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Speculators Driving Up Commodity Prices? Hardly
Goldman, Morgan Stanley Profits Conceal Reliance on Commodities
By Christine Harper
June 16 (Bloomberg) -- On Wall Street, where just about everyone has lost confidence in financial assets, Goldman Sachs Group Inc. and Morgan Stanley are making money the old-fashioned way: Buying and selling commodities.
Goldman and Morgan Stanley are expected by analysts to report the best second-quarter earnings of the world's biggest securities firms this week, having limited their losses from the collapsing credit market. They also lead Wall Street in commodities trading, where crude oil futures doubled in the past year and the price of products from gold to corn soared to record highs.
Surging prices are attracting investors, as well as companies hedging their positions by buying derivatives. That's played to the strength of Goldman and Morgan Stanley, which dominate the market for commodity derivatives. The two New York-based companies accounted for about half of the $15 billion of revenue that the world's 10 largest investment banks generated from commodities last year, said Ethan Ravage, a financial-services industry consultant in San Francisco.
Commodity trading ``is very large for them, and that is even more important now given what's happening with the rest of the businesses,'' said Frank Feenstra, a consultant at Greenwich Associates, the Greenwich, Connecticut-based research firm whose survey last month found Goldman and Morgan Stanley were the preferred dealers of corporate users of commodity derivatives. ``There are more commodities used, more hedging by companies, and the investor population has increased significantly as well.''
Goldman probably will report a 32 percent drop in second- quarter profit tomorrow, and Morgan Stanley may say on June 18 that net income fell 59 percent from a year earlier, according to the average estimate of analysts surveyed by Bloomberg.
Blankfein and Mack
That's relatively good news for Goldman Chief Executive Officer Lloyd Blankfein, 53, and Morgan Stanley CEO John Mack, 63, when compared with the $2.8 billion second-quarter loss reported last week by Lehman Brothers Holdings Inc. Bear Stearns Cos. was forced to sell itself to New York-based JPMorgan Chase & Co., the third-biggest U.S. bank, after almost going bankrupt in March.
``Fixed-income is really, really tough right now,'' said Ralph Cole, a senior vice president of research at Ferguson Wellman Capital Management Inc. in Portland, Oregon, which manages $2.7 billion and holds Goldman shares. ``The two names that had so much trouble were big fixed-income shops, whereas Goldman obviously has commodities.''
Goldman, the only one of the 10 biggest investment banks to show a gain in its stock price last year, fell 17 percent so far in 2008, and Morgan Stanley tumbled 23 percent in New York Stock Exchange composite trading. By contrast, Merrill Lynch & Co. dropped 29 percent and Lehman fell 61 percent.
Commodity Cushion
The earnings declines at Goldman and Morgan Stanley will be driven largely by writedowns of real estate-backed securities and leveraged loans. Goldman probably will take $1.3 billion of such writedowns, and Morgan Stanley may write off $1.6 billion, said David Trone, a New York-based analyst at Fox-Pitt Kelton Cochran Caronia Waller, who has an ``in line'' rating on the companies.
Morgan Stanley has already taken $12.6 billion of such writedowns since the beginning of last year, compared with Goldman's $3 billion, data compiled by Bloomberg show.
Goldman and Morgan Stanley, the two largest U.S. securities firms by market value, don't report commodity revenue separately, lumping it instead into the same line as fixed-income and currency trading. That makes it difficult to assess just how much commodity revenue has cushioned earnings.
Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York, estimates that commodity trading accounts for more than 7 percent of revenue at Goldman and Morgan Stanley. That would have added up to more than $3.2 billion at Goldman last year and $1.9 billion at Morgan Stanley.
`Money Chasing'
Those numbers may be higher this year based on the strength of the markets.
``There's just a lot of money chasing these markets,'' said Peter Fusaro, chairman of New York-based Global Change Associates, which advises hedge funds on energy investments. The number of energy-related hedge funds his company lists has more than tripled to 634 in less than four years.
``I would assume, since those two have stellar people, they're doing phenomenal business now,'' said Fusaro, referring to Goldman and Morgan Stanley.
The Standard & Poor's GSCI Total Return Index, part of a suite of commodity indexes created by Goldman in 1991 and sold to McGraw-Hill Cos.' Standard & Poor's last year, gained 67 percent in the year ended May 30.
Food Prices
Global trading in commodity derivatives on exchanges rose 52 percent to 489 million contracts in the first quarter from a year earlier, according to data compiled by the Bank for International Settlements. Energy and agricultural products led the climb. In the over-the-counter market, the value of outstanding commodity- derivative contracts jumped 26 percent to $9 trillion in December 2007 from a year earlier, the most recent BIS data show.
Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or the weather.
The dominance of Goldman and Morgan Stanley in commodity trading comes as a 60 percent increase in food prices over the past 18 months has sparked riots in 30 countries and as record oil prices have led to hearings in Congress on energy markets.
``We are facing a very dangerous situation caused by these tremendously increasing prices for commodities, food and oil,'' German Finance Minister Peer Steinbrueck told a meeting of executives and government officials in Russia this month.
Soros's View
While supply shortages and rising demand from emerging markets such as China and India account for much of the price gains, money managers such as Michael Masters at Atlanta-based hedge fund Masters Capital Management LLC say financial speculators and a shift of pension fund money to commodities are also responsible.
Billionaire investor George Soros has said commodity prices may be turning into an unsustainable ``bubble.'' Crude oil rose 697 percent since trading at $17.45 a barrel on the New York Mercantile Exchange in November 2001. That surpasses the 640 percent gain in the Nasdaq Composite Index before a reversal in technology stocks in March 2000 triggered a 78 percent decline.
Goldman's commodity business, J. Aron, dates from its 1898 founding as a coffee-trading company, according to Lisa Endlich's book ``Goldman Sachs: The Culture of Success.'' Goldman purchased the family-owned company in 1981, and the next year the division hired Blankfein, a metals salesman who has since become Goldman's chairman and CEO.
Mortgage Market
Morgan Stanley was founded in 1935 by a group of executives, including the grandson of John Pierpont Morgan, the financier who created the trust that controlled more than half of the U.S. steel market. It didn't get into commodity trading until 1982. Today it owns heating-oil storage terminals, and it bought fuel- distribution company TransMontaigne Inc. in 2006.
Some doubt that commodities can take the place of businesses like structured credit that are being shunned by investors after mortgage-related assets plummeted.
``It's hard for me to imagine that it could be the same scale of profits as what was being generated in the glory days doing structured credit, but that doesn't mean it's not big,'' said Brian Barish, president of Cambiar Investors LLC in Denver, which manages $8 billion and owns stocks in energy and gold companies instead of investment banking stocks. ``Even if one's made some money in commodities, and maybe a lot of money, it's tended to be overshadowed by problems in fixed-income.''
Risky Business
The commodities business is also risky. Amaranth Advisors LLC collapsed in September 2006 after trader Brian Hunter's natural gas positions lost about $6.6 billion in one month, the biggest loss ever by a hedge fund.
Commodities revenue can swing wildly. Morgan Stanley said in December that its fourth-quarter commodities revenue decreased 84 percent, without providing an actual figure.
The firm's traders were ``badly positioned in electricity, natural gas and oils,'' Chief Financial Officer Colm Kelleher told analysts on a conference call. ``It was poor trading; it is as simple as that.''
In the first quarter, Morgan Stanley said commodities revenue was the second-highest ever at the firm.
Asked last year about competition from Wall Street banks that have been building commodities divisions -- chief among them London-based Barclays Plc and New York-based JPMorgan -- Goldman Chief Financial Officer David Viniar warned about the pitfalls.
``A lot of very smart people have gotten into a lot of trouble or lost a lot of money by getting into the commodities business,'' Viniar said at an investor conference in February 2007. Goldman has a ``long history of watching our competitors get into the commodities business at the top of the market.''
Value-at-Risk
Goldman's value-at-risk in commodity prices, a statistical measure of how much it estimates it could lose in a day of trading, rose to $38 million in the first quarter from $26 million in the prior quarter, the firm reported in March. At the same time, it lowered risk in equities and kept it unchanged in interest rates. Morgan Stanley lifted trading VaR in commodities to $40 million from $34 million, while reducing the risk in equities and currencies, the firm reported.
Isabelle Ealet, a 45-year-old French woman based in London, took over management of Goldman's global commodities business last year. Ealet, who has been a partner at the firm since 2000, has two New York-based deputies: Peter O'Hagan and Jeffrey Resnick. Her business is overseen by four co-heads of global securities trading.
Rise and Fall
John Shapiro, 56, has run Morgan Stanley's commodities trading business from Purchase, New York, since March 2005. Olav Refvik oversees trading of crude and oil products, and Simon Greenshields manages electricity trading.
At New York-based Merrill Lynch, the third-biggest U.S. securities firm after Goldman and Morgan Stanley, President Gregory Fleming said the commodities boom could turn out to mirror the rise and fall of technology stocks in the late 1990s and structured-credit products between 2002 and 2007.
``I'm hearing a lot of talk about supply and demand in commodities is not necessarily what we should be looking at,'' Fleming said in an interview on May 29. ``Boy I've heard that twice before in less than a decade in two different markets.''
To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net.
Last Updated: June 15, 2008 19:01 EDT
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