By Robert "RJ" Raglin

In the early 2000s, many of the largest investment banks in the United States rushed into the new territory of physical commodities trading. Now they are one-by-one making a strong retreat. Over the past decade, Goldman Sachs, J.P. Morgan, Barclays, and Morgan Stanley were the biggest traders of commodity derivatives among banks. Last month, J.P. Morgan announced it would be selling its $3.5 billion raw-materials trading unit to Mercuria Energy Group, and Morgan Stanley plans to sell its physical oil trading arm to Russia’s OAO Rosneft. Even banks with smaller commodities businesses are pulling out, such as Deutsche Bank, who left the business in December 2013. The most recent exit was announced last Tuesday when Barclays made the decision to leave the commodities trading business to focus on its investment banking arm. With this domino effect of banks leaving commodities trading occurring, the question now becomes what is the cause?

There are several reasons that an increasing number of banks are leaving the commodities business, including increasing regulatory scrutiny, falling profits, thin margins, and worries about reputation. A relative calm in commodities prices and stiff competition have also pinched profits. Returns on commodities have been very weak as of recently. Commodities trading revenue for the ten largest banks fell from $14 billion in 2008 to $4.5 billion in 2013 according to Coalition, a market analytics firm. As a result, commodities trading becomes an inefficient use of capital at a time when other markets such as equities are booming. Margins are slim, prices are stable, and shipping natural resources across the world ties up a lot of money as products move through several terminals and warehouses to get from mine to end user. Commodities trading has become less and less profitable; however, more dangers are beginning to mount.

Commodities trading, especially when accompanied by derivatives, generates complex risks. Regulators and even some U.S. Senators are concerned about banks being in natural resources at all. Bank holding companies “should be prohibited from owning physical assets like warehouses, pipelines and tankers,” Senators Sherrod Brown of Ohio and Elizabeth Warren of Massachusetts, both Democrats, said in an April 16 letter to the Fed. “These activities pose significant safety and soundness, legal and reputational risks to the institutions.” These officials make a solid argument: if large financial institutions own industrial assets a financial catastrophe could possibly lead to an environmental one. Additional costs and risks  that arise from commodities trading is the work of clever humans who need to gain an edge in the business. Reports of port congestion, equipment breakdown, and security problems make the business increasingly unattractive when a bank cannot devote the necessary resources to obtain the intelligence to stay ahead.

The trading of commodities is certainly on a decline, but some banks have decided to stay in the business. Morgan Stanley will retain its large power and natural gas desks, as the firm believes that their combined performance is the reason for an increase in net revenue from $1.5 billion in the first quarter of 2013 to $1.7 billion in the same quarter the following year in its Fixed Income & Commodities (FICC) arm. Morgan Stanley attributes this performance to volatility in the market driven by weather and real robust client activity. Goldman Sachs, who has never had any intention of backing out of the commodities business, reported “significantly higher” net revenues in natural resources in early 2014 compared with in early 2013. This was primarily due to the high volatility in the energy markets caused by a deep freeze that swept much of North America this winter triggering price volatility for many regional fuel, electricity, and natural gas markets. The higher net revenue help offset lower returns across the rest of the Goldman Sachs’ FICC division. It also seems that both Morgan Stanley and Goldman Sachs are beginning to see some marginal benefit from competitors exiting the commodities business where they had otherwise charged in with excess. It will be interesting to see where the future of commodities trading is headed, but personally I believe that like everything else on Wall Street, this is cyclical and it is simply commodities' turn to bite the bullet.

Sources:http://www.reuters.com/article/2014/04/17/us-goldman-morgan-commodity-idUSBREA3G12320140417http://www.businessweek.com/news/2014-04-23/bank-cutting-commodities-trade-severs-link-with-equities#p2http://www.economist.com/news/finance-and-economics/21601295-banks-are-scrambling-ditch-their-commodity-trading-businesses-sell-signalshttp://hereisthecity.com/en-gb/2014/04/23/goldman-poised-to-gain-from-other-firms-leaving-commodities-trad/http://dealbook.nytimes.com/2014/04/21/barclays-poised-to-announce-exit-from-commodities/