Commodity, Project, Trade and Asset-Backed Finance in the Commodities Markets

“LEND A LITTLE, AND YOU HAVE A DEBTOR—LEND A LOT, AND YOU HAVE A PARTNER!”

-JAMES CLAVELL, NOBLE HOUSE

Commodity, Project, Trade, and Asset-Backed Finance are distinct types of financing that serve different purposes in the commodities markets. While they share similarities, they differ in nature, scope, and application. This is not an exhaustive text on how to structure commodity deals, off-balance-sheet lending, or an in-depth critique of the tax benefits and commercial differences between a VPP (volumetric production payment) and a standard RBL (reserve-based lending) facility but a higher-level overview of what and where facilities are used, and the interchangeability of names and terms used (sometimes incorrectly!)

Commodity Finance refers to financing commodities' production, purchase, transportation, and storage. Commodity finance is typically used in industries where commodities' production, distribution, and sale are central to business operations; it includes loans, prepayment arrangements, inventory finance, and structured trade finance. The last type of financing evolved dramatically during the 1981-2020 period as many investment (and then commercial) banks began to get involved in all aspects of the commodity supply chain.

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Project finance involves financing long-term infrastructure (pipelines, power stations, hydroelectric facilities, etc.) using?a non-recourse or limited recourse financial structure. The?debt and equity used to finance the project are paid back from the cash flow generated, and the project's assets can be used as collateral until payment is complete.

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Trade Finance refers to international trade transactions, including import and export of goods (like commodities) and services. Trade finance facilitates international trade by providing financing solutions that mitigate many of the risks and uncertainties associated with cross-border transactions; it includes various forms of financing, such as letters of credit, documentary collections, trade loans, and trade credit insurance.As such, commodity finance is often considered a subset of trade finance.

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Asset-backed finance involves using assets as collateral to secure financing. These assets can be tangible (commodities or commodity-related assets) or intangible (such as commodity receivables) contracts and serve as a guarantee to the lender in case of default by the borrower. Asset-backed finance can take different forms, including asset-based loans, securitisation, factoring, and sale and leaseback arrangements. These funding forms can be found within the commodity and commodity-related business, making commodity finance a subset of asset-backed finance.

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Financing the physical movement of commodities can involve complex logistics and storage arrangements. ?In the oil and gas industry, molecules are often transported through pipelines, ships (VLCC and LNG), or other means and may require storage at various points in the supply chain. Commodity finance provides funding for these logistical operations, allowing commodities to be transported and stored economically.

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Commodity prices can be volatile due to supply and demand dynamics, geopolitical events, weather conditions, and regulatory changes. Price fluctuations can have significant impacts on the profitability of commodity transactions. Commodity finance can have embedded risk management products, such as futures, options, and swaps, that allow traders, consumers, and producers to manage their exposures to market prices and mitigate potential losses.

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Commodities often have long production cycles and require a significant upfront investment in raw materials, processing, and transportation. However, commodity payments are typically received only after the goods are sold and delivered. This creates a large cash flow gap for producers and traders. By providing them with working capital solutions, such as pre-export, inventory, and receivables financing, producers and traders of commodities will have the funds to continue their operations.

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Banks and financial institutions primarily provide commodity finance. They leverage their expertise in commodity markets, risk management, and trade finance to structure financing solutions that meet the specific needs of commodity market participants. Commodity finance transactions are often structured as collateralised loans, where the commodities themselves serve as collateral for the financing. This allows lenders to mitigate their credit and performance risks by holding physical assets as security and providing borrowers with cheaper funding.

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In the cases of electricity generation (solar, wind, hydro, tidal or CCGT), the project sponsors have an agreement with a future buyer of the electricity off-take, commonly known as a power purchase agreement (or PPA), to demonstrate the financial viability of the project often before breaking ground on the construction or development of a new facility. Well-developed, liquid, and transparent derivatives markets have allowed Project Finance to flourish and be an integral part of the broader commodity finance canon. Many projects qualify for off-balance sheet accounting treatment, favoured by many companies, as their financial ratios are unaffected by the extra debt.? (Enron, however, took it too far!)

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Commodity finance is crucial in supporting global trade and funding economic development (and perhaps political stability). Commodities are the building blocks of all economies that produce goods and services. The ability to efficiently finance commodities' production, transportation, and storage is critical to ensuring their availability in global markets.

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Providing working capital to producers and traders supports business growth and job creation, particularly in developing countries where commodities are often a vital source of export revenue. The financing of commodity transactions often involves multiple currencies, jurisdictions, and legal frameworks. Commodity finance helps provide the necessary funding and risk management tools to facilitate cross-border trade, allowing producers and traders to access global markets and capitalise on international trade opportunities. This is particularly important for developing countries as many still need better financial infrastructure and resources for international trade; with the support of commodity finance, they can overcome the limitations of their sometimes underdeveloped and inexperienced local financial systems.

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Commodity finance focuses on financing and managing commodities throughout their supply chain, whereas trade finance encompasses a broader range of trade transactions beyond commodities. Trade finance involves more traditional trade instruments, such as letters of credit, which provide payment guarantees and facilitate purchasing and selling goods and services, often physical commodities. While both commodity finance and trade finance involve financing and risk management, the specific instruments and techniques used may vary depending on the nature of the transactions and the types of goods being traded.

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Asset-backed finance uses assets as collateral to secure financing. This provides security, and in the event of default, the lender can seize and sell the underlying assets to recover their investment. This makes asset-backed finance attractive to lenders, as it provides a tangible form of security compared to unsecured loans, where the lender relies solely on the borrower's creditworthiness.

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Asset-backed finance depends on the type of assets used as collateral and the borrower's specific needs. Some common types of asset-backed finance include asset-based loans, securitisation, factoring, and sale and leaseback arrangements.

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1. Specific assets, such as inventory (manufacturers with copper widgets or aluminium extrusions), equipment, or accounts receivable, will secure asset-based loans. The lender assesses the value of the assets, and the loan amount is typically based on a percentage of the appraised value of the assets. An example might be an oil and gas reserve-based lending (RBL) facility where the Loan-to-value is often around 65% of the proven reserves (it is much more technical than that, but you get the idea!) Asset-based loans are commonly used by businesses with valuable assets that creditors can easily liquidate in case of default.
2. Securitisation involves pooling assets, such as mortgages, auto loans, or Commodity-based accounts receivable (google Trafigura's $700 million+ recent financing deal) and converting them into tradable securities that can be sold to investors. The cash flows generated from the underlying assets are used to repay the securities. Financial institutions often use securitisation to transfer risk and raise capital. The most common usage is in the mortgage lending industry: A bank may bundle a portfolio of mortgages into a mortgage-backed security (MBS) and sell it to investors. The cash flows from the borrowers' mortgage payments are used to repay the investors who hold the MBS. Securitisation allows financial institutions to free up capital tied up in loans, transfer risk to investors, and generate additional liquidity.
3. Factoring involves the sale of accounts receivable to a third party, known as a factor, in exchange for immediate cash. The factor assumes the risk of collecting the receivables from the customers, and the business receives immediate cash to meet its working capital needs. Companies use factoring when they have large notional values of accounts receivables and need expedited cash flow. With cash flow constraints, a physical commodity supplier may sell its accounts receivables (they deliver copper locally but wait up to 90 days for total payments to a factor in exchange for immediate cash, which can be used to pay suppliers or cover other expenses). The factor takes over the responsibility of collecting the receivables, and the business can focus on its operations (metals trading).
4. Sale and leaseback arrangements involve selling a valuable asset, such as real estate, a commodity pipeline, terminal or facility, or equipment, to a third party and then leasing it back from the buyer. This allows the business to unlock the asset's value while retaining its use. Sale and leaseback arrangements are commonly used by companies that need capital but want to maintain access to their investments. For example, in mining and farming situations, everything from tractors to trucks and ships is often sold and leased back.

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Modern finance has helped develop all commodity markets and funded global extraction, transportation, and procurement expansion. The proliferation of derivatives and financing methods has allowed producers and consumers to create and manage their products and needs and allowed traders to efficiently facilitate the movement of commodities globally. It has also allowed many people to make a lot of money. And there is nothing wrong with that, as it has also led to employment, socio-economic development, and political stability.

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Many free resources exist on all commodity-related deal structures, many written by banks and legal firms. These will enlighten readers who wish to investigate commodities funding and deal structuring.

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This essay complements my previous works: ‘So, what is a Commodity?’ and ‘Exchanges, Markets and Who is Trading!’ The three taken together should inform the most curious minds and help educate and enthuse tomorrow's commodity professionals.? I leave you with some sage advice and famous words from a man who knows about money.

“IF YOU WOULD KNOW THE VALUE OF MONEY, TRY TO BORROW SOME.”

-BENJAMIN FRANKLIN, FOUNDING FATHER OF THE UNITED STATES