ability for many oil concerns to service debt loads has become more than problematic. This will translate to problems for the banks of the world. Oil is a huge business around the world and while consumers receive a boost from lower energy prices, other macro effects on the global economy are not positive.

Crude oil companies make up a significant percentage of companies that trade on equity exchanges in the U.S. Therefore, lower crude translates to pressure on equity prices. Additionally, lower crude oil means that the production cost for other commodities moves lower. In a bear market for all raw materials, this is likely to cause increased producer selling in metals, minerals and other commodities as the cost of goods sold decreases.

The monthly chart of the price of copper highlights that this industrial metal has lost half of its value since 2011. As the production cost of copper drops, major producers like BHP (NYSE:BHP), Rio Tinto (NYSE:RIO) and Glencore get a bit of a bonus. The strong dollar is also helpful as most copper production in the world is outside of the U.S. and the stronger dollar lowers production cost in terms of employee expenditures as well. These producers can continue to sell copper into the market as it falls. However, the falling price of the commodity means that the value of the collateral held by banks continues to decrease as well. If prices hit a level where servicing debt becomes impossible for producers, the banks could wind up owning the producing properties that are worth far less than the value of outstanding loans.

Banks - a commodity noose around their necks

Commodity prices are becoming a noose around the necks of the banks and financial institutions around the world. To complicate matters, emerging market economies of Russia, Mexico and Brazil, all large commodity producers, have suffered in the raw material bear market. The currencies of the nations have swooned and the chances of defaults have risen. The currencies of Australia and Canada have also moved appreciably lower as these nations depend on commodity revenues in terms of cash flow. The major banks in the world hold the debt of these countries; therefore, the commodity bear also has indirect effects on the banking world.

In 2008, the world faced a housing crisis in the U.S. and a financial crisis in Europe. In 2016, the commodity bear market could be creating the next major world financial crisis. The commodity-related and emerging market debt portfolios of banks are creating stress that will cause regulators to require the institutions to trim risk. The effects of that haircut and increasing loan defaults could spiral into a crisis.

Commodity prices are screaming deflation

China is slowing. Europe remains an economic basket case. Last week, the U.S. ISM Non-manufacturing and PMI both came in at levels below analyst expectations. The dollar tanked last Wednesday, moving to the lowest level since December, as the chances of the next interest rate hike declined slightly due to that weak economic data. However, last Friday the dollar rebounded marginally to recoup some of the week's losses on a strong jobs report. The Fed has promised interest rate hikes in 2016 and that is not bullish for the prices of raw materials.

Meanwhile, the commodity bear continues to bite at markets. While recovery rallies are possible and even probable, the trend since 2011 in raw material prices is clearly lower. All this adds up to an environment in which global deflationary pressures abound. Deflation makes the prices of all assets move lower. In 2016, fear and the resulting volatility have gripped all asset classes. Only very few assets have appreciated thus far in 2016. Gold, silver and high-quality bonds have been strong. This is a clear sign of the fear that is rippling through markets around the world. The bottom line is in this deflationary environment led by a bear market in raw materials, commodities are the hanging judge for the banks around the world. Commodities have moved from mainstream investment vehicles during the bull market that ended in 2011 to alternative investments. The current problem for many banks is a clear reminder that these assets affect all others. A bottom in commodity prices could provide a reprieve for the banks, but another leg down could amount to a harsh sentence for many banks around the globe.

As a bonus, I have prepared a video on my website Commodix that provides a more in-depth and detailed analysis on banks and debt to illustrate the real value implications and opportunities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.