Syndication/Distribution, Tax, and Vendor Performance Risks

Lehman Brothers Put Their Artworks Up For Auction
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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. This article will focus on three other important risks in the world of commodities -- syndication/distribution, tax and vendor performance risks.

These issues pose serious economic risks for participants in the raw material markets around the world.

Syndication/distribution is the risk of retaining too large of a credit exposure to a counterparty through the inability to syndicate sufficient credit exposure. This risk is often a function of timing. Consider if Lehman Brothers did a large financing deal with a gold or copper mine or an oil producer in 2008 and they could not syndicate or distribute the deal to other financial institutions or financiers because the timing coincided with their bankruptcy. When a bank or financial institution becomes the lead manager on a financing deal they negotiate terms and once the deal is agreed, they go to the market to syndicate and distribute the risk to other parties. In the case of Lehman, if they were lead manager on a deal just before the problems encountered, they may not have been able to syndicate the risk.

In that case, all of the risk would have wound up with a bankrupt counterparty. Thus, syndication/distribution risk is a timing risk that the lead manager is not able to garner the necessary funding and distribute risk away from its' own balance sheet. 

Tax risk is a country's tax regime will adversely affect a contract or position.

The commodities business is an international business. While consumption of raw materials occurs all over the world, production is local. There are certain areas in the world where there are reserves of minerals or land that is appropriate for growing agricultural commodities such as corn, soybeans, and wheat for example. Therefore, the tax policies in nations around the world come into play when it comes to the production side of the commodity business. Often, negotiation and agreement to long-term commodity finance deals were under the then-current tax regime. If that regime changes suddenly, it will change the terms and economics of existing agreements. An example of this is the mineral export ban in 2014 by the Indonesian government. That government changed policy and either banned or imposed high tariffs on mineral exports of select commodities like copper and nickel. This affected the flow of commodities and long-term arrangements to purchase or mine production domicile in that nation. A long-term copper producing property owned by an international mining concern became a source of concern. Changes in government policy whether tax-based or based on another policy can affect standing agreements and present a risk to counterparties, particularly in terms of long-term agreements.

Vendor performance risk is the risk that a vendor fails to perform in a commodity transaction. In many agreements, third parties play an important, sometimes an imperative role in the successful execution of the deal. As an example, consider a deep sea drilling oil project. The financing and production are often highly dependent on a third party vendor, an oil services company. These vendors play a key role in the success or failure of the project, which is the ultimate extraction, and capture of the commodity. If the vendor, in this case, the oil services company contracted to implement production, fails the entire project could turn into a disaster. We saw this back in 2010 when the BP oil spill in the Gulf of Mexico occurred. While responsibility ultimately fell on BP for the spill, vendor companies in the oil services industry, Transocean and Halliburton played an important role in the mistakes and issues that caused the spill.

Syndication/distribution, tax, and vendor performance risks are important considerations in the world of physical commodity production and trading.