Wall Street is rethinking commodity trading role

Goldman Sachs has held preliminary internal discussions in the last two years about splitting off its lucrative commodities trading business, according to people briefed on the discussions.

The idea hasn't gained traction and has been tabled, as the New York investment bank is waiting to see how the business fits into the final version of new regulations such as the Volcker rule, which is scheduled to be implemented in coming months. The final rule is expected to ban some types of trading and could hit commodities trading revenue hard, these people said.

But the fact that Goldman has considered a possible restructuring of such a major business shows how dramatically new rules are reshaping the investment banking landscape.

Separately, Morgan Stanley is in discussions to sell part of its commodities unit to a sovereign wealth fund from the Persian Gulf state of Qatar, according to people briefed on the talks.

At Goldman, Isabelle Ealet, the London-based head of the firm's commodities business who was recently promoted to co-head the securities division, oversaw an internal study about the possible commodities split-off, according to people familiar with the bank's plans.

She and other top executives decided not to pursue the matter. In a statement, Goldman said, "While we constantly evaluate all our businesses, senior management never seriously looked at spinning out all or part of our commodity business."

Splitting off the business for Goldman or other banks could unleash an array of tax and regulatory issues, which is one reason the discussions haven't led to any deals. One problem is how an independent commodities business would be capitalised, which has pushed the discussion at Morgan Stanley to a joint- enture approach with Qatar.

Goldman's commodities business, which grew out of the J Aron brokerage firm that Goldman bought in 1981, has produced leaders of the firm such as chairman and chief executive Lloyd Blankfein and president Gary Cohn.

It has also generated about 20% of the firm's fixed income division revenue from 1999 to 2010, according to Sanford Bernstein analyst Brad Hintz.

Banks once gorged on commodities trading "because they had the advantage of really cheap financing," said Hintz.

But now, he said, lowered bond ratings and higher capital requirements have squeezed profits out of the business. That is because the commodities business, like other trading desks, needs to borrow to do business.

Banks have faced credit rating downgrades in recent years, which make borrowing costlier. Regulators' demands that banks set aside more capital on trades also hit the business.

After hitting records in many markets over the past few years, the prices of many commodities have stagnated. Some investors are concerned that a slowdown in China could put a further chill on the market.

Through the first half of this year, the 10 largest investment banks globally took in about $3.5bn in revenue from commodities, according to data firm Coalition. That is 20% lower than in the same period last year and 56% lower than in the period in 2009.

The banks also cut 5.7% of the employees in commodities units from 2009 to 2011, Coalition said. That compares with a 1% increase in employees overall, according to Nomura Securities.

The deal rumblings at Goldman and Morgan Stanley show that looming regulation, slower markets and lower revenue are starting to throw a cloud over the commodities businesses, especially for US banks that have to comply with the Volcker rule.

That rule could give a boost to other, less regulated players from sovereign wealth funds to hedge funds and independent trading houses.

Wall Street traders have traditionally made money in commodities by hedging the risk of price swings for corporate clients and by placing their own bets on where prices are headed. They buy and sell futures contracts on commodities, and sometimes the raw materials themselves. They have also expanded into storing and transporting commodities.

Regulators increasingly want banks to get out of risky businesses, and some are skeptical about the commodities business.

At one meeting with Morgan Stanley since the financial crisis, regulators pressed the firm about its TransMontaigne energy business, which carries and stores gasoline and other petroleum products.

"What does this have to do with a bank?" one of the regulators asked, according to a person involved in the discussion. "It all seems like prop trading."

In proprietary, or "prop," trading, Wall Street firms buy and sell assets such as commodities for the sole purpose of making a profit on the trade, rather than serving clients who want to buy or sell.

Some banks are selling commodity based assets for reasons that include shifts in strategy and attempts to get in front of regulations.

In September, Goldman agreed to sell a power plant developer called Cogentrix to private equity firm Carlyle Group.

The Morgan Stanley talks with Qatar in recent months have been pushed by the unit's leaders, who have expressed the view that the business would be more profitable outside a bank, according to a person familiar with the bank's discussions.

One scenario entails Morgan Stanley selling a majority stake in its commodities business to Qatar. Last week, Qatar's prime minister said officials were "looking at it seriously."

In October, a JP Morgan Chase-owned hedge fund and a trading partner announced they were selling a commodities venture to an investor group that included family trusts created by hedge fund billionaire Paul Tudor Jones. In June, JP Morgan also shed a metals concentrates unit to comply with Federal Reserve restrictions on banks' ownership of physical commodities businesses.

While JP Morgan remains a large player in the business, its commodity unit has also suffered volatile results in recent years.

On its earnings call last Tuesday, Goldman reported "significantly lower net revenues" in commodities.

Morgan Stanley on Thursday said business bounced back a bit from a slow second quarter, but remained below its level from a year ago.