Commodity traders caught up in the aftermath of oil trader Hin Leong’s shocking collapse are facing three major issues -- short-term disruptions of physical supply, a rapidly deteriorating credit environment and potentially tighter regulatory oversight.
These challenges come in the midst of a historic oil price collapse that has strained finances and jittery traders and oil companies have already stepped up tightening of internal risk management and scrutiny of counterparties, traders said.
The most immediate response was to cut exposure, to Hin Leong-related businesses, and other entities rumored to be in financial trouble, affecting spot and long-term oil contracts.
A credit-based fuel supplier in Singapore said it stopped extending credit to Zenrock Commodities Trading, even before the embattled oil trader issued its statement on April 23 saying it was not under statutory restructuring or insolvency protection.
Zenrock was the subject of an application by HSBC on May 1 for being placed under judicial management for fraudulent oil deals. The affidavit cited a letter by Zenrock saying its obligations included term deals for 0.5% VLSFO to an oil major, Upper Zakum crude to an Indian refiner and 88 RON gasoline supply to Indonesia.
Disengaging from such contracts when a trader collapses can be tricky and attempts have included filing notices to impound vessels, such as those operated by Ocean Tankers, and holders of bills of lading retaking possession of petroleum products on the basis of retention of title.
Reducing exposure becomes even more problematic as the judicial management process puts a moratorium on lawsuits and claims until a rehabilitation plan is approved by the majority of creditors within 60 days, lawyers said.
However, the legal proceedings do not prevent actions by creditors in jurisdictions outside Singapore.
Companies are also scrutinizing the use of letters of indemnity in place of bills of lading, which carry the actual title to a cargo, for oil payments. Their misuse underpinned fraudulent trades in all three cases of Hin Leong, Zenrock and Hontop Energy in Singapore this year.
Letters of indemnity or LOIs were devised as a solution when the original bills of lading are not available, especially when a cargo passes through many hands in a physical trade.
Karnan Thirupathy, maritime lawyer and Partner for Kennedys Legal Solutions, said LOIs are quite common amongst oil traders and they can work in the appropriate circumstances and when the risks are properly understood.
“My experience, however, is that quite often things can go wrong when traders and carriers simply treat the issuing and accepting of LOIs as part of their everyday standard business practice and without properly appreciating the risks involved in each case,” he added.
CREDIT CRUNCH AND INDUSTRY OVERSIGHT
Banks are cutting back on commodity lending due to an abundance of caution since the oil price crash, which was also a key reason for oil traders to use “creative” means to generate cash, like multiple pledging of cargos.
It was only when banks dug deeper into these trades that wider malpractice, such as Hin Leong’s accumulated derivatives losses of $800 million and Zenrock’s secondary financing deals, were discovered.
Banks were also hit by huge losses in paper trading, such as Bank of China’s oil futures losses running into several billions of dollars, leading to even more lending curbs.
This has had a ripple effect on Singapore-based brokerages, which have imposed risk limitations on account holders who are traders, stopping physical players from taking new positions, traders said.
Everyone has to meet their own margins calls, and the only way to do that is to reduce positions, which is ridiculous for people who are hedging with oil, the trader added. This spells trouble for small traders with overstretched positions and little cash in hand.
However, the bigger players are expected to survive.
“While the insolvencies of major commodity traders will impact many players in the oil and gas market, including banks, it will not cause severe pains in the industry because most of the players in Singapore are state-owned companies or international oil companies with deep pockets,” Lian Yok Tan, Partner at K&L Gates LLP, said.
“It’s likely that these SOEs [State Owned Enterprises] or international oil companies will have to cut jobs and costs, but they will be able to ride out the storm. The key disruption to them (and everyone else) is the deep fall in oil and gas consumption/demand caused by the COVID-19 outbreak,” Tan said.
She said while the impact will be limited to short-term contractual disruptions, there will likely be an organic review of how banks lend to commodity traders going forward.
“Specifically, what should and should not be on the balance sheet of a commodity trader and what changes in accounting practices need to be made in order to prevent major commodity traders from becoming insolvent,” Tan added.