What Is Commodity Financing?
Commodity financing is an area of financing that deals in securing funds for the production, transport and trade of commodities. It is a specialized field, as there many complex aspects involved, including cross-border regulations, securing shipments and low margins. The term commodity trade finance is also used when the commodity is being traded or moved across borders. Any natural resource or agricultural product that has an intrinsic value on its own is considered a commodity, such as corn, wheat, cotton, lumber, gold, oil and natural gas. Commodities that are traded are broadly grouped into four categories: metals, energy (such as oil and gas), livestock and agriculture.
Often, commodity financing is referred to as self-liquidating because the borrower can repay the loan and make a profit entirely from the commodity processing chain, without relying on any additional assets. There are three general types of commodity financing: pre-export, countertrade (barter) and inventory. Pre-export financing occurs when funds are advanced to a borrower based on current orders from customers. Countertrade, or barter, is when goods or services are exchanged as payment instead of hard currency. Finally, inventory finance is based collateral held by the borrower, usually in public or third-party-controlled warehouses.
Any party involved in the production or sale of commodities may rely on commodity financing for a variety of transactions, including pre-payment of supplies, payment while in transport and even the financing of stocks. Since commodities are usually items needed for everyday life, they are always in demand and thus there is a lower risk of default on a loan by the borrower. In addition, most commodities increase in value as they move along the production chain (by turning a raw material into a finished product; for example, turning raw cotton into a shirt) so lenders are likely to see a positive return on investment. However, there is some volatility involved, as agricultural products are highly susceptible to adverse weather conditions (such as drought or flood) and livestock populations can be decimated by an outbreak of illness.
Until the global financial crisis in 2007-2008, commodity financing was under the purview of global transaction banking or corporate banks. However, after the crisis new regulations were put in place to ensure adequate capital was held at the banking institutions. This decreased the liquidity from large banks, but also created new opportunities for investors to participate in this niche industry. Commodity financing is essential to the production and sale of everyday goods that are essential to modern living.
