COMMODITY MARKETS UPDATE Issue 1 2016
Crude Oil and the Four Laws of Gravity
Issue 1 2016
COMMODITY MARKETS UPDATE
Executive Editors Alice Birnbaum Lewis Hart Editors Kaitlin Barbour Jake Turner Contributors Lewis Hart Max Schlubach Benjamin Durfee Tucker Randle John Secor Ajit George Alice Birnbaum Designer/Illustrator Jessica Feiden
inside 3 A Letter to Our Readers From Lewis Hart, Executive Editor
4 Crude Oil and the Four Laws of Gravity by Max Schlubach
12 Steel Market Update: As Foreign Imports Surge, U.S. Steelmakers Launch Trade War by Benjamin Durfee and Tucker Randle
18 Working Capital Adjustments in Commodities M&A Transactions by John Secor and Ajit George
22 Interview with essDOCS Co-Founder Alexander Goulandris by Alice Birnbaum
28 Summary Snapshots Commodity Price Charts
Issue 1 2016 1
This insidious combination of market forces creates a challenging operating environment for even the best managed and wellcapitalized companies in the commodities and logistics sector. The environment has produced a ripple effect up, down and across the value chain, with investors scrutinizing banks’ exposure to energy credits, shipowners staring into the abyss and growth slowing in the commodity export world.”
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A Letter to Our Readers Dear clients and friends, There has been a palpable sense of pessimism in the C-suites of even the most resilient commodity companies over the past 18 months. Whether we are speaking with clients in copper, crude oil or corn, the story has been similar: overcapacity leading to oversupply, soft demand in Asia and – to make matters worse – a persistently strong dollar. This insidious combination of market forces creates a challenging operating environment for even the best managed and well-capitalized companies in the commodities and logistics sector. The environment has produced a ripple effect up, down and across the value chain, with investors scrutinizing banks’ exposure to energy credits, shipowners staring into the abyss and growth slowing in the commodity export world. Sound familiar? While we are far from recovery territory, over the past two to three months we have begun to see some renewed optimism as the Bloomberg Commodity Index has advanced by approximately 8% year to date, bolstered in part by a weaker U.S. dollar. This may be partly driven by the benefits felt by those who ultimately consume the aforementioned commodities and represent approximately 70% of U.S. GDP – people who drive cars, eat hamburgers and use electricity. But the incipient sense of optimism is also flowing from the market participants themselves, who report that the free market is performing as such and responding to low prices the way it is supposed to. Oversupply is gradually being taken out of the market as higher-cost producers exit the area, which Max Schlubach discusses in his article, “Crude Oil and the Four Laws of Gravity.” Steel prices in the U.S. (and globally) are actually rising, albeit from a low base – a phenomenon Benjamin Durfee and Tucker Randle explore in their piece on steel imports and the impact of anti-dumping duties. The gradually improving sentiment seems to be encouraging business owners in the sector to increasingly evaluate strategic alternatives, a trend that has experienced an uptick over the past few months. This is perhaps driven by opportunities to streamline business models and cost structures in the wake of a protracted downturn in the commodity cycle and, on the positive
side, by opportunities to grow revenues as demand rises. As the positive market signals return, owners are finally feeling more confident, and buyers are increasingly looking for growth and consolidation opportunities. More and more, we are helping our commodities and logistics clients think through these important strategic matters; in this vein, John Secor and Ajit George from our Corporate Advisory Group discuss a critical nuance in the merger and acquisition process that always seems to trip up commodity companies whose inventory values and short-term financing levels change daily: the working capital adjustment. If not structured properly, this important term can derail a transaction and risk drastically affecting the proceeds a seller receives, particularly in volatile commodity price environments. Last but not least, innovation has continued in our sector, and the startup essDOCS is at the forefront of bringing the digital world together with the “old economy” activities of shipping, commodity trading and trade finance disciplines. Alice Birnbaum spoke with essDOCS co-founder Alexander Goulandris to discuss his effort to bring bills of lading into the cloud economy. At Brown Brothers Harriman, our commitment to the commodities and logistics sector continues unabated regardless of where we are in the economic or commodity cycle. We are proud to provide our clients with capital and advice, whether we are serving their private businesses or helping their families protect and grow their wealth. It would be difficult to call this a bottom given the continued uncertainty, but we are hopeful that these positive signals herald more prosperous times. Sincerely,
Lewis Hart Senior Vice President
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Crude Oil and the Four Laws of Gravity By Max Schlubach
As we have witnessed in the crude oil market over the past handful of years, the law of gravity also applies to commodity markets. While gravity is a measurement of how light or heavy a particular batch of crude oil is compared with water, the scientific principle may also provide a helpful analogy for the current state of affairs in the marketplace. Indeed, the last few quarters in crude markets have provided a deluge of information to process. From the lifting of the 40-year-old export ban on U.S.-produced crude oil, to headline-grabbing growth in global crude inventory levels, to secretive OPEC meetings we seem to hear about every month or so – an article could be written about any of these topics. But amid all of the media’s white noise, a central question of market fundamentals rises to the fore: When will the crude oil market finally rebalance? We don’t have all of the answers, and nobody does. In this article, we address four key questions affecting future crude supplies and aim to answer them.
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The 40-year-old congressional ban on U.S.-produced crude oil exports was lifted in December 2015. How will this affect global crude oil physical flows?
Over the past six years, domestic exploration and production (E&P) companies have essentially drilled their way out of the ban. The advent of hydraulic fracturing technology led to a nearly 10% annual growth rate in U.S. crude oil (and lease condensate) production volumes between January 2010 and December 2015. This has resulted in a remarkable shift in U.S. dependency on foreign-produced oil, highlighted by the following chart, which compares U.S. field production to net imports of crude oil. As such, public sentiment around U.S. energy security has shifted perhaps as dramatically as it did during the early 1970s, albeit in the direction of less anxiety. As sentiment has changed course, legislators have come to see the export ban as an anachronism.
Let’s start with the historical context of this legislation. In October 1973, in response to the Arab oil embargo, Congress banned U.S. companies from exporting U.S.-produced crude oil. Following the embargo’s announcement, domestic gasoline rations were quickly implemented, and lines across the country to refill gas tanks grew long: Domestic energy security raced to the forefront of the collective American consciousness. Congress had two policy objectives in mind when implementing the export ban: to conserve domestic reserves of crude oil, which were then believed to have “peaked,” and to replace U.S. imports of foreign-produced oil with consumption of domestically produced oil.
U.S. Net Imports, Field Production and Refinery Consumption of Crude Oil 18,000
U.S. Monthly Field Production of Crude Oil bbls/day (000s)
16,000
12,000
8,000 6,000
14,000 12,000 10,000 8,000 6,000 4,000
4,000
Average Net Imports
1920 1922 1924 1926 1928 1930 1932 1934 1936 1938 1940 1942 1944 1946 1948 1950 1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
0
Average Field Production
2015
2013
2011
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
Export ban in place from October 1973.
1975
2,000 2,000
1973
bbls/day (000s)
10,000
Average Refinery Consumption Source: U.S. Energy Information Administration.
Source: U.S. Energy Information Administration.
As early as spring 2015, we heard rumors that the ban would “soon” be lifted. By March 22, 2016, the difference between WTI1 and Brent prices had collapsed to roughly 20 cents per bbl. It thus appears that while a headline-grabbing regulatory change now allows companies to freely export U.S.-drilled crude oil, its near-term impact on global energy trade flows will be negligible. Recent data from ClipperData supports this view; according to the cargo analytics firm, year-over-year daily export volumes of waterborne U.S. crude oil declined 5% during the first three months of 2016. Congress’ lifting of the export ban appears to have anchored WTI prices to the global market, but there is simply too much oil stockpiled worldwide for U.S. crude to be attractive – especially when WTI costs virtually the same on a per barrel basis (before shipping costs) as its “competitor,” Brent crude.
At the time, those objectives were hardly misplaced. For the first time in 50 years, domestic oil production was falling, and policymakers were preparing for a “new normal” of U.S. dependency on foreign-produced oil. During the five decades preceding 1970, U.S. oil production grew at an annualized rate of roughly 4.5%. In October 1970, U.S. crude oil field production peaked at slightly above 10 million barrels (bbls) per day before beginning to contract. Over the three years following the peak, field production fell at an annualized rate of just under 3%; in this short time frame, the United States’ perception of domestic energy security shifted dramatically. This exacerbated the embargo’s impact and magnified the legislative response to it. In connection with falling domestic production and OPEC wielding a strong fist, Congress banned the free export of U.S.-drilled crude. This was perhaps an appropriate legislative response to the market and geopolitical environment of the early 1970s, but as we fast-forward to 2016, the trends could not be more different.
The global crude oil supply and inventory glut – addressed in our next question – has resulted in slim demand for U.S.-drilled 1
W est Texas Intermediate.
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Export Economics
crude. This has been compounded by sheer chemistry, taking into consideration the global refining industry is mostly hardwired to process the more sulfurous, heavier crude oils produced by the Middle East, whereas North American shale oil is light, sweet crude that is arguably ill-suited for processing by non-U.S. refineries. In conclusion, while the lifting of the export ban will likely keep WTI, LLS2 and Brent prices in a reasonably tight range over the medium and long term and is unlikely to alleviate the U.S. supply glut, it will likely mean any temporary differences between those various pricing mechanisms will be arbitraged away by physical traders more quickly.
Since the ban’s lifting last year, we have not witnessed a rush to sell crude on international markets, although some traders have taken advantage of the new markets. This is partially because the spread between WTI and Brent crude began to narrow as rumors circulated that the ban would be lifted, and many pipelines were reversed, providing previously stranded crude in the middle of the country with easier and cheaper transportation access to the coastal refineries. Prior to the pipeline reversals and construction of several new pipelines, booming U.S. shale production in 2011 and 2012 had outpaced
Will U.S. production cuts reverse the global storage buildup?
physical takeaway capacity – meaning production volumes exceeded pipeline transportation capacity – which resulted in a deep discount for WTI-priced U.S. crude oil because trucks and railcars, each much
World Oil Production and Demand
more expensive than pipeline transportation, were the only way for
2.5
tic pipeline projects and flow reversals of existing pipelines were
96
finalized, resulting in the rapid normalization of WTI prices relative
2
94
MMbbls/day
to Brent. After reaching parity in late 2013, the WTI market returned its focus to still-booming U.S. production volumes that seemed on pace to outgrow even the newest pipeline projects. Few, if any, pipeline builders in the midstream anticipated prices falling beneath $60
1.5
92 1 90 0.5 88
MMbbls/day
producers to take crude to market. During 2013, several new domes-
98
0
or $70 per bbl in their worst-case models, so even more pipeline
86
capacity was built throughout 2014, again bringing landlocked WTI
(0.5)
84
prices back toward parity with Brent prices by year-end. Oil prices at
(1)
82
this time were in retreat, but U.S. shale producers were slow to cut production. Supply continued to outpace demand, which depressed
(1.5)
World production (left axis)
count between $10 and $13 per bbl of WTI relative to Brent oil.
World consumption (left axis)
Q4 2016
Q3 2016
Q2 2016
Q1 2016
Q4 2015
Q3 2015
Q2 2015
Q1 2015
Q4 2014
Q3 2014
Q2 2014
Q1 2014
Q4 2013
Q3 2013
Q2 2013
Q1 2013
Q4 2012
Q3 2012
Q2 2012
Q1 2012
Q4 2011
Q3 2011
Q2 2011
Q1 2011
Q4 2010
Q3 2010
the price of WTI relative to Brent in early 2015, resulting in a dis-
Q2 2010
Q1 2010
80
Implied stock change and balance (right axis) Source: U.S. Energy Information Administration.
$140
$5
$120
$0
$100
($5)
$80
($10)
$60
($15)
$40
($20)
$20
($25)
$0
We are in the thick of a well-publicized global crude oil inventory glut, driven by several years of production growth supported by free-flowing capital markets. Over the course of the past decade, E&P companies worldwide have issued $121.7 billion of high-yield debt. Issuance has been concentrated to U.S. shale; of the entire amount, 75% – or $91.1 billion – was issued by junkrated U.S. E&P companies during the past five years. As the following chart indicates, capital markets have been extremely accommodative to sub-investment grade U.S. shale producers, particularly since 2010. This convergence of capital and
$/bbl
$/bbl
WTI Discount to Brent
($30) 2011
2012
Brent Crude Oil (left axis)
2013
2014
WTI Crude Oil (left axis)
2015
2016
WTI vs. Brent (right axis) Source: Bloomberg.
2
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L ouisiana Light Sweet.
Global Crude Oil Storage Levels 1,200
1,150
1,100
Mb
technology in the oil patch resulted in supply growth outpacing demand growth, with excess production placed in storage. Before the supply/demand equation can return to equilibrium, excess inventory needs to be consumed, and production must slow. Prices and access to capital will drive the latter. This will take time – perhaps longer than many expect.
1,050
1,000
950
High-Yield Debt Issuance Among E&P Companies
2014
2015
er mb De
mb ve No
ce
er
er tob Oc
pte
mb
er
st Au
Average 2010-2014
$25,000
Millions
gu
ly Ju
ne Ju
M
Ap
ay
ril
h arc M
Se
$30,000
Fe
Ja
nu
bru
ary
ary
900
Range 2010-2014 Source: OECD and International Energy Agency.
$20,000 $15,000 $10,000 $5,000 $0 2006
2007
2008
2009
2010
US
2011
Worldwide Total
2012
2013
2014
2015
2016
Source: Bloomberg.
Recent U.S. Energy Information Administration (EIA) estimates indicate that in fourth quarter 2015, global crude production still outpaced demand by nearly 700,000 bbls per day, which implies a global inventory build of about 63 million bbls during the quarter.
order to single-handedly take EIA’s estimated daily surplus out of the global market. While they may continue to cut if prices return to the $30s, supply discipline cannot come from U.S. producers alone, particularly with financial leverage near historic levels. This leads to our third driving question on crude supplies.
($000s)
Capital Expenditure in Oil and Gas
$600,000
$500,000
$400,000
Excess production continues to plague the market despite a substantial cutback in E&P investment, particularly by U.S. shale producers, where consensus 2016 capital expenditure estimates across a representative basket of 13 investment grade E&P companies fell 45% year over year for 2015 and projected an additional 26% decline during 2016. This has resulted in domestic crude production dropping nearly 5% – or between 400,000 and 500,000 bbls per day – from its peak of just below 9.7 million bbls per day in April 2015 to roughly 9 million bbls per day currently. More cuts must be made to address the remaining imbalance. Using the EIA forecast, U.S. shale producers would need to cut between 7% and 8% more from current production volumes in
$300,000
$200,000
$100,000
$0 2009
2010
2011
2012
Global: Integrated Oils
2013
2014
North America: E&Ps
2015 Consensus Estimate
2016 Consensus Estimate
Source: U.S. Energy Information Administration.
When will conventional capital stop flowing? Break-even crude oil prices vary widely across drilling regions – from as low as 25 cents per bbl in some areas of Saudi Arabia to as high as $100-plus per bbl in Arctic and certain offshore drilling projects. In North America, drilling costs typically range from $30 or less per bbl on the low end to $80 or more per bbl on the high
Issue 1 2016 7
companies’ financial statements indicates that even the highest quality balance sheets in shale show signs of weakness.
Now more than ever is a reminder that commodities are cyclical and that what goes up most often comes down. We balance this view with the age-old adage that the best cure for low prices is often – you guessed it – low prices.” end. It stands to reason that higher-cost production is “shut in” – the pump is turned off – when barrels come out of the ground at a loss, but the decision is not as intuitive as “when production costs exceed the price of oil, stop pumping.” Part of this phenomenon can be explained by the amount of financial leverage in the sector. In order to pay down debt, the industry must keep producing oil and generating cash flow – even in environments where it may not produce an attractive return for investors. This can delay the inevitable reckoning. Having said that, a can may only be kicked so many times before it turns into a square and stops rolling. Nowadays, E&P companies’ balance sheet debt loads remain heavy, and industry access to capital markets will play a large role in the length of time it takes for them to restructure their more onerous obligations. An examination of 13 investment grade integrated oil
Total Debt vs. EBITDA:
Millions
$10,000
5.0x
$8,000
4.0x
$6,000
3.0x
$4,000
2.0x
$2,000
1.0x 0.0x
$0
(1.0x)
LTM EBITDA (left axis)
15
-15
er-
ne Ju
tob
Oc
14
-15 ary
bru Fe
-14
er-
ne Ju
tob
Oc
13
-14 ary
bru Fe
-13
er-
ne Ju
tob
Oc
12
-13 ary
bru Fe
-12
er-
ne Ju
tob
Oc
11
-12 ary
bru Fe
-11
er-
tob
Oc
ry11
ne Ju
rua
Fe b
-10
er10
ne
tob
Oc
Ju
Total Debt (left axis)
Companies included: Anadarko, Apache, Canada Natural Resources, Devon Energy, EOG Resources, Hess, Husky Energy, Marathon Oil, Murphy Oil, Occidental Petroleum, Pioneer Oil and Repsol.
The debt spiral phenomenon highlights the perils of using significant leverage in a cyclical sector where the borrowers are price takers selling a commodity. While deleveraging can occur quickly in a rising price environment, this environment tends to promote investment and production growth as opposed to deleveraging. As production grows and capital flows freely, supply tends to overshoot demand; prices fall, and producers are stuck holding significant debt at the very time when cash flow is lower – and as a result, the ability to service that debt is shrinking. Many producers are facing this exact environment today. While there are certain factors delaying this inevitable reckoning, the process has already begun and – unless prices start to rise – should result in a continued decline in U.S. production.
Can we look to OPEC for the necessary production cuts?
North American Investment Grade Oil and Gas
($2,000)
The nearby chart depicts median total debt against median last-12month (LTM) EBITDA for a basket of North American investment grade integrated oil companies. This reflects only a (relatively speaking) high-quality subset of domestic E&P companies that are investment grade, so it may be seen as an optimistic view of the broader shale industry. After years of growing profits and typical EBITDA leverage of about 1x, industry earnings have fallen into negative territory. Equity markets have thus become more expensive – if they can even be accessed – due to the increased risk in the sector. Fixed income markets, too, have become more difficult to access as cash flows have fallen and leverage has increased. The combination of falling cash flows and growing leverage has led to a classic “debt spiral” where producers at times must choose to drill at loss, sacrificing near-term profit for the simple cash flow required to service debt and prolonging and compounding the supply problem.
Total Debt/LTM EBITDA (right axis) Source: Bloomberg Intelligence and BBH Analysis.
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Here we turn the page from domestic to global crude markets. Domestically, we have already seen some production restraint, but falling North American production may not be sufficient to address the supply imbalance. Turning to the global supply outlook, OPEC does not appear to be cutting. Hardly a week goes by without news of an OPEC meeting taking place, and the media is usually quick to draw conclusions from attendance and outcome. Most of these meetings have indicated that OPEC members (excluding Iran) have agreed to freeze production at current levels. Even if Iran joined its OPEC counterparts in freezing production, failing a unified commitment to cut production by all members,
we have a difficult time painting a picture where the crude oil market rebalances in the near future. Perhaps, though, we can try to draw a silver lining on an otherwise cloudy outlook.
Crude Oil Production in Iran, Iraq and Saudi Arabia
12,000
10,000
MMbbls/day
Saudi Arabia Crude Oil Production 11,000
10,500
Year-over-year cut
6,000
4,000
10,000
MMbbls/day
8,000
9,500
2,000
9,000 0 1991
8,500
2010
2011
2012
2013
2014
2000
2003
Saudi Arabia
2006
2009
2012
2015
Source: International Energy Agency and Bloomberg.
er
Iraq
mb ce De
ve
mb
er
er
2015
No
tob
mb pte Se
Oc
er
st gu
ly
Au
Ju
Ju
ne
ay M
ril Ap
h M
arc
ary
ary
bru Fe
nu
1997
Iran
8,000 Ja
1994
2016
Source: International Energy Agency and Bloomberg.
Seasonal Saudi crude production levels may provide a glimmer of hope. As the nearby chart depicts, Saudi Arabia has historically increased daily production volumes in order to meet additional “cooling days” demand arising from the increased use of air conditioning throughout the arid Middle East. If the country keeps its pledge to hold production volumes flat to January levels, it will have the net effect of taking about 45 million bbls of total supply offline for the final three quarters of 2016. Unfortunately for oil bulls, this relative cut in Saudi production equates to a reduction of about 166,000 bbls per day to the current global crude surplus of 700,000 bbls daily, which still leaves the market in a net surplus of more than 500,000 bbls per day. We are left hoping for supply restraint and are facing some producers who want anything but. As noted, while Saudi Arabia and the rest of its OPEC brethren have pledged to freeze production levels, Iran has not joined the crowd, and Iraq is waffling as a result. Following the lifting of sanctions, Iran in late February 2016 expressed a commitment to return its sovereign crude oil production to pre-sanction output levels of 4 million bbls per day. Current Iranian production totals roughly 3 million bbls a day, meaning the country has telegraphed to the market a targeted production increase of roughly 1 million bbls of daily output. Iraq’s oil minister, Adel Abdul Mahdi, was soon to respond: “If some people freeze and others raise, then this is not a good policy. … [W]e have to reach a complete agreement.” Complete agreement seems nearly off the table at this point. Iran has pledged to increase production, so it seems neither Iraq nor Saudi Arabia is likely to commit to a cut.
There are, of course, several OPEC producers other than Saudi Arabia, Iran and Iraq, each of which competes in its own interest of balancing sovereign social obligations with the ability to fund them. While we see a complete and unified agreement of OPEC members as unlikely in the near future, members do share a common goal of preventing social unrest. A recent International Monetary Fund (IMF) report published in October 2015 (when crude prices were closer to $50 per bbl) suggested that low oil prices would wipe out $360 billion in sovereign revenues from the Middle East during 2015 alone. Massive surpluses have turned into growing deficits, and “oil exporters will need to adjust their spending and revenue policies to ensure fiscal sustainability.” After years of huge budget surpluses, Saudi Arabia’s cash reserves are still substantial at $700 billion but are dwindling fast. At this rate, the IMF estimates the kingdom has enough of a rainy day fund to survive five years of $50 oil. The country responded with a plan to free its economy from oil dependency over time. There is still a day of reckoning approaching in global oil markets too – when it comes is anybody’s guess. Whereas U.S. shale producers appear to be in a game of chicken Fiscal Sustainability and Break-Even Oil Prices Kuwait . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $49 Qatar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56 Iran . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $72 United Arab Emirates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $73 Iraq . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $81 Saudi Arabia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $106 Bahrain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $107 vs. CURRENT PRICE/BARREL. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $45 So urce: International Monetary Fund.
Issue 1 2016 9
with capital markets, OPEC producers seem to be in a game of chicken with themselves. There will be winners, and there will be losers – and we are watching closely.
Conclusion In conclusion, the past few years have shown that crude, along with most commodities, is bound by the laws of gravity. Now more than ever is a reminder that commodities are cyclical and that what goes up most often comes down. We balance this view with the ageold adage that the best cure for low prices is often – you guessed it – low prices. Although many factors point to a “lower for longer” environment, we cannot ignore the influence of geopolitics on short-term oil prices. Short-lived spikes aside, the market remains bound by its fundamentals, which currently tell us this: • We have likely already seen the eye of the hurricane. The storm will pass, but that will take time. There is a global crude inventory glut that took well over two years to build, and it will probably take a similar amount of time to dissipate. While we don’t see lifting the U.S. crude oil export ban as adding the time it will take for demand to work through global crude stocks, we also see very few things as reducing this time frame. A coordinated OPEC production cut would be one of them. Unfortunately, we believe that is unlikely to take place given the social welfare requirements of Middle East sovereigns. • Looking closer to home, between 2010 and 2015, U.S. shale companies took on massive debt loads in accommodative capital markets. The cash flow required to service these obligations in the short term now incentivizes E&P companies to continue pumping crude into the market, even when doing so at a net loss. This leverage issue can only be resolved by a combination of industry deleveraging and restructuring – a process that by its very nature requires higher prices or restructuring/capital losses, meaning it will likely happen over the course of years. Having said that, the amount of time over which deleveraging takes place is largely a function of when capital markets grind to a complete halt. Only then will prices recover, improving cash flow, debt service and setting the stage for the next phase in the price cycle.
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Issue 1 2016 11
Steel Market Update: As Foreign Imports Surge, U.S. Steelmakers Launch Trade War By Benjamin Durfee and Tucker Randle
So far, 2016 has been something of a disaster for commodity markets. A worldwide surplus of commodities has driven returns for raw materials to the lowest level since 1999, as measured by the Bloomberg Commodity Index. And steel has been among the hardest hit commodities. Although there are several factors contributing to the pronounced decline in steel prices, the main problem is that the world produces too much of it. With global excess capacity around 400 million tonnes to 700 million tonnes relative to total global demand estimated at 1.513 billion tonnes this year, according to a forecast from the World Steel Association, foreign steelmakers have had to look abroad for new markets to sell their steel, exerting downward pressure on prices. The current economic climate has made the U.S. a magnet for steel imports, resulting in imports capturing a record 29.6% share of the domestic market in 2015. This surge, which has been gaining momentum since 2011, has exacerbated trade frictions and prompted domestic steelmakers to call for punitive tariffs on foreign steel imports.
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While governments are permitted to invoke anti-dumping laws under the rules of the World Trade Organization, the U.S. government’s trade policy has always been a highly politicized affair, especially when pertaining to the steel industry. Rather than insert ourselves into a political debate, the purpose of this article is to identify some of the main economic drivers supporting an increase of imported steel and provide an overview of how recent protectionist legislation has affected the domestic steel market.
2014, when U.S. steel consumption increased by 6.5%. That same year, foreign imports jumped 24.4% year over year while production growth for U.S. steelmakers remained flat. As a result, steel imports grabbed a record 28.9% share of the U.S. market in 2014 – a milestone that was surpassed again in 2015.
Why Are Steel Imports Increasing Market Share?
Foreign Imports Gain Market Share
The collapse in global steel prices over the past two years may help explain why the U.S. has been an increasingly attractive market for foreign imports.
Elements of the United States’ manufacturing industry have historically depended heavily on raw material imports. Imports of rare earth metals and iron ore are critical to keeping the U.S. economy moving, and domestic producers alone – whether due to supply or capacity constraints – can’t meet total demand for these commodities. Steel is certainly no exception. Dating back to 1999, annual steel consumption in the U.S. has exceeded total domestic production by an average of 22.9%, representing foreign imports’ critical role in maintaining the supply/demand balance for steel in the country.
The U.S. price of hot-rolled steel coil – the benchmark steel product used to make everything from cars to washing machines – declined by 54.7% last year to $364 per metric ton (MT). Since year-end 2015, prices have made a modest rally, hitting $402 per MT on February 1, 2016, according to Bloomberg daily price data. As imported steel prices have declined, domestic steelmakers have been forced to compete with cheaper imports, although the spread between domestic and foreign prices has continued. There are several factors driving the global price weakness for steel.
The flow of steel imports into the U.S. is closely correlated to the spread between domestic and foreign steel pricing. Service centers, which are among the largest consumers of steel in the country, justify purchasing foreign supply if the spread is wide enough to offset the transportation cost and longer lead times.
U.S. Steel Imports as a Share of Domestic Consumption
(000s MT) 120,000
Consumption
100,000
80,000
60,000
79.7%
71.1% 80.1%
40,000
79.0%
77.9%
75.7%
76.6%
24.3%
23.4%
70.4%
78.5%
20,000
20.3%
19.9%
21.5%
21.0%
22.1%
28.9%
29.6%
0
2007
2008
2009
2010
Steel Imports
2011
2012
Steel Production
2013
2014
2015
Source: U.S. Department of Commerce.
The preceding chart depicts annual net steel imports and total U.S. steel production since 2007. The recent surge of imports above historical levels points to the difference in pricing between domestic and foreign steel. This structural change was most evident in
First, a global oversupply of steel has put downward pressure on prices. It’s a safe bet that if the global steel market is in a state of flux, the first place to look for an explanation is the world’s largest producer, China. Since 1990, Chinese annual steel output has expanded at a compound annual growth rate of 11.5%, fueled by robust industrialization and accelerated urbanization. Contemporaneous with the rise of its steel production capacity, China’s global market share has increased. According to the World Steel Association, the country’s share of global crude steel production rose from 12.7% in 1995 to 49.5% in 2015. However, when looking at the latest crude steel output data, a disturbing trend is emerging: Steel demand in China is falling as economic growth slows. In 2015, although China’s crude steel production declined for the first time since 1991 as local demand dropped and producers remained under pressure from overcapacity, production continued to far exceed domestic demand. Although local regulators have announced aggressive measures to address overcapacity, recent production cutbacks have not outpaced falling demand, leaving the domestic market saturated. As a result, Chinese producers have chosen to ship excess capacity overseas. In 2015, total steel exports from the country reached an all-time high of 112.5 million tonnes,
Issue 1 2016 13
representing a 44.6% increase over a two-year period, based on data from China’s government export agency. To put that in perspective, China’s steel exports are now 1.5 times larger than total U.S. production in 2015. This trend is also consistent in other major steel producing countries like India and South Korea, where excess capacity continues to ship overseas even though it may not be profitable.
Annual Chinese Steel Exports
(000s MT) 120,000
100,000
80,000
60,000
40,000
Hot-Rolled Coil vs. U.S. Dollar (Inverted) $900
$0.70
0 2006
2007
2008
2009
2010
2011
2012
2013
2014
Source: World Steel Association.
As the nearby graph shows, U.S. dollar appreciation can also encourage foreign producers to boost exports as goods become more competitive relative to their competitors. Generating sales in U.S. dollars, foreign producers are afforded more leeway to lower prices due to the fact that a larger proportion of their costs are denominated in local currency. This is what economists mean when they describe a stronger dollar as the perfect environment for foreign producers to “export deflation.”
$0.80
$700
$/MT
Second, recent appreciation of the U.S. dollar is affecting steel prices. Although the greenback no longer has an official link to the price of gold, or any other commodity, a strong (inverse) correlation still exists between commodity prices and the dollar’s value. As the dollar strengthens, it makes dollar-denominated commodities – like steel – more expensive for consumers using other currencies. This typically weighs on demand, as import prices of commodities become more expensive in local currency terms. For example, if the dollar increased by 20% against the euro, an unchanged steel price would look 20% more expensive to a German manufacturer. If that happened, consumers in Germany would buy less steel, which could push down the price.
$0.75
$800
2015
$0.85 $600 $0.90 $500
$0.95
$400
$1.00
$300
U.S. dollar (inverted scale)
20,000
$1.05 2011
2012
2013
Hot-Rolled Coil (left axis)
2014
2015
U.S. Dollar (right axis)
2016 Source: Bloomberg and BBH Analysis.
U.S. Producers Protest Higher Imports The acceleration of foreign imports into the U.S. market during the second half of 2014 and in 2015 has been followed by strong protest from the domestic steel industry. Although politicians regularly promote the U.S. as the most open market worldwide, it also wields the power to act aggressively against “unfair” trade practices by foreign companies or governments. To ensure a “level playing field,” the government commonly relies on protectionist tariffs known as anti-dumping and countervailing duty laws. Anti-dumping duties aim to prevent foreign imports from being sold in the U.S. at “less than fair value,” or “dumped,” whereas countervailing duties seek to tax imported goods that benefit from subsidies provided by foreign governments. Interestingly, the number of anti-dumping cases initiated by the steel industry has far outpaced any other domestic business. Since 1990, there have been 580 preliminary U.S. anti-dumping hearings, of which 217 pertained to imposing duties on steel products.
14 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
and the domestic industry having significant available capacity, the surge has “idled U.S. mills, led to layoffs, and has damaged the production, sales, profits, and market share of the U.S. industry.” This statement seeks to support the claim that imports have threatened the U.S. industry with “material injury,” which is necessary to prove in order for the DOC to initiate the establishment of anti-dumping tariffs.
One of the more significant trade cases filed in 2015 pertains to corrosion-resistant steel products imports. This product category – which includes steel sheet that has been coated with zinc, aluminum or any of several zinc-aluminum alloys, such as coldrolled or galvanized coils – represents 19.4% of steel sold in the U.S. market in volume terms. In June 2015, six U.S. steelmakers filed anti-dumping and countervailing duty petitions with the U.S. International Trade Commission (USITC) and Department of Commerce (DOC) concerning imports of corrosion-resistant steel products from five countries. In the filing, the steelmakers allege that corrosion-resistant steel from China, India, Italy and South Korea was likely being dumped in the U.S. at less than fair value and that those producers likely benefit from a range of countervailing subsidies provided by their respective governments.
U.S. Steel Imports Year-over-Year Change (000s MT) 4,500
4,000
31% 3,500
3,000
37%
To summarize, the petitioners representing the domestic industry argued that despite a market with U.S. demand increasing
1%
-10% 6%
47%
2,500
-10% 2,000
-79%
4%
1,500
-3% 1,000
500 0
Cold-Rolled Coil
Hot-Dipped Galvanized
2013
Witness testimony during the preliminary phase of the anti-dumping investigation, which was hosted by the USITC, highlights the contrasting views of tariffs on corrosion-resistant products from the perspective of both domestic and foreign producers.
18%
-12%
Import volume
In response to the recent surge of steel imports, the U.S. has been swift to initiate anti-dumping investigations across a broad spectrum of product categories. In 2015, the number of new steel-related dumping preliminary hearings considered by the U.S. was 46, which accounted for 45.1% of the total cases filed that year.
The respondents, which included representatives of foreign steel mills and importers from the six countries named in the petition, struck a decidedly different tone. While they acknowledged that imports have risen across all segments of corrosion-resistant products, they argued that the increases reflect strong demand growth in the U.S. and that supply constraints in the domestic industry require purchasers to diversify with foreign sources. For certain product categories, there is a substantial shortfall of domestic supply – and in some cases, no availability from the domestic industry – which requires foreign steel imports to fill the vacuum. Finally, they argued that corrosion-resistant steel products prices declined as a result of the collapse in raw material prices, including scrap, iron ore and hot-rolled coil, which is the primary feedstock for such products.
2014
Hot-Rolled Coil
2015
Oil Country Goods Source: U.S. Department of Commerce.
The preliminary determinations rendered by the DOC announced that corrosion-resistant steel imports would be subject to both countervailing and anti-dumping duties. The countervailing and anti-dumping duties, which are not necessarily aggregated, range from 0% for Taiwan to a punitive 255.8% for China and must be posted in the form of a deposit at the time of import.
Issue 1 2016 15
Trade Tariffs for Corrosion-Resistant Steel Products COUNTRY
ANTI-DUMPING DUTY
COUNTERVAILING TARIFF
China
235.66%
255.80%
India
6.92%
7.71%
Italy
3.11%
13.04%
South Korea
3.51%
1.37%
Hot-dipped galvanized prices typically track closely to hot-rolled coil because the latter is the primary feedstock for production, so the fact that the price of the former is rising more rapidly suggests that anti-dumping duties have accomplished their goal of restricting imports and stabilizing prices.
Hot-Rolled Coil vs. Hot-Dipped Galvanized Prices $950
$170 $160
$850
$150
So urce: United States Federal Register and Department o f Co mmerce.
While anti-dumping duties are designed to protect domestic industries by achieving a level playing field, their effect can be negative for U.S. consumers. Ultimately, these laws drive up the cost of imported products, eventually resulting in consumers paying higher prices for domestically produced goods.
$/MT
$750
$140 $130
$650
$120 $550
$/MT
The DOC is expected to issue its final ruling in this trade case in the second quarter of 2016.
$110 $100
$450
$90 $350 $250 Jan-13
$80 May-13
Sep-13
Jan-14
Hot-Rolled Coil (left axis)
May-14
Sep-14
Jan-15
Hot-Dipped Galvanized (left axis)
May-15
Sep-15
Jan-16
$70
Price Spread (right axis) Source: Steel Market Update and BBH Analysis.
Since the initial June 2015 filing of anti-dumping and countervailing duty petitions, the flow of corrosion-resistant steel into the U.S. has slowed considerably. According to the American Iron and Steel Institute, net imports of hot-dipped galvanized steel fell 39.3% in fourth quarter 2015 compared with the same period in 2014. The year-over-year decline of hot-dipped galvanized imports has been similar to net flows of other corrosion-resistant products. The price of hot-dipped galvanized in the U.S. has reacted in kind. As illustrated in the nearby chart, the differential between hot-dipped galvanized and hot-rolled coil has increased to its widest level in more than seven years. The premium for hot-dipped galvanized has risen from $110 per MT to $160 per MT over the past six months.
Conclusion For many U.S. steel buyers, it has become cheaper to purchase imported products from Asia than from domestic mills in, for example, Ohio. Several factors have prompted the recent surge of imports, but increased exports from emerging markets and a strong U.S. dollar have had the biggest influence. As a consequence, steel prices have declined to levels not seen since 2002. While the introduction of anti-dumping duties in the U.S. has offered some price stability, any positive momentum in the price will hinge on emerging markets, like China, reducing domestic steel production capacity to align with current market demand.
In response to the recent surge of steel imports, the U.S. has been swift to initiate anti-dumping investigations across a broad spectrum of product categories. In 2015, the number of new steel-related dumping preliminary hearings considered by the U.S. was 46, which accounted for 45.1% of the total cases filed that year.”
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Issue 1 2016 17
Working Capital Adjustments in Commodities M&A Transactions By John Secor and Ajit George
Working capital is a well-understood reality to business owners – it is the funds required to manage a company’s day-to-day operations. It reflects the balance of collections from customer payments and the disbursements made to suppliers. However, the calculation and treatment of working capital is often complex and heavily negotiated in a sale transaction. Buyers want to ensure the acquired business is able to continue meeting short-term operating requirements post-closing, as they would need to provide additional capital if a seller failed to do so. Sellers, on the other hand, want to be adequately compensated for business that they have already performed and are cautious about handing over more working capital than necessary at closing.
18 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
Acquisition agreements typically include working capital adjustments in order to protect against potential adverse shifts in value and ensure the new business has the appropriate level of working capital. These adjustments are particularly relevant for commodities businesses given that they hold significant inventory that is subject to price volatility and largely financed by short-term secured debt. A well-constructed working capital adjustment mechanism negotiated early in the process will protect both buyer and seller, prevent last-minute surprises and provide a greater level of certainty that the transaction will close.
Defining Working Capital In accounting terms, working capital is simply defined as the difference between current assets and current liabilities. Balance sheet items typically included are cash, inventory, accounts receivable, short-term debt and accounts payable. These components represent items critical to a company’s daily operations and revenue generation. Because most transactions are completed on a “cash-free, debt-free” basis assuming a normal level of working capital, cash and shortterm debt are excluded from working capital. Other items normally excluded may include loans to officers, intercompany accounts and shareholder receivables – reflecting items which are not part of the liquid assets and liabilities necessary to operate the business. While the working capital calculation appears straightforward, the traditional definition is often modified to account for specific characteristics of a business. In a transaction, it is critical that the buyer and seller reach an agreement on the specific current assets and liabilities to be included in the definition of working capital. The accounting principles used to define working capital should also be consistent with past accounting practices and industry norms.
Constructing a Working Capital Adjustment Mechanism One complicated and unavoidable issue in a transaction is that the purchase price of a business is determined on the signing date, whereas the company continues to operate until being transferred to the new owner on the closing date. The period between signing and closing typically ranges from a few weeks to a couple of months, during which time the business’s working capital balance will inevitably change. Accordingly, best practice is to construct a mechanism to adjust the purchase price for changes in working capital between signing and closing.
As noted, the adjustment mechanism is particularly important for commodities firms because their balance sheets are primarily composed of inventory that is exposed to commodity price volatility, and these fluctuations are often funded with short-term revolving credit facilities. The working capital levels at any point in time may reflect transient variations due to changes in commodity prices, volumes, seasonality (for example, crop seasons in the case of agricultural and weather in the case of energy) or even purchase and delivery contracts (that is, holding product on behalf of clients). If not properly structured and negotiated, the mechanism can be an unforeseen way for a commodity business to lose significant value in a sale transaction. The concept of a working capital mechanism is that the purchase price determined on the signing date is contingent on receiving an agreed target level of working capital at closing. The target level is often established based on a historical average. If the value of the business is based on the last 12 months’ EBITDA, the average working capital over the same period is likely a good starting point for determining the target. The simplest method of adjustment is a dollar-for-dollar adjustment. If a seller delivers a level of working capital greater than the target amount at closing, it will receive a dollar-for-dollar increase in purchase price. Conversely, if
[T]he adjustment mechanism is particularly important for commodities firms because their balance sheets are primarily composed of inventory that is exposed to commodity price volatility, and these fluctuations are often funded with short-term revolving credit facilities.”
Issue 1 2016 19
a seller delivers less working capital than the target, the difference will be deducted from the purchase price. An effective working capital adjustment mechanism will help to eliminate the impact of seasonality, shifts in customer demand, changes in payment terms, the addition of new product lines and geographic expansion – to name a few – between the signing and closing dates.
ABC Orange Juice Company To put this into perspective, let’s look at the following example – depicted in the nearby table – where the owner of an orange juice company agreed to sell his business for $100 million and signed a purchase agreement with the buyer on September 30, 2015. Both parties agreed that the working capital target should be the $35 million of working capital on the balance sheet as of September 30, 2015. The buyer was given 90 days exclusivity to complete due diligence and close the transaction. Between signing and closing, the owner continued to operate the business in the normal course. However, in October, unseasonably cold temperatures damaged orange crops, and orange prices skyrocketed. To fulfill its floating price order book, the company was forced to purchase its share of the crop at substantially higher
Signing 9/30/2015
Closing 12/31/2015
$5
$5
Selected Balance Sheet Items (millions) Cash
prices, which the firm funded via its short-term credit facility. All else being equal, the impact to the balance sheet was a $20 million increase in inventory and a corresponding $20 million increase in the credit facility, both of which are illustrated in the nearby table. If the purchase agreement did not include a working capital adjustment, then the burden of the weather event would have fallen on the seller. In this case, the buyer would have paid the same price of $100 million, and the seller would have delivered a higher level of inventory than anticipated; however, the seller would also have been liable for the increased debt incurred, depending on how working capital is incurred, and thus receive only $37 million of equity value instead of $57 million. It is worth mentioning that the reverse situation could have occurred. If the price of oranges had plunged, inventory could have decreased, short-term debt would have declined in tandem, and the seller would have been better off. To avoid this scenario, the buyer and seller incorporated a working capital adjustment clause in the purchase agreement such that there was a target amount of working capital to be delivered to the buyer on the closing date – in this case, $35 million.
Signing 9/30/2015
No Adjustment With Adjustment
(millions)
Purchase Price
Closing 12/31/2015
$100
$100
$100
Inventory
$25
$45
Working Capital Adjustment
-
-
$20
Accounts Receivable
$50
$50
Purchase Price
$100
$100
$120
Current Assets
$80
$100
Short-Term Debt
$43
$63
Short-Term Debt Long-Term Debt
$43 $5
$63 $5
$63 $5
Cash Net Debt
$5 $43
$5 $63
$5 $63
Equity Value 2
$57
$37
$57
Accounts Payable
$40
$40
Current Liabilities
$83
$103
$5
$5
Long-Term Debt Working Capital Adjustment (millions) Working Capital Target at Signing 1 Working Capital at Closing Working Capital Increase
$35 $55 $20
For illustrative purposes only. 1 Negotiated Target = (Current Assets - Cash) - (Current Liabilities - Short-Term Debt) on Balance Sheet at Signing 2 Equity Value = Purchase Price - Net Debt
20 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
Conclusion
Any increase or decrease in working capital would be reimbursed on a dollar-for-dollar basis. While the transaction was still completed on a cash-free, debt-free basis, the initial offer price was then adjusted on the closing date, and the seller was able to offset the $20 million of higher debt incurred with the incremental $20 million received through the working capital adjustment. The seller received the equity value expected; the buyer received the target working capital expected as well as incremental working capital that was convertible to the equivalent incremental amount of cash that was paid. Both parties were satisfied with this outcome, as the economics of the deal at signing were maintained.
Fluctuations in working capital are natural for most businesses, but the impact is exacerbated for commodity-based businesses where inventory represents a large portion of the balance sheet, has the potential for large swings given price fluctuations for the underlying commodity and tends to be financed with shortterm secured debt. Working capital adjustment mechanisms are often a complex point of negotiation for both buyers and sellers in the context of acquisition agreements, in part because they lie at the intersection of corporate finance, accounting and law. However, a well-advised buyer or seller should be able to construct the adjustment mechanism that facilitates the transaction and protects both sides from potential value shifts as a result of changes in working capital. Addressing working capital early on in negotiations and closely coordinating among the accountants, attorneys, internal finance staff and the deal team will prevent a working capital dispute from derailing the transaction.
Determining the Working Capital Target What, then, is an appropriate working capital target in a sale transaction? Theoretically, it is the normalized level of working capital that enables the buyer to generate the cash flow that is being purchased. In practice, there are various factors that may add complexity to determining this target. For instance, rapidly growing companies often need higher levels of working capital to fund inventory growth. Seasonal businesses see fluctuations in inventory and receivables at different times in the year.
The Corporate Advisory Group (CAG) is dedicated to building and expanding relationships with clients and prospects of Brown Brothers Harriman (BBH) Private Banking through an objective long-term corporate finance dialogue. CAG operates outside of the traditional transaction-focused, success feebased investment banking model. As a result, CAG is able to approach clients’ unique needs without bias for any particular outcome and provide advice to best help clients achieve their business and personal goals and objectives. For more information on CAG, please contact your BBH relationship manager or Charles Shufeldt, Head of Corporate Advisory, at
[email protected].
The essence here is that there is no straightforward answer – sellers often focus on the headline enterprise value, but setting the working capital target is a fundamental part of the transaction negotiations and must be mutually agreed upon by both parties. The best way to get comfortable with potential variations is to perform an in-depth analysis of historical working capital as part of the negotiation of a letter of intent.1 Sellers should define working capital clearly and develop a strong rationale for the inclusion of any atypical balance sheet accounts that should be included. Working with advisors who are familiar with the industry norms as well as precedent transactions can provide a good reference point for the negotiations and ensure that there are no surprises at the closing.
1
L etter of intent: an initial written document that sets out the key terms of a proposed transaction, such as the price and structure.
Issue 1 2016 21
Interview with essDOCS Co-Founder Alexander Goulandris By Alice Birnbaum
In the early 1800s, the founders of Brown Brothers Harriman & Co. invested in the Collins and Cunard steamship lines and pioneered the use of travelers’ letters of credit issued on its clients’ behalf – all of which served to increase the speed at which international trade could move. To that same end, Alexander Goulandris co-founded essDOCS in 2005 to help enable global trade of physical cargoes without the need for exchanging physical paper documents as part of the trade. Today, essDOCS is the world’s largest provider of electronic bills of lading. The company’s flagship product, CargoDocs, allows its users – who include largely every party involved in a global trade of physical cargo – to engage in a partial or 100% paperless trade. Mr. Goulandris spoke with Brown Brothers Harriman about his endeavor in starting essDOCS and how he hopes to continue to bring the shipping industry into the digital age.
22 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
Brown Brothers Harriman: What was the impetus for starting essDOCS? Alexander Goulandris: I began my career as a maritime attorney, which gave me a front row seat in seeing the disconnect in the speed at which global trade moved vs. that at which trade documents moved – and the friction caused because of it. When I went back to school to receive my MBA, I met Martin Glesner, with whom I would later co-found essDOCS. Martin had also come from a shipping background and experienced first-hand the issues that arose from shipping’s continued reliance on paper documents. It was 2002, and shipping still lagged behind other industries when it came to digital infrastructure. Martin and I saw an opportunity there and formed essDOCS in 2005 to address the issue. BBH: How would you describe essDOCS? AG: essDOCS is a fintech1 company for international trade of physical cargoes, with a specific focus on reducing or eliminating the burden of paper involved – while still ensuring possessory security. CargoDocs is our cornerstone solution, which includes two modules: DocPrep and DocEx. DocPrep allows users to draft original paper or electronic documents, such as electronic bills of lading (or eB/Ls), warehouse warrants, certificates of origin, invoices and other supporting documentation – for bulk, tanker or containerized cargoes. DocEx facilitates the exchange of original electronic documentation. Users can adopt some or all of these products, though our ability to generate and exchange eB/Ls is what essDOCS is best known for. We’ve packaged certain products as sub-solutions for different user types. For example, we have eUCP presentations for banks and compliance solutions such as eSDS, TraceDocs and eDocs for government regulators, customs authorities and inspectors. BBH: Before essDOCS came along, had there been prior attempts at dematerializing shipping documents? AG: Yes, there had been a number of attempts, and we estimate at least a quarter of a billion dollars was spent on finding a solution. The big question that Martin and I asked ourselves at the outset of developing essDOCS was why these past attempts had failed. We eventually found three leading reasons
for failures. First, these projects had been technologically ahead of their time. One of the critical drivers in moving logistics documentation into the cloud was data security. Prior to 2001, most internet web browsers did not offer acceptable levels of data protection to safely house and transfer legal title documents. Neutrality was also a big problem. A number of industry-driven solutions were explored by participants – including energy majors and shipowners – and several projects failed due to the perceived lack of neutrality on the part of the service provider. Aside from confidentiality and neutrality issues, there were also a number of legal hurdles that stood in the way of electronically presenting or transferring title documents, most of which were resolved by 2005 with ESIGN Acts recognizing e-signatures being enacted in all of the top 25 trading nations, as well as the eUCP supplement, allowing for original e-docs to be presented to banks in place of paper. BBH: I would imagine that the ability to legally accept electronic title documents in lieu of paper may vary by recipient and country. How does essDOCS make its e-docs and electronic exchange universally acceptable among its users? AG: Transfer of title under a paper document is governed by international treaties – for example, the Hague Rules in the U.S. and the Hague-Visby Rules in the U.K. None of these treaties facilitates electronic transfer of title, so the only way of doing so falls under national legislation or by way of a multipartite agreement. The solution we chose was with our multiparty user agreement, which essentially recreates the rights and obligations of a paper bill of lading. The agreement connects each party in the trade flow and binds them legally to one another. This is different from your average user agreement, which exists between a service provider and service buyer. In the future, there may be a new set of international treaties that specifically speaks to and allows electronic transfer of title. The Rotterdam Rules were meant to deal with this but have yet to come into force. These rules will go into force if 25 countries ratify the treaty, which would make the related clause in our user 1
F intech: financial technology.
Issue 1 2016 23
My experience is that plent y of p eo ple c an create a fake paper bill of lading; with a good photocopier or printer, they could probably do it in 30 minutes. It takes someone far more sophisticated to create an electronic fake – so, when it comes to comparing the two, paper is far less secure.” agreement superfluous. However, we would still need the user agreement for other aspects specific to adoption and use of our eB/Ls, which is why it’s such a big part of our solution. BBH: In the event of a trade dispute, are there any legal differences that arise if the bill of lading is electronic vs. paper? AG: If your legal agreement is written correctly, then there shouldn’t be. An eB/L is not really a bill, since it does not exist in the same physical form; legally, it is the functional equivalent of a paper bill of lading. The legal agreement creates the framework where the rights and obligations under the electronic bill pass in the same time and the same way to the same person that they would under a paper bill. So in all intents and purposes, there should be no difference. The slight difference is that if I am a customer, I now have the potential to argue that the electronic bill of lading itself is not a valid bill. If someone made that argument, he or she would need to make it in the jurisdiction identified in the legal agreement, so in our case the U.K. High
Court or New York State Supreme Court. Any other claim – about misdelivery or ownership at a certain time, for example – would be handled as per the jurisdiction clause whether it’s an eB/L or a paper bill. BBH: How secure is essDOCS? AG: Security and privacy is the cornerstone of everything we think about. If we were to ever breach either, we would most likely be out of business overnight. We have very strict protocols even within the organization about who has access to any form of data, and we’re very careful about how we handle customer data. For example, we’ve always had two-factor authentication for accessing our eB/L solution. We have annual IT and security audits, our solution is hosted in facilities with SAS level 5 (or equivalent) certifications – as you would expect – and so forth. My experience is that plenty of people can create a fake paper bill of lading; with a good photocopier or printer, they could probably do it in 30 minutes. It takes someone far more sophisticated to create an electronic fake – so, when it comes to comparing the two, there is no comparison. A lot of progress has been made in securing paperless trade, but often, because it’s a departure from the norm, people discount it or say, “We can get an electronic insurance certificate, but what about my certificate of origin or bill of lading?” A large part of our job is to tie all of these things together and give people one secure and dependable solution that lets you do it all. BBH: Let’s move on to your user base. Who can sign up for essDOCS? Once a company signs up, who else from that party’s trade network needs to be involved, and how do you go about doing that? AG: The group of potential users includes pretty much everyone involved in global trade, including users in the physical supply chain – such as exporters and importers, ship carriers and shipping agents – to independent inspectors, government or customs authorities and trade finance banks. Historically, in starting our user base, we began with the big commodity flows like energy and agriculture where you often end up with quite long sales chains. We decided that the easiest way to break into and build out those markets was to start
24 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
with the biggest players – for example, Cargill and Bunge in the agriculture space, BP and Shell in energy and BHP Billiton and Vale in metals and minerals.
AG: Ultimately, everyone. It’s a chicken and an egg situation, because the whole supply chain needs to be educated. I think everybody has a part to play in telling the rest of the supply chain, “I’m CargoDocs-enabled.” essDOCS does a huge amount of that. A large part of our job is to facilitate communication in the supply chain and make sure the exporters know which of their buyers and banks are on the platform.
We’re finding that as the user network expands, adoption can happen increasingly faster, and we think we’ll be able to move into new markets without the huge amount of business development efforts that we’ve had historically. Especially when we get to the container business – where it’s often just an exporter who sells to a buyer that can account for a significant number of trades – we won’t need to worry quite so much about building a large cluster of users, because as long as enough of the container lines are signed up, we can probably facilitate many transactions with a handful of customers.
There are three groups that are particularly important: container lines, banks and national plant protection organizations (NPPOs). Many people look at NPPOs and banks as blockers, so it’s key for those two to let the market know that they’re ready to move to electronic. BBH: In what industries have you had the most success, and why do you think that is?
BBH: Much of essDOCS’ success hinges on the size of your user network. Are there any key stakeholders that are very important toward promoting more widespread adoption of eB/Ls over paper?
AG: There are four verticals that we’ve been focusing on: energy, metals and mining, agriculture and chemicals. When Martin and I started the business, my background was bulk
DocEx Workflow Example
/L
CR
EA
TE
AF
TR
IEW
SE
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LD
eB/
EV
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EVI
1
1
DR
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1
2
3
/L
eB
APPROVAL PRESENT eSET
2
4
Online B/L Drafting Original B/L Sign & Issue Adding Peripheral eDocs Title Transfers eB/L Surrender Cargo Release
Cargo Delivery
3
(B/L Accomplished)
TRANSFER
eB/L
1. 2. 3. 4. 5. 6.
5
NT
E ES
PR
T SE
e
Supporting eDocs
CargoDocs
4
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E SF
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Negotiating Bank
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4
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6
ERY O R
eB
Shipowner or Agent
DELIV
Shipper or Freight Forwarder
ET
T
Issuing Bank
End Receiver/Buyer Issue 1 2016 25
We’re still at the very early stage of BPO adoption; we’ve seen good traction within the industry, and we’re working on traction with banks. I think we’re on the right track.”
shipping, and his was container shipping, so we had a bit of a competition to see which market showed interest earliest. The energy business ultimately adopted essDOCS first, which is how we ended up in bulk commodities. Beyond brand recognition – everyone’s heard of the big oil majors – there are a number of advantages to bulk commodities. First, bulk traders tend to deal with many more banks than a retailer may need to. The other aspect of some of these areas is that they flow into each other. For example, in the energy business, many oil companies are also in the petrochemical business, which then takes you into chemicals. It gives you various modes of shipping, too. You start with a tanker, end up with a container, and it’s ultimately the same customer base.
BBH: essDOCS is web-based and therefore easy to access. Does that also make it more flexible to integrate with other software platforms that users may already be relying on?
known for its integration capabilities. The problem with integrating is that you typically need quite a mature product, because if I integrate, what I’m really trying to get to is a situation where people don’t need to directly log in to your system at all. For example, if I am a container line creating millions of bills of lading annually, the idea that my employees will actually log in to CargoDocs, review bills of lading and edit and sign them is just not feasible. Those employees have their own platforms and systems. As such, essDOCS has taken on the burden of integrating with other third-party platforms so we can have the “work with us once, and work with everyone” model. To be able to do that, our product must be mature, because if it isn’t, clients need to keep changing the API,2 which is expensive.
AG: Yes, ease of integration was first and foremost on our mind from the early days; the platform was built on middleware
BBH: Can you talk about essDOCS’ experience with bank payment obligations, or BPOs, and the SWIFT TSU? 3
The largest advantage in the bulk business is probably that many of these companies are very politically connected, and customs and government is an important stakeholder in electronic document adoption.
2
A PI: application program interface.
3
S WIFT TSU: Society for Worldwide Interbank Financial Telecommunication Trade Services Utility.
26 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
AG: A BPO is an irrevocable undertaking given by a bank to another bank that payment will be made on a specified date after successful electronic matching of data based on ISO 20022 Trade Services Management messaging standards and an industrywide set of rules – ICC’s Uniform Rules for Bank Payment Obligations (URBPO). The BPO was developed by SWIFT when its corporate membership expressed interest in moving away from letters of credit due to the complexity and costs associated with them. The SWIFT TSU is the data matching engine behind a BPO. We found the BPO interesting because it fits perfectly with essDOCS’ paperless trade approach. When we engaged with our customers, they expressed concern that there weren’t enough banks on the BPO platform and asked several questions, including: “Where does the data come from? If people just send copies of documents to the banks, and the banks need to type it in, that’s not straight-through electronic processing,” and “What happens to the documents?” essDOCS saw an opportunity to solve these problems. We could connect with the TSU on the banks’ behalf so they could avoid individual integration costs, and we could provide buyers
and sellers with essDOCS access, enabling them to send transport and invoice data electronically for matching purposes. We started working with SWIFT and with BHP Billiton and Cargill – our first clients to do this. They took our CargoDocs BPO+ solution and used it to replace a letter of credit. In many of the iron ore trades that we came across, the transit time for documents to move from BHP as the seller to Cargill and then to the ultimate buyer exceeded the actual shipping time, which was about 10 days. Even if a letter of credit was subject to electronic presentation of the original documents, it was still almost impossible to get the documents to the discharge port in time. The use of BPO+ enabled them to eliminate the step where the banks needed to receive the documents, as documents would move directly from BHP as the seller to Cargill and then to the ultimate buyer; BPO+ easily accomplished that in 10 days. We’re still at the very early stage of BPO adoption; we’ve seen good traction within the industry, and we’re working on traction with banks. I think we’re on the right track. BBH: Alex, thank you so much for your time and insight.
Issue 1 2016 27
Agricultural Prices Arabica Coffee
Cocoa Beans
$1.40
$3,500
$1.35
$3,400 $3,300 $3,200 $/MT
$/lb
$1.30 $1.25
$2,900 $2,800 Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Mar-16
$2,700 Sep-15
Oct-15
Nov-15
$0.66 $0.65 $0.64 $0.63 $0.62 $0.61 $0.60 $0.59 $0.58 $0.57 $0.56 Sep-15
$1,650 $1,600 $/lb
$/MT
$1,550 $1,500 $1,450 $1,400 $1,350 $1,300 Sep-15
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Mar-16
Plywood
Oct-15
Nov-15
$0.15
Mar-16
Jan-16
Feb-16
Mar-16
Jan-16
Feb-16
Mar-16
Jan-16
Feb-16
Mar-16
Feb-16
Mar-16
$0.11
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
$0.10 Sep-15
Mar-16
Oct-15
Nov-15
Corn $3.90 $3.80 $/bu
$3.70 $3.60 $3.50 $3.40 $3.30 Oct-15
Nov-15
Dec-15
Dec-15
Rice
$4.00
$/bu
Feb-16
$0.12
$4.10
Jan-16
Feb-16
Mar-16
$14.00 $13.50 $13.00 $12.50 $12.00 $11.50 $11.00 $10.50 $10.00 $9.50 $9.00 Sep-15
Oct-15
Nov-15
Soy
Dec-15
Wheat
$9.40
$5.40
$9.20
$5.20 $5.00 $/bu
$9.00 $/bu
Jan-16
$0.13
$355
$345
GRAINS
Dec-15
$0.14
$360
$350
$8.80 $8.60
$4.80 $4.60 $4.40
$8.40
$4.20 Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
$4.00 Sep-15
Mar-16
Oct-15
Live Cattle
Nov-15
Dec-15
Lean Hogs $0.80
$1.50 $1.45 $1.40
$0.70
$/lb
$1.35 $/lb
LIVESTOCK
Mar-16
$/lb
$0.16
$365
$8.20 Sep-15
Feb-16
$0.17
$370
$3.20 Sep-15
Jan-16
Sugar
$0.18
$375
$340 Sep-15
Dec-15
Cotton
Robusta Coffee $1,700
$/1,000 sq ft
SOFT COMMODITIES AND PLYWOOD
$1.15 $1.10 Sep-15
$3,100 $3,000
$1.20
$1.30 $1.25
$0.60
$1.20 $1.15 $1.10 Sep-15
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Mar-16
28 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
$0.50 Sep-15
Oct-15
Nov-15
Dec-15
Jan-16
Metal Prices Silver
Gold $1,300
$17
$1,250
$16 $16
$/oz
$/oz
$1,200 $1,150
PRECIOUS METALS
$1,100
$15 $14
$1,050 $1,000 Sep-15
$15
$14 Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
$13 Sep-15
Mar-16
Oct-15
Palladium
Dec-15
Jan-16
Feb-16
Mar-16
Platinum
$750
$1,050
$700
$1,000
$650 $600
$/oz
$/oz
Nov-15
$550
$950 $900
$500
$850
$450 $400 Sep-15
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
$800 Sep-15
Mar-16
Oct-15
Nov-15
$11,000
$1,650
$10,500
$/MT
$/MT
$1,550 $1,500
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
$7,500 Sep-15
Mar-16
Oct-15
Nov-15
Dec-15
Mar-16
Mar-16
$1,900 $1,850 $1,800 $1,750 $1,700 $1,650 $1,600 $1,550 $1,500 $1,450 $1,400 Sep-15
$5,200
$/MT
$5,000 $4,800 $4,600 $4,400 $4,200 Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Oct-15
Nov-15
Dec-15
$1,850 $1,800
$/MT
$1,750 $/MT
Jan-16
Feb-16 Mar-16
Zinc
Lead $1,900
$1,700 $1,650 $1,600 $1,550 Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Mar-16
Feb-16
Mar-16
Iron Ore
Hot-Rolled Coil $470
$70
$450
$65 $60 $/MT
$430 $/MT
Mar-16
Tin $18,000 $17,500 $17,000 $16,500 $16,000 $15,500 $15,000 $14,500 $14,000 $13,500 $13,000 Sep-15
$5,400
$/MT
BASE METALS
Feb-16
$9,000
Copper
STEEL & IRON ORE
Jan-16
$9,500
$8,000
$5,600
$410 $390
$55 $50 $45
$370 $350 Sep-15
Mar-16
$8,500
$1,450
$1,500 Sep-15
Feb-16
$10,000
$1,600
$4,000 Sep-15
Jan-16
Nickel
Aluminum $1,700
$1,400 Sep-15
Dec-15
$40 Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Mar-16
$35 Sep-15
Oct-15
Nov-15
Dec-15
Jan-16
Issue 1 2016 29
Energy Prices Brent-WTI Spread
Crude Oil $5
$55
$4
$45
$3
$40 $/bbl
$/bbl
CRUDE OIL
$50
$35 $30
$1
$25 $20 Sep-15
$2
$0
Oct-15
Nov-15
Dec-15
Jan-16
Crude Oil (WTI)
Feb-16
Mar-16
-$1 Sep-15
Crude Oil (Brent)
Gasoline $21
$1.45
$19
$/gal
$/bbl
$9 $7
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
$5 Sep-15
Mar-16
Oct-15
Nov-15
Heating Oil
Mar-16
Feb-16
Mar-16
$1.55
$1.30
$/bbl
$/gal
Feb-16
$1.60
$1.40 $1.20 $1.10
$1.50 $1.45 $1.40
$1.00
$1.35
$0.90 Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
$1.30 Sep-15
Mar-16
Oct-15
Nov-15
Dec-15
Jan-16
Gasoline-Ethanol Spread
Ultra-Low Sulfur Diesel $1.60
$0.20
$1.50
$0.10 $0.00
$1.30
-$0.10 $/gal
$1.40 $1.20 $1.10
-$0.20 -$0.30
$1.00
-$0.40
$0.90
-$0.50 Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
-$0.60 Sep-15
Mar-16
Oct-15
$2.90
$45
$2.70
$40
$2.50
$/MMBtu
$50
$35 $30
$1.90 $1.70
Dec-15
Jan-16
Jan-16
Feb-16
Mar-16
$2.10
$20 Nov-15
Dec-15
$2.30
$25
Oct-15
Nov-15
Natural Gas
NYC Electricity (On-Peak)
$/MWhr
Jan-16
Ethanol
$1.50
Feb-16
Mar-16
$1.50 Sep-15
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Mar-16
Feb-16
Mar-16
Uranium
Coal $39 $37 $35 $/lb
$/MT
Dec-15
$1.65
$1.60
$45 $45 $44 $44 $43 $43 $42 $42 $41 $41 $40 Sep-15
Mar-16
$11
$0.95
$15 Sep-15
Feb-16
$13
$1.05
$1.70
$/gal
REFINED PETROLEUM PRODUCTS AND ETHANOL
$1.15
$0.80 Sep-15
Jan-16
$15
$1.25
$0.80 Sep-15
Dec-15
$17
$1.35
POWER AND POWER GENERATION
Nov-15
WTI 321 Crack Spread (Cushing)
$1.55
$0.85 Sep-15
Oct-15
$33 $31 $29 $27
Oct-15
Nov-15
Dec-15
Jan-16
Feb-16
Mar-16
30 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
$25 Sep-15
Oct-15
Nov-15
Dec-15
Jan-16
YTD % Change: Commodities
YTD % Change: Currencies and Indices
Silver
17%
Gold Crude - Brent
15%
RBOB ULSD
12%
Lumber
7%
Coffee - Robusta
3%
Copper
1%
Palladium
1%
Sugar No. 11
1%
Wheat
Dow Jones
-1%
Cotton
-2%
Coffee - Arabica
3%
S&P 500
2%
London FTSE 100
2% 0%
Indian Rupee
-1%
Nasdaq
-1%
Mexican Peso
-1%
Bombay Stock Exchange
-2%
British Pound
-3%
U.S. Dollar Index
-4%
German DAX
-2%
Cocoa
3%
Chinese Yuan
1%
Frozen OJ
4%
Bloomberg Commodity
4% 3%
5%
Euro
6%
Aluminum
6%
Mexican Bolsa
7%
Palm Oil
9%
Russian MICEX
8%
Corn
10%
8%
9%
Crude - WTI
Japanese Yen
Australian Dollar
10%
Platinum
11%
Canadian Dollar
11%
Soybeans
22%
Brazilian Real
Russian Ruble
13%
Ethanol
Natural Gas
BM&F Bovespa
16%
-7%
-6%
Shanghai Composite
-14%
Nikkei
-14%
-17%
Bloomberg Commodity Index (2000-2016) 250
Index price (USD)
200
150
100
50
0 2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
The Bloomberg Commodity Index is a diversified index made up of 22 exchange-traded futures contracts for physical commodities. The futures contracts are weighted to account for each commodity's economic significance and market liquidity.
Source for all charts on pp. 28-31: Bloomberg.
Issue 1 2016 31
The BBH Commodities & Logistics Team Our goal is to be the financial partner of choice to premier, privately held businesses and their owners in the areas of commodities, logistics, transportation and infrastructure. We provide advice and capital across an integrated suite of services: Corporate Lending, Private Wealth Management, Corporate Advisory and Private Equity. With a nearly 200-year commitment to the sector, we are deeply experienced across multiple subsectors including metals, energy and agricultural/ soft commodities as well as port services, shipping and transportation, and warehousing and logistics. As a privately owned partnership, our Partners interact directly with clients, allowing BBH to forge intimate owner-to-owner relationships. We strive to become your trusted advisor. To learn more, please contact Lewis Hart at 212.493.7886/
[email protected], Max Schlubach at 212.493.8864/max.
[email protected] or Alice Birnbaum at 212.493.8920/
[email protected].
Business insights from
one company owner to
another
Quarter 3 / 2015
Business insights
from one company
Quarter 1 / 2016
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4 / 2015
s from
owner to another
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Board Com
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Interested in insights around private business ownership? Owner to Owner provides business insights to private company owners, executives and those who serve them. Topics covered include business transition and succession planning, corporate governance, innovation, leadership, technology and family business issues, to name a few. Each issue of Owner to Owner also features an interview with a successful CEO or executive from our network to provide valuable third-party insights on the ownership and management of private businesses. Visit bbh.com for the latest edition of Owner to Owner.
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32 Brown Brothers Harriman | C O M M O D I T Y M A R K E T S U P D A T E
This publication is provided by Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) to recipients, who are classified as Professional Clients or Eligible Counterparties if in the European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information has been obtained from sources believed to be reliable that are available upon request. This material does not comprise an offer of services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. © Brown Brothers Harriman & Co. 2016. All rights reserved. 2016. PB-2016-04-25-0771
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