Commodity Risk- Sovereign Control/Country Moniker and Sponsor Risk

In a recent article, I gave an overview of the topic of risk in commodity markets. In that piece, I described 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. Sovereign control/country Moniker and sponsor risks are important things to consider for those trading in physical commodity markets and associated derivatives.

Sovereign control/country moniker risk is the risk that a country imposes exchange controls or other policy changes that makes it impossible for counterparties to honor their obligations under contracts. Companies and traders in the world of commodities are always at risk when it comes to changes in government policy and unforeseen new laws that can change the business environment. If there is time to prepare for a change, the effects on business are less however, if the change comes suddenly and unexpectedly large losses can result. An example of this from history is the move made by the late President of Venezuela, Hugo Chavez, in 2011. In an unexpected move, Chavez repatriated all of the nations gold reserves and suddenly nationalized the gold mining industry. There were many mining concerns around the world that had made investments in Venezuela. These nations spent hundreds of millions, if not billions of dollars, to extract gold from proven and probable reserves within the nation.

The action by the then President of the nation immediately wiped out those investments. This is one example of how sovereign control can affect investments in the commodity markets around the world.

Another example of this type of risk was something that happened in the late 1980s when I worked for a major physical commodities trading company.

The company I worked for contracted to buy a large percentage of the cocoa crop from the world's largest producer, the Ivory Coast. As part of the deal, the company paid for the cocoa beans in advance -- prior to the harvest of the crop. This pre-export finance transaction not only provided cash up front for the seller, it set the price for the cocoa. This meant that the buyer and seller agreed on the price for the cocoa at the time the cash was paid. The physical commodity trading company took all of the risk that the producing nation would harvest and deliver the cocoa beans. As it happened, the price of cocoa moved higher as the crop grew which meant that the seller sold the crop below the market price. The government accused the physical trading company of manipulating the price higher and upon the harvest of the beans. They insisted upon renegotiating the price for the cocoa. When the commodity trading company, the contract partner refused, the government agency in the Ivory Coast sold the output to another party without returning the financing to the original buyer. The action of the government resulted in a huge loss for the commodity trader.

Another risk that commodity traders face is sponsor risk.

This is the risk that counterparties or sponsors to a transaction will not have sufficient capability, creditability or incentive to participate favorably. In many financing deals, companies go to a lead bank or financial institution to borrow the funds necessary to operate. In the world of commodities, that funding is often for the mining and extraction of proven and probable reserves of a commodity. The lead bank will assemble other banks and financiers in what is a syndicate of lenders to fund the company. Sponsor risk is the risk that one or more of the financing institutions or parties find themselves unable to perform on the agreed upon financing transaction. This can cause economic hardship or devastating effects on the commodity producing company that depends on those loans in order to conduct its business.

In the world of physical commodity trading there are many risks and pitfalls that trader's, producers and consumers face in each transaction. Sovereign control/country Moniker and sponsor risks are just two of the many risks they face.