Commodity Risks - Regulatory and Reputational Risk

Gold mining in Venezuela
Gold mining in Venezuela. Martin Harvey/Getty Images

In a previous article, I gave an overview of the topic of risk in commodity markets, describing the difference between assessed and non-assessed risks. That piece gave the view from 30,000 feet. This offering is a continuation of the series that examines risk on a granular basis. Regulatory and reputational risks are both important things to consider for those trading in physical commodity markets and associated derivatives.

Regulatory risk is the risk that a change in market regulations will have a negative impact on business. The perfect example of regulatory risks is the increase in market oversight and regulations that followed the global economic issues of 2008. Due to the government bailout of banks in the United States and Europe, many new regulations caused changes in physical commodity business, particularly in the U.S. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 caused a dramatic increase in compliance costs for banks and companies operating in the commodity business. Many physical commodity businesses found these costs too high to bear and relocated overseas. Others sold off business segments. JP Morgan sold its physical commodity business to a company, Mercuria, as the new regulations made the prospects for trading physical raw materials uneconomic.

Today, the majority of physical commodity trading companies operate in Switzerland or Asia where the costs of regulation are far lower than in other jurisdictions.

There is always a risk that changes in regulations can change the nature of commodity trading. Another example of this type of risk occurred in the gold mining industry in Venezuela in 2011 when then President Hugo Chavez signed a decree nationalizing gold reserves. Many gold mining companies who had invested in gold production in Venezuela suddenly found their investments gone and in the hands of the sitting government.

This change in domestic regulations directly affected segments of the global mining industry that had invested in the South American country but it had other ancillary effects on mining around the world. The risk suddenly rose on investments in other nations, if Venezuela could nationalize production so could other nations. Regulatory risk is present in markets every day; governments have the ability to change the ground rules under which businesses operate at any time.

Reputational risk is the risk that involvement in an activity or a force majeure event arising from an activity will adversely affect the reputation of a party to a transaction. When it comes to international business, reputation is an imperative. The track record of performance is often an important consideration when assessing the credibility of contract partners. An example of damage to reputational risk could be if a producer of a commodity or a producing nation decides to sell a majority of commodity output to a trader or consumer at a fixed price in the future. If the price were to rise and the producer then decided to either require the buyer to pay more or reneged on the deal selling output to another party that will pay more, this could damage the sellers reputation.

In the world of commodities, these types of situations occur more often than one would think. Many commodity-producing nations need financing to produce raw materials. Banks, financiers and commodity consumers will often provide immediate funds in the promise for delivery of a commodity once produced in the future. This type of transaction is a pre-export finance. If the party that receives the money does not perform by delivering the commodity, this could affect their ability to contract with others in the future. A producer or government that does not meet contractual obligations will often suffer reputation effects, which will prevent them from securing contract parties in the future. Another example of reputational risk could arise when companies receive bad press in terms of corporate actions or scandals.

A problem with reputation could put a company out of business. Regulatory and reputational risks are important to consider for all companies around the world who operate in commodity businesses or any area of commerce.