Outlook CommodityTrading ubs

8/12/2019 Outlook CommodityTrading ubs

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UBS outlookThought-provoking impulses for decision-makers

Commodity trading

A critical look at underlying

trends and cycles


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UBS outlook commodity trading 3

Foreword 5

Executive summary 6

Switzerland as a hubfor the commodity trading business 8Energy 12

Metals 18

Agricultural (soft) commodities 22

The impact on ancillary businesses 24

Critical issues facing the trading industry 26

What UBS has to offer 28

A look ahead 30

Masthead 34

Content


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For more than a decade, UBS outlook thought-provokingimpulses for decision-makers has served as a reference tool forSwiss business leaders. Addressing industry-specific and key

managerial issues, these studies are backed by expert panels thatgenerate a person-to-person exchange of views and ideas.

Both the reports and the panel programs stem from a dialoguewith business sector leaders, management consultants, industryexperts, and the heads of industrial and trade associations.

The series seeks to portray the big picture, capture importanttrends and data, and sketch out the business challenges thatlie ahead.

In researching and writing past editions, our approach hasbeen to focus on a particular industry and the specific issues

it faces. For example, what strategic choices are open tomanagement as that industry faces changing technology,new consumer trends, or the emergence of foreign competition?

Rarely do we focus on changes in the industrys products orservices themselves.

That is not the case in the present edition of UBS outlook.

Unlike other industries we have examined in this series,commodity traders do not make the products they buy andsell. Rather, they add value by smoothing the delivery of

raw materials from producers to users. Their function in the

economy is essentially a constant, even if practitioners arealways looking for better ways of going about their business,

for example, by upgrading communication technologiesor establishing relationships with different business partners.

Although the dynamics of trading change little from year to year,the underlying commodities markets have seen major upheavalsin recent years. Prices for most raw materials whether oil or

gas or metals have risen spectacularly across the board.This unprecedented increase results from several factors thatthis report will address in detail. At the same time, these high

prices are inflicting pain worldwide, necessitating uncomfortableadjustments in most economic sectors.

This still-unfolding drama as this is written, prices are in facttumbling almost as spectacularly as they rose just a few monthsearlier is not just a colorful backdrop to the commodity trading

business; it is without doubt the main story. Consequently,this edition of UBS outlook will focus much of its attentionon the dynamics behind the current price fluctuations, and

then examine the commodity trading business itself, with a viewto assessing how these price increases might change the strategicoutlook for traders.

The UBS outlook Editorial Team

Zurich, October 2008

The UBS outlook series

Foreword


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6 UBS outlook commodity trading

Executive summary

The outlook for commodities is shaped by the following trends:

In the past, commodity prices were driven mainly by supply

factors. That has largely changed. Now most commodity pricesare demand-driven.

Fueling the unprecedented growth in demand is the nextbillion an emerging urbanized middle class in the developingworld. China and India account for about half of this billion,

and the remainder is spread over Asia, Latin America and Africa.Relatively wealthy compared to the previous generation,these consumers aspire to an urban lifestyle: a house, a car and

other durable goods, as well as a better diet all of which requireadditional raw materials and energy. The result has beena dramatic run-up in the price of virtually every kind of commodity.

These fundamentals are unlikely to change. High prices aretherefore probably here for the long run.

High fuel prices may dampen consumer demand for cars andother vehicles. This could seriously undercut the profitability

of the automotive industry as buyers shift to smaller(or at least more efficient) cars, which are typically soldat a smaller profit margin.

Thanks to various incentives, a substantial amount of agriculturalproduction has been diverted from food to energy products(biofuels). This has exacerbated the demand-supply imbalance

and helped to lift food prices.

Meanwhile, pension and hedge fund managers, as well as

other investors, have taken notice of this extraordinary price

performance and have invested heavily in commodities.According to some observers, this has superimposed a bubble

on the already ample fundamental reasons for pricesto increase. Others believe that these investors are chasingthe prices rather than causing them to rise (Fig. 1).


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Executive summary

Increasing commodity prices will have various politicalrepercussions:

They fuel inflation, which may bring about politically motivatedsolutions (for example the US Congress wanting to impose

a tax on the so-called windfall profits of oil companies).

High food prices in the developing world have already ledto popular unrest in more than thirty countries. This could

destabilize certain countries or even trigger changes ofgovernment.

In the face of high food prices, governments may modify oreven reverse their policies on biofuel subsidies, which couldhave a negative impact on this nascent industry.

In general, resource nationalism is on the rise. This desire toprotect and / or subsidize domestic raw materials, as well as

acquire foreign resources more aggressively, could also lead toa kind of neo-colonialism. Chinas move to secure iron oresupplies from Congo in a 12 billion US dollars quid pro quo

arrangement may hint at the shape of things to come.

Political and economic developments have always influenced

the commodities trading business, but in todays environment,their impact is much more severe. The turnover of all tradingcompanies has doubled and even tripled over the last two years,

without necessarily increasing the volumes traded.

Unfortunately, instead of doubling or tripling profits, the effecthas more often been a large increase in financing costs and risk.

The outlook for trading itself includes the following observations:

In general, higher commodity prices mean greater risk, sincethe value of deals is going up with the price of the goods traded.Risk management will therefore become a critical competitive

advantage. Firms that cannot manage risk properly, or cannotafford to because they are less well financed, may fail. Or, toavoid such an outcome, they may seek shelter from potentially

fatal trades by joining forces with larger trading firms. A certaindegree of industry consolidation may therefore take place.

Trading margins may be driven up to compensate tradersfor the higher costs and higher risks they face.

Switzerland will remain an excellent location for the tradingindustry, which is taking active measures to addressthe shortage of talent.

Lastly, environmental concerns have created a new and potentiallyhuge market for commodity traders: carbon.

Fig. 1: Commodity prices soar to new highs

Index (1967 = 100)

500

450

400

350

300

250

200

150

100

50

0 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: Reuters


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Switzerland as a hubfor the commoditytrading business

Since the 1990s, Switzerland has quietly

evolved into one of the worlds leadingcenters for commodity trading. Tradingcompanies in Geneva account for up to

an estimated one-half of the global tradein soft commodities, one-third of thetrading volume of the worlds oil, and

one-fifth of the worlds crude oil shipping.Zug is a major international platformfor industrial metals trading, in addition

to certain agricultural specialties suchas coffee. Two-thirds of the worlds coffeetrade runs through Zug.

HistoryHow did this predominance arise, especially if almost allthe commodities in question are not only produced elsewhere,but for the most part do not even pass through Switzerland

in the course of a transaction?

Switzerland has always benefited from the important trade

routes that cross its territory. However, the countrys positionas a world-class commodity trading center goes back only to theimmediate post-World War II period. At that time, when diplomatsplayed a more active role in facilitating international trade

than they do today, the presence of the United Nations in Genevameant that a vital communications network underpinningtrade development was already in place. At the same time,

the presence of the leading international inspection companiesin the same city helped move the nascent trading industry forward.

One of the key events accelerating Switzerlands importance incommodities trade was the arrival in Lausanne of virtually allof Egypts cotton traders, who left the country with King Farouk

after his abdication in 1952. It was this team that convinced

Geneva-based banks to finance their trading operations.Trade finance, and the associated expertise in risk management,

thus became one of the Swiss banking industrys specialties, fuellingfurther growth of the commodity trading business in the country.

A further event then cemented this position: the adoptionin the 1970s of a special tax regime for trading companies.This allowed commodity traders to base their companies here

yet manage operations anywhere, without the needfor the goods they traded to physically transit Switzerland.

Lastly, the fact that the General Agreement on Tariffs andTrade (GATT) and its successor, the World Trade Organization(WTO) are headquartered in Geneva helps shape Switzerlands

reputation as a financial center with a favorable climatefor trading activities and a flourishing community of professionals.


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Switzerland as a hub for the commodity trading business

Enormous scope, yet difficult to recognizeToday, Switzerlands share of worldwide trading belies thecountrys small size and the paucity of its own natural resources(Fig. 2). According to the Geneva Trading & Shipping Association

(GTSA), the volume of commodity trading in Geneva alonegenerated aggregate profits of CHF 2.1 billion in 2007,produced tax revenues for the canton of CHF 200 million,

and provided employment for 2,700 people. As impressive asthese figures are, they do not include the ancillary businessthat is generated by trading activities, such as trade finance and

other banking services, inspection, shipping and transport,legal and accounting services, insurance, security, consulting,and so forth. Whats more, the recent run-up in commodityprices has increased the value both of trading and also of many

of these related services (Fig. 3).

According to the GTSA, the volume of all the commodities

traded in Geneva is approximately two billion Swiss francs a day.In other words, commodity trading in Switzerland is very bigand getting bigger.

Despite the considerable size of the industry, it operates belowthe radar of many economic observers. Sometimes it is omitted

altogether from the various tallies and lists of the largest Swissenterprises. This is partly because the commodity tradingbusiness leaves such a small footprint it is an industry based

not on factories, muscle, and other visible operations,but on brainpower, computer screens and telephone lines,with a relatively small number of individual traders generating

huge volumes from a quiet office tucked away on the fourthfloor of an otherwise unremarkable office building. It is alsodue to the fact that many trading companies are unlisted

and therefore do not publish their financial results.

What Switzerland has to offerIn principle, commodity trading operations could be basedpractically anywhere. So why have so many companies set

up their activities in Switzerland? There are a number of reasons(Fig. 4):

Switzerlands central location and excellent infrastructure above all telecommunications, logistics and flight connections assure trading companies that their business is unlikely to suffer

from any disruption, and that counterparties and trading partnerscan be easily reached, and the business therefore easily grown.

Likewise, Switzerland offers an outstanding array of trade financepartners and ancillary service providers, from banks specializedin trade finance to lawyers, shipping, experts in risk management,

inspection firms, insurance brokers, and the many otherprofessionals needed to ensure the smooth operation of a trade or an entire company.

Switzerlands favorable tax rates and fiscal structure are alsoimportant contributing factors to the growth of commodity

trading in the country.

Of the ten largest Swisscompanies by turnover,four are in the commoditiestrading business.

Dr. Daniel KaltHead of Economics and Swiss Research,UBS AG

Fig. 2: Largest Swiss companies by turnover(except financial institutions)

1. Glencore

2. Nestl

3. Novartis

4. Roche

5. Xstrata

6. ABB

7. Adecco

8. Mercuria Energy Trading

9. Holcim

10. Cargill

Sources: Handelszeitung, Dun & Bradstreeet


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Switzerland as a hub for the commodity trading business

Lastly, businesses run on talent. In Switzerland, the availability

of a well-educated and motivated workforce has always beenan advantage for companies doing business in this country.In commodity trading, however, Switzerlands small size,

and the fact that successful trading relies so much on a highlyskilled pool of specialists, mean that companies often needto augment local staff by importing foreign traders. In Geneva,

an estimated 50% to 80% of the traders employed in commoditytrading firms are non-Swiss. Thanks to Switzerlands largelypro-business immigration policies, trading firms can usually

bring in the people they need, with only minor bureaucraticor legal obstacles.

It is also a decided advantage that the high standard of living

enjoyed here helps trading companies attract excellent peoplefrom all over the world.

All in all, Switzerland is a near-ideal location for the commoditiesbusiness, although it cannot afford to become complacent.As in any industry based more on brains than brawn, a trading

firms main assets the traders themselves can easily move

to another country where business conditions might be evenbetter, or where talented staff can be found in greater

abundance. On this last point, Switzerland still comes up short.But the commodities industry is addressing this issue.

Fig. 3: Commodity wholesale trading employment

Employees in commodity and wholesale trade*

Area Absolute Percentage of total

Geneva 14,071 6.5

Ticino 7,815 5.4

Zug 8,728 14.7

Switzerland 168,502 5.4

* The employment figures are from the Swiss Business Census of 2005.They are updated every 4 5 years.

Sources: Federal Statistical Office (FSO), UBS Wealth Management Research

Fig. 4: Switzerlands key success factors

Availability of financially skilled professionals on the labor market

Lack of capital controls

Low degree of protectionism

Long history of peace and neutrality

Very strong economic, fiscal and monetary policy environment

Swiss franc as a safe haven currency

Free movement of labor

Sources: Swiss Bankers Association, UBS outlook


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Energy

As the past few years have demonstrated,mankinds thirst for energy is havinga dramatic impact on the world of

commodities and the outlook for trading.The first, and most visible, effect of rising

demand for energy is the spiraling priceof oil, which before 2004 rarely touched35 US dollars a barrel but by thesummer of 2008 was hovering between

120 US dollars and 140 US dollars,a fourfold increase in just four years.Seen in this light, its subsequent drop to

about 80 US dollars, as we go to press,may be an overreaction to an anticipatedrecession, i.e. reduced demand.

A second area of impact is the growingdemand for agricultural-based biofuels,driven at least in part by political

considerations. A third, only speculativetoday, is the possible future demand forcarbon capture and sequestration (CCS),

one of several proposed solutions toenvironmental concerns about the effectsof carbon dioxide released into theatmosphere by burning fossil fuels.

Each of these three areas of activityrepresents solid opportunity forcommodity trading firms, although

not without risk.

Oil price becomes demand-drivenThe sharp increase of oil prices over the past year, up to thedizzying level of 140 US dollars a barrel at one point and alongwith it, the painful increase of gasoline prices at the pump

have led many observers, and especially politicians, to look for

someone to blame. Greedy oil companies? Speculators?Surely somebody must be manipulating the market!

The fact is that nothing more evil than market fundamentalsare at work. It is true that other factors, particularly the decline

in the US dollar, may have played a role in oils surge. In addition,hedge funds and pension fund investors, who previouslywere not active in these markets, now have easy access to them

electronically. As a result, they can make huge purchasesthat may affect prices to some extent. But the main culprits arenone other than supply and demand. As if to underline thiscontention, the price plunged back to well under 100 US dollars

a barrel when the financial crisis took hold and conjecturemounted that recessionary times were ahead i.e. a periodwhere economic activity, and thus demand for oil, may ease.

Supply issuesAlthough the price of a barrel of oil had already been creeping

steadily higher prior to 2005, large inventory surpluses overthe next two years kept the price rise in check. It was only whenOPEC cut production by 1.2 million barrels a day in late 2006

that the price began to increase again, and as markets workedthrough the inventories, it rocketed upward (Fig. 5).

Oil supplies and supplies of distillates such as gasoline, dieseland heating oil have tightened, and will remain tight forthe foreseeable future. This has been the result of a number

Our thesisHigher oil prices are here to stay. Thatmeans pain in the short term, but highprices may be the incentive needed forthe serious development of alternativeenergy sources, such as biofuels andother renewables. For commoditytraders, this will lead to enormousmedium and long-term opportunities.

Fig. 5: Price of oil 19982008

World, Energy, Oil, Light Crude Spot (WTI), Nymex, USD

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140

120

100

80

60

40

20

0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: Reuters


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Energy

of factors, such as strike-related outages in Nigeria, export

limitations from Saudi Arabia and Iran, Iraqi interruptions,setbacks in Venezuela, and various other production problemsin non-OPEC countries, where output actually fell by almost

300,000 barrels a day.

Adding substantial new supply to the worlds oil reserves is not

accomplished easily. Developing new oil resources, such asthe new Tupi offshore reserves discovered in Brazil, is a long andexpensive process. New oil cannot be expected to come

onstream for several years.

In the US, limited refining capacity, and declining utilization

rates, now around 83%, have also been blamed for keepinggasoline supplies below demand. Stringent environmentallaws and community action have made it difficult to buildnew refineries there, although by one estimate, 300 billion

US dollars is earmarked for new refineries over the next 20 yearsin the rest of the world. Most of this capacity will feed growingdemand from developing countries.

Similarly, regulatory issues also have an impact on supply.For example, according to Bloomberg News, new EU diesel

specifications will cut the allowable maximum sulfur contentby 80% in 2009, to 10 parts per million. That typically lowersthe maximum diesel output ceilings of refiners, as well as

prompting inventory reshuffling all of which invariably causessupply upsets.

All in all, oil markets are tight in key places, and relief from thattightening is still several quarters away.

Demand rules the daySet against this dire supply scenario is an ever thirstier worldwhen it comes to oil and petroleum products. In the developing

world, demand for heating oil and diesel fuel is especiallyacute. In China, India and the Middle East, demand is drivenby major infrastructure projects.

But these projects are not the whole demand story far from it.As emerging economies grow, more and more of their population

emerges into the middle class, demanding a lifestyle featuringcars and the other energy-consuming appliances which Westernhouseholds have long taken for granted (Fig. 6).

India, for example, is expecting a dramatic surge in the size ofits middle class: from 5% of its total population in 2005 to 41%

in 2025, or a rise of some 550 million people, according toan article in The Hindustan Times (30 December 2007).Gearing up for increased demand for mobility by this

newly affluent segment of the population, Indias Tata Groupin January 2008 launched the Nano, which at 100,000 rupees(about 2,300 US dollars) is the worlds cheapest car.

Likewise, China has overtaken Japan to become the worldssecond largest market for new cars after the USA, and the

demand for a car there is only scratching the surface. Between2006 and 2020, the number of privately owned cars on the roadin China is forecasted to increase seven-fold, from 20 to 140

million. The demand for fuel will increase accordingly.

Because of an economic slowdown in the West, it was expected

that demand for oil would ease somewhat (particularly inresponse to the huge increase in prices), and the price of a barrelof crude would drop. Indeed, a modest decline in demand

was noted, but it was more than offset by the supply restrictionsmentioned above, so that the supply/demand balance was asskewed as ever. The result was that oil soared even higher,to more than 140 US dollars a barrel, with very high volatility.

Gasoline prices also reached unprecedented levels.

We should bear in mind, however, that elevated prices ultimately

have a dampening effect on the level of demand, although thismay take some time to materialize. For this reason, the easing ofdemand may be less obvious than the minute-by-minute upticks

in the price.

New resource nationalism is

partly a result of the unprecedentedincrease in prices, leading to thebelief that high revenues arepossible without correspondinginvestments.

Dr. Philippe R. ProbstCorporate Head of New Ventures,Addax Petroleum Corporation Ltd.

Fig. 6: Booming commodities trade in China and India

Compound annual growth of commodities imports and exports (in %, 19902007)

25

20

15

10

5

0China France Germany India Japan Switzerland UK US

Source: United Nations Conference on Trade and Development (UNCTAD)

Exports Imports


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Energy

Our thesisThe high price of oil, combined withvarious subsidies and tax incentives,has led to an unprecedented diversionof commodities such as corn and sugarcane out of the food chain and intobioethanol production. Although this isnot directly responsible for food short-ages, politicians may place the blamehere, and insist that biofuel programsbe reduced.

Where to now?A few years ago, OPEC and other suppliers could turn the tapon or off, controlling oil prices fairly closely. From this supply-ledworld, we have now moved clearly toward a demand-driven

price for oil. If the fundamentals discussed briefly aboveare correct, the price rally though interrupted by the financialcrisis triggered in the autumn of 2008 is far from over.

Barring the kind of global crisis which could lead pricesexponentially higher, UBS foresees the possibility of a demand-

led price of around 200 US dollars a barrel by the year 2015.Even at this price, say market observers, there will still betoo much demand and / or too little supply.

What could be the consequences of such a situation? It is hardto make predictions about such a sensitive issue, with such wide-ranging implications, but these could perhaps be summed up

in three or four main scenarios (which may occur in combination):

gasoline rationing (which ever higher prices might bring

about de facto anyway, as financially less well-off consumers

are no longer able to afford to fill their tanks like before).This would almost certainly lead to reduced demand for

thirsty cars, which would have an impact on future automotiveproduction;

higher inflation, as increased energy costs are passed

on to consumers in higher prices for a wide range of goodsand services;

a political consensus to undertake the necessary steps

to increase the supply of oil (e.g. by opening certainenvironmentally protected areas to drilling, presentlyoff-limits), and / or to bring alternative energy sources

onstream much quicker, for example by returning to nuclearpower or massively gearing up renewable alternativessuch as biofuels (see below), solar, wind, and wave energy;

increased political tensions between countries producing oiland those consuming it.

For traders, the consequences are unclear. As oil prices rise,the value of deals also goes up. Thus, traders profits even though based on thinner margins should increase, too.

But the other side of the coin is that because the value ofeach trade has increased so sharply, the cost and complexityof financing each trade have also risen, along with the overall

risk of the deal. Well discuss this in more detail below.

Biofuels a realistic alternative?Spurred by rising oil prices and greenhouse gas emission targets,some governments regard the local production of agricultural

biofuels as a way of reducing dependence on imported oil andthus enhancing their energy security. Consequently, they have putin place tax breaks and subsidies for biofuel feedstocks, and even

legislated mandatory percentages of biofuel to be blended withgasoline. What they failed to do, however, was to anticipatethe market distortions that this could cause.

The biofuel conundrumUnlike fossil fuels, biofuels are a renewable energy source,produced from a broad range of agricultural products, such as

corn and soybeans (USA); sugar cane (Brazil);

wheat, sugar beets and rapeseed (Europe); palm oil (Asia).

Supported at the highest levels of government, the productionof biofuels has taken off as a real growth industry. The US

government, for example, wants such alternative fuels to meet15% of the countrys total gasoline demand within a decade,and has established generous subsidies to help make thathappen. American grain farmers have rallied enthusiastically

around this cause, embracing the (much more profitable)business of selling their corn crop to ethanol distilleries,instead of into traditional markets, where the corn ends up

either as feed for livestock or food products (Fig. 7).

And herein lies the problem. By creating attractive financial

incentives that encourage farmers to divert agricultural products(and arable land) away from the food chain, the biofuel industryhas instead contributed to food price inflation around the world.

It is very difficult to say exactly how much of the price increasecan be attributed to this diversion; in the case of corn, it isthought to be 10% to 15%. Spiralling prices particularly hurt

the poor, who have to spend a higher proportion of their incomeon food. Political unrest has been the result in some countries,as food riots have broken out.

Fig. 7: Global production of ethanol to soar

In billions of gallons

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20

15

10

5

02004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: Trostle

Brazi l (sugarcane feedstock) US China EU Canada


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Energy

The blame for high food prices cannot be laid entirely at the feet

of biofuels, however. Rice, for example, doubled in price in just aseven-month period in 2008, although it is not used as a biofuelfeedstock. Other factors come into play. Among others, food

prices are affected by weather anomalies (a sustained droughtin Australia), bad harvests, and the higher cost of farming due toincreased energy costs.

Most of all, prices are being driven up worldwide by the increaseddemand from the developing world. In China, for example,

where recent economic growth has allowed millions of peopleto change their eating habits, increased demand for meatis diverting 220 million metric tons of grain per year fromhuman consumption to livestock feed. Biofuels simply add

to existing pressures.

Search for efficiencyBiofuels are touted as a sustainable alternative to oil, since thecrop can be grown again every year. But does that make biofuelsa superior option in terms of efficiency?

For the moment, the answer to this question may still be no,at least for certain biofuels such as corn-based ethanol.

There exists a large disparity in the energy produced froma kilogram of corn compared to a kilogram of sugar cane.Moreover, crop yields in terms of liters of ethanol per hectare

also favor sugar cane.

But perhaps the biggest paradox concerning the efficiency of

biofuels is their large carbon footprint when the entire productionprocess is taken into consideration, from clearing the landand putting seed in the ground to actually pumping the fuel

at the gas station. Based on this life cycle analysis, the trueimpact of biofuels includes the emissions generated by removingthe original vegetation, plowing up existing biomass, irrigation

and fertilization, spraying with pesticides, harvesting andtransport every activity associated with farming the land.When everything is added into the calculation, biofuel

production is very carbon-intensive and may actually makethe climate situation worse.

This does not need to be the case, though. By investing in theproduction of the right biofuels, it is possible to avoid the needfor deforestation, reduce fertilization and irrigation requirements,

cut CO2emissions substantially and avoid competition with the

food chain.

Carbon capture and sequestration the technology exists,but does the will?One way to deal with greenhouse gas emissions is to reduce or

eliminate them. An alternative, however, is to capture the CO2before it is released into the atmosphere and store it, usually byinjecting it into an underground geological formation, where

it will remain trapped permanently. This process, called CarbonCapture and Sequestration (CCS), is meant to work on a large

scale, i.e. with big stationary CO2emitters such as coal-firedpower plants or industrial factories, and not with individual carsand trucks.

The CCS process can be broken down into a value chainconsisting of capture and separation, compression, transport bypipeline and finally injection. Each stage requires specialized

technologies. The final stage, CO2injection, may be used notonly to store the CO2but in some cases to produce additionaloil from declining oil fields. This injection method, called

Enhanced Oil Recovery (EOR), is already practiced on a limitedbasis in 2008 and can yield an additional economic benefitdepending on current oil prices.

CCS technology is feasible, and some two dozen projectsare being discussed around the world to try it out. If it were

to be implemented to capture and store the emissions fromthe top 250 emitters worldwide, a total volume of 3 to 4 gigatonsof CO2would be set aside, about 15% of the worlds annualanthropogenic emissions.

In terms of CO2, not allbiofuels are created equal.

Gilbert BrunnerChief Executive Officer,Fair Energy SA


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Energy

That is a promising figure. But in spite of its potentially huge

impact, a number of issues need to be resolved before thisindustry takes off. It is expected, for example, that the CCSindustry will develop along the same lines as the natural

gas industry, with stand-alone projects leading the way, leadingto main trunk lines being built and eventually, as more emittersare connected, to full-scale pipeline grids. It is imaginable that

this could lead to NIMBY-type conflicts (not in my backyard!)in certain places, possibly slowing the growth of the industryas these disputes are settled in or out of the courts.

But beyond these matters, the biggest issue of them all is,who will pay? If the industrialized countries are serious abouttackling emissions, and demonstrate the political will to bring

about such changes, then the capture, transport and storagemust be compensated in some way, so that the companiesentering the CCS arena have a chance of earning an attractive

return on their investment. This model has not been workedout yet, but points to a potentially new commodity to be traded:CO2itself.

For the commodity trading industry, the birth of a new tradeableproduct would mean a business opportunity of unknown,but potentially huge, scale at least for those traders preparedto grasp it. The path to success would certainly be fraught

with many challenges as well: the creation of a global market,the evolution of a patchwork of regulatory environments,and so on. At the same time, the world itself would arguably

be improved thanks to trading and ultimately removingthis carbon would traders then become heroes in our eyes?

Without CCS, it is unlikely thathumanity will be able to tacklethe challenge of global warming.

Eric Boudier

Partner,The Boston Consulting Group

Our thesisThe costs of implementing Carbon Cap-ture and Sequestration (CCS) on a largescale will be considerable. Until it be-comes economical on its own, subsidieswill have to finance the progress re-quired. If CCS is to succeed, therefore, itwill be just as important to have thepolitical will to push such projects for-ward as the technological know-how.


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Metals

The worlds building blocksIndustrial metals iron ore, copper, nickel, lead, zinc, tin,aluminum are the building blocks of the worlds infrastructure.

For years, their price levels have been largely determinedby demand from the developed world. According to this

conventional wisdom, an economic slowdown in theOrganization for Economic Co-operation and Development(OECD) countries should result in easing commodity prices,as investment in projects requiring these metals levels off or even

declines temporarily. This is no longer the case. Demand fromBrazil, Russia, India and China (BRIC) the next billion is not only compensating for lower demand from the OECD,

but is growing so dramatically that we must now think in termsof long-term scarcity.

The supply side: bad newsProduction of base metals is not keeping pace with globaldemand. Although there are some exceptions to this gloomy

outlook, the main reasons why we can expect a long-termsupply crunch can be summed up as follows:

a lack of current supply due to years of underinvestment;

a shortage of projects and a skills shortage to build them;

falling grades / production; lower quality;

higher costs and delays.

According to UBS, grades for many mined materials, for examplecopper and iron ore, are falling. Meanwhile, the mining

operations that extract these materials are becoming moregeologically challenging, as they must go deeper undergroundthan before. Whats more, compared to today, future mines

are likely to be located in remote, higher-risk countries such as

Congo or Russia. Lastly, quality issues will result in rising costs,and marginal costs are likely to become an increasingly important

component in determining longer-term commodity prices.

Our thesisThanks to the booming economies ofthe BRIC countries, their demand forindustrial metals for housing, infra-structure projects and consumer dura-bles will continue to surge, far outpac-ing supply. Prices will remain high.


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Metals

Demand: no end in sightThe growth of the emerging economies is leading inevitably toincreased urbanization, and increased consumerism. Both factorshelp to drive demand for industrial metals. Urbanization means

demand for infrastructure and housing, while consumerismincreases demand for durable goods such as cars, refrigerators,TVs, etc. In Beijing alone, 30,000 new cars are being added to

the roads a month one thousand every day.

Example: steelSteel has only recently joined the club of quoted commodities;

before its inclusion in the London Metals Exchange in 2008,its price was not clearly visible to the public. Nevertheless,as a vital component of any economy, it is definitely indicative of

the way demand is developing (Fig. 8). Also, since about 50%of the worlds iron ore, from which steel is made, is suppliedby just three companies BHP Billiton, Rio Tinto and Vale

prices are negotiated and thus somewhat less volatile.

Ten years ago, Chinas steel consumption was about 30 million

tons per year. In 2007, China used 434 million tons, more thanthe USA and Japan combined, and about 35% of the entireworlds steel consumption. The countrys annual growth in steel

consumption is expected to rise at more than 12% ahead ofChinas 8.5% economic growth rate. Even though the countryis the worlds largest producer of iron ore, it still had to import

375 million tons in 2007 to meet demand for steel.

India is presently consuming steel at about one-seventh the rate

of China, but growth there is booming as well.

No wonder that iron ore prices have risen from 65 US dollars

a ton in 2006 to 177 US dollars a ton in April 2008 and areexpected to rise more next year (Fig. 9).

Fig. 9: Global crude steel supply/demand balance

2004 2005 2006 2007 2008 2009 2010

China steel production mt 271 354 424 488 540 594 650

Growth % 23.9 30.5 19.8 15.2 10.6 10 9.4

Total world steel production mt 1035 1112 1231 1322 1404 1476 1567

Growth % 9.6 7.3 10.7 7.4 6.2 5.2 6.1World ex-China steel production mt 764 759 807 834 864 882 917

Growth % 5.3 1 6.4 3.2 3.6 2.1 3.9

EU (15) steel consumption mt 159 153 189 199 195 193 199

US steel consumption mt 126 115 134 119 118 119 124

China steel consumption mt 285 353 387 430 487 535 585

Growth % 10.9 23.8 9.5 11.2 13.1 9.9 9.4

India steel consumption mt 32 36 47 52 63 65 63

Rest of world mt 435 454 473 521 541 566 597

Total world steel consumption mt 1037 1112 1231 1322 1404 1476 1567

Growth % 9.8 7.3 10.7 7.4 6.2 5.2 6.1

World ex-China steel consumption mt 752 759 844 891 917 942 982

Growth % 9.4 1 11.2 5.6 2.9 2.7 4.3

Price forecast Euro (hot rolled coil, HRC) US$/t 515 477 503 594 870 835 772

Sources: International Iron and Steel Institute (IISI), Climate Research Unit (CRU), UBS estimates

Fig. 8: World steel production growth and steel price

20

15

10

5

0

5

10

15

700

600

500

400

300

200

100

0

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

2008

Sources: International Iron and Steel Institute (IISI), Climate Research Unit (CRU)

y /y Change in world steel p roduction (in %) Hot rolled coil (HRC)


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Metals

Precious metals a store of value in a crazy worldAside from their centuries-old use in jewelry, the attractivenessof precious metals primarily gold, silver and platinum as aninvestment commodity lies in their capacity to serve as alternative

assets and thus as a store of value which is less vulnerable to,or even countercyclical to, the economic swings and pressuresthat affect the price of traditional investments. Searching for

assets with low correlations to equities and other conventionalsecurities, investors view precious metals as a means ofdiversifying their portfolios, mainly against inflation fears and

as a hedge against future uncertainties such as politicalinstability. Investment funds are increasingly buying preciousmetals for this reason, adding to the demand, so fueling

the recent increase in prices.

A barometer of global eventsFinancial markets respond to any major change in the global

status quo, and precious metals are no exception. Prices can risequickly on all kinds of geopolitical developments, from newsof a military conflict to election results, and even natural disasters

such as droughts. The precarious political situation in Iraq

and the Middle East, the subprime crisis and subsequent lossof confidence in our financial systems and companies, and

the outcome of the US Presidential election in November 2008(uncertain at the time this report was established), can all beexpected to maintain upward pressure on precious metal prices

over the near term.

Role of interest ratesHistorically, the price of precious metals has been more or less

inversely proportional to the strength of the dollar. Since thedollars attractiveness is, in part, a function of the rate of interestthat investors expect to earn on their dollar holdings, it followsthat as US dollar interest rates decline, demand for precious

metals increases, driving prices higher. And indeed, this is whatwe have seen over most of the past decade, with preciousmetal indices in the summer of 2008 about 3.5 times higher

than in the year 2000 (Fig. 10, 11).

Interest rates influence the price of precious metals in an

additional way. The cost of financing is one of the componentsof the premium that must be paid for a forward metals contractover the spot price. For this reason, investors monitor key rates

such as the overnight Fed Funds rate and the rate on USTreasuries, especially the 30-year long bond.

Supply shocksPrecious metal prices are also vulnerable to supply restrictions,which can be brought about by a variety of causes, for example:

a slowdown of mining activities, resulting in less explorationor fewer discoveries;

labor unrest in precious metal producing regions of the world;

pressure from environmental groups, which can increasethe costs of mining or curtail it altogether.

OutlookThe outlook for precious metals is linked to the overall

economic outlook, in particular the strength of the dollar.In fact, as a traded commodity, gold exhibits many of thecharacteristics of a currency rather than a metal like copper

or tin. Continuing uncertainties in the equities markets,and ongoing fears about the dollars value and rising inflation(fueled in large part by the rise in price of other commodities

such as oil and agricultural products), will therefore keepprecious metals attractive as an alternative investment, andkeep traders busy as well.

Our thesisGold and silver should benefit from theweak dollar, high price of oil, and fearsof inflation.

Fig. 10: Gold price 19962008

US$/oz

1000

800

600

400

200

Jan 1996 Jan 1999 Jan 2002 Jan 2005 Jan 2008

Source: UBS Investment Bank

Fig. 11: Silver price 19962008

US$/oz

Jan 1997 Jan 1999 Jan 2001 Jan 2005Jan 2003 Jan 2007

Source: UBS Investment Bank

21

18

15

12

9

6

3


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Agricultural(so) commoditiesBiofuel production (thanks again to politically expedientincentives) has shifted a portion of the worlds agriculturalcommodities out of the food chain and into energy production.

In the USA, for example, ethanol usage takes up 29% oftotal domestic corn production, up from 17% in 2005 06.

Urbanization has reduced available acreage in many markets,and the amount of arable land per capita is dropping (Fig. 13).More land needs to come onstream, but quality is an issue,

and accordingly, yields may be lower. On the other hand,some observers believe big improvements in this areacan be expected in Ukraine, Russia, Kazakhstan, Poland,

Argentina and Brazil.

Fertilizer supplies are also a factor in production, and they

remain tight. Demand and prices are on the rise.

Politicization of agricultural markets will certainly continue.

Rice is a good example. Panic over high prices led somecountries (for example India, Thailand, Japan, Indonesia, Vietnamand China) to restrict exports in an attempt to counter

domestic inflation and ease potential unrest over shortages.Together with modest supply growth, this merely tightenedthe fundamentals and drove global prices even higher.

Should food prices continue to climb, particularly in thedeveloping world, we may well see calls for interventionin the markets on humanitarian grounds resulting in more

artificially induced distortion. We may also see a changein public attitudes toward biofuels, as they perhaps come tobe regarded as indirectly accountable for human suffering

in those parts of the world where elevated prices for basic

foodstuffs do indeed cause hardship.

Agricultural commodities are we all going to starve?Agricultural products, the so-called soft commodities, have ralliedsharply in 2007 08, leading to higher food prices around theworld a situation which has gained global media attention,

and become the subject of UN crisis-level debates.

Agriculture has long been a sector of the economy subject to

political intervention of all kinds. Subsidies, stockpiling, tax breaksand export restrictions all aim to protect domestic productionand manage supply, but ultimately distort market prices.Recently, however, new factors have begun to crop up:

The next billion want to eat better. Rising incomes in theemerging markets mean changing diets, especially more

meat consumption. In 1980, meat consumption (globally)was about 28 kg per person. Estimates for 2010 put thissame figure at 41 kg. This is a 46% increase per capita.

When population growth during this same period is factored in,the incremental demand is staggering (Fig. 12).

Our thesisAgricultural output has always beensubject to the hazards of the realworld drought, floods, bad harvests,etc. as well as supply distortionsbrought about politically. Now we areentering a phase of world agriculturalproduction in which an additional onebillion people are demanding animproved diet. Prices will rise until newproduction methods allow supply tocatch up with demand.


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Agricultural (soft) commodities

Fig. 12: Per capita food consumption

In calories per capita per day

4,000

3,800

3,600

3,400

3,200

3,000

2,800

2,600

2,400

2,200

2,0001964/66 1974/76 1984/86 1997/99 2015 2030

Source: Food and Agriculture Organization of the United Nations

Industrial countries Developping countries

Fig. 13: Share of world population considered urban

In %

80

70

60

50

40

30

20

10

0

1950

1960

1970

1980

1990

2000

2010

2020

2030

2040

2050

Source: United Nations Population Division


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InspectionA buyer of commodities agrees with the seller not only the priceof the goods to be delivered, but also a number of other

conditions which define the quality of the products purchased.The inspection industry steps in at this point to make

an assessment of the quality on behalf of the buyer and verifythat the goods are as advertised. This may include a rangeof activities, from physical inspection, sampling, and testingto calibration of instruments, supply chain audits, supervision

of loading and certification.

The inspection industry is evolving in two fundamental ways.

First, profit margins in the industrys traditional business ofproviding trade-related services are declining. This has ledthe larger firms those which have the necessary resources

to diversify into upstream services. For example, instead of focusingonly on the transactional aspects of the oil business, SGS hasacquired companies that support oil companies in the exploration

process, including the provision of teams of geologists and otherexperts. Profitability here is more attractive.

Inspection companies are also becoming more specializedin response to a second trend, namely the evolution in the wayquality which they are responsible for assessing is defined.Particularly in areas that involve environmental protection,

regulatory or legislative changes may introduce stringentnew requirements that have to be met by sellers of commodities.Ensuring that these rules are being followed often requires

a higher level of technical expertise than previously neededin the inspection companies, and they are responding to thisnew requirement by recruiting highly specialized and costly

experts in a much wider number of fields than ever before.

Commodity traders buy and sell

the worlds cornucopia of raw materials.But these trades are financial transactionsand do not usually involve the actual

physical transport of the traded

commodities from one spot on the globeto another. Following the moment

the goods change hands legally, a numberof other services come to the fore:inspection, insurance and shippingare among the most important.

The impact onancillary businesses


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The impact on ancillary businesses

InsuranceHere again, we note that the increased price of a givencommodity raises the value of an individual deal (the volume

remaining the same, of course), with repercussions forinsurers. For example, insurers are assigned country limits by

their reinsurers, and larger deals mean that they now approachthese capacity limits quicker, particularly for countries such asRussia, ex-CIS countries and Turkey, where such limits are closelymonitored. This is pushing insurance rates higher.

Another trend that the insurance industry is expecting stemsfrom Basel II. Among other stipulations, Basel II gives banks

that finance commodity transactions a degree of capital reliefby allowing them to replace the rating of the buyer by the ratingof the insurer. This will create additional business opportunities

for insurers who are Basel II-compliant.

Shipping

To ship commodities from the seller to the buyer, an appropriatevessel has to be chartered. Price swings of a commodity, no

matter how dramatic, have no effect on the cost of shipping it.

The run-up in the price of a barrel of oil during 200708, for

example, did not have a direct impact on the cost of transportingone. So the fact that the price of hiring a Very Large CrudeCarrier (VLCC) a supertanker of 300,000 tons skyrocketed

100% since November 2007 to the end of July 2008 has tobe attributed to one key factor: demand. Demand for oil alsodrives demand for the means of transporting it, and if the supply

or availability of tankers doesnt keep pace with this demand,the cost of transportation will increase.

Conversely, as the economic crisis has taken hold and oil demandhas softened, highlighted by OPECs decision to reduce oilproduction by 1.5 million barrels per day, so does the demand for

tankers to transport it. The VLCC mentioned above can nowbe hired for around half the rate that would have been chargedin July. Current rates are back to November 2007 levels.

Shipyard order books clearly reflect the optimism felt whendemand was high, with some 1,400 new vessels due for deliveryin the next four years, equivalent to an increase of over 30%

of vessels on the market. However, with oil demand andtherefore shipping rates decreasing, and an oversupply of vessels

on the market, some ship owners with vessels on order may findit difficult to repay the financing on their new vessels. Even withthe planned phase-out of some 384 older, single-hulled vessels,and the potential inability of inexperienced shipyards in China

to meet delivery deadlines, an oversupply looks increasingly likely.

With the essential credit needed to provide liquidity in the

shipping market becoming significantly more difficult to obtainas the banks tighten their lending criteria, and the worlds majoreconomies heading directly into recession, it would seem that

there will probably be harder times ahead for the shippingindustry.

OutlookIncreasing demand for raw materials means more global trade,

pure and simple. Thanks to this growth, the ancillary businessescan expect to do well in the future provided they havethe capacity to deal with the ever-increasing size of the trades.

Some firms may not be in such a position, so it may be reasonableto expect a degree of industry consolidation.

If the OPEC countries continueto alter their output and the volatility ofoil supply remains, the question is:Could it have a major impact

on the supply of shipping capacity?Marc Lecoanet

Chief Executive Officer,Riverlake Shipping SA


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So far in this report, we have focusedmore on the dynamism of commoditiesand less on the dynamism of commodity

traders.

Here, however, we turn our attentionto these companies and the newchallenges they face. The price surgethat has affected nearly every category

of commodity has also unsettledthe firms who are in the business of buyingand selling these raw materials.

Their fundamental activity trading is still the same. But in running theirbusinesses, many of the management

issues they must cope with haveintensified.

Like any other business, a commoditytrading firm has revenues to generate,costs and expenses to control, competitors

to beat and stakeholders to satisfy.What are the unique managementchallenges this industry faces?How has the run-up in commodity

prices affected these challenges?

Risk is everywhereTrading is a business surrounded by risk: price risk, counterpartyrisk, regulatory risk and many similar elements must all beunderstood, quantified and properly managed, or trades

can swing easily from profit into loss. Risk management is a vital

part of any trading operation.

But risk is increasing. For example, take two trades, each forthe identical volume of a given commodity, but separatedin time by one year. If the price of the traded commodity rose

during that year by 100%, then the total value of the seconddeal even though it is for exactly the same amount of the rawmaterial in question is also double the value of the previous

deal. This can affect the operation of the trade itself. For instance,is the creditworthiness of the buyer sufficient at this new level?The buyers credit risk is now an issue. Perhaps the deal can befinanced as easily as before, but perhaps the buyers bank

will require new conditions, possibly eating into the deals profitmargin. Insurance providers covering the trade must alsobe able to take on the required level of risk. Business may shift

to larger companies, leaving relatively small insurers behind.

What are the strategic options open to a smaller trading

company that is no longer able to make such high-value dealscompetitively? If prices continue to rise, such a companymay be restricted to ever smaller trades. Or perhaps it forms

an alliance or merges with a larger house. This would implythat increased commodity prices may well encourage industryconsolidation.

The need for talentEvery company, in every industry, needs talented people working

in it to make it successful. However, unlike other professionsin the business arena, such as marketing, operations management,or finance, it is not possible for potentially keen young university

students to gain exposure to commodity trading within theirstudies, even at the MBA level. The lack of a talent pipelineleading students directly into the industry makes it difficult

for trading companies to find qualified staff, not just in tradingoperations but also risk management, financing operations,and shipping. An increasing number of companies are therefore

competing for the same people.

Addressing this issue has been identified as a strategic priority

for the industry. Accordingly, the Geneva Trading & ShippingAssociation (GTSA) embarked last year on a mission to developan educational program to fill this gap, and in 2008 received

the green light for a specially designed Masters degree

Critical issuesfacing the trading industry

Our thesisIncreased risk is, from a strategic pointof view, an obstacle to growth, giventhat smaller companies may not beadequately equipped or capitalized tohandle it.


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Critical issues facing the trading industry

in International Trading, Commodity Finance and Shippingdelivered through the University of Geneva. The course,taught in English, combines in-class and in-company work,over a period of 18 months (Fig. 14).

In addition, a series of executive courses has been developed,providing the opportunity for professionals active in other sectors

to change business direction. At the same time, to createawareness of trading as a profession, the GTSA is also involvedin developing communication campaigns ultimately aimed

at stimulating more interest in the sector.

Ethical issuesBut could more information about the business and role ofcommodity trading especially when price increases for foodand gasoline make headlines on a daily basis be a double-

edged sword?

With high commodity prices causing misery on a global scale,

could traders be seen as responsible at least to some degree?Likewise, the political debate whether to continue offeringincentives to divert certain food commodities into energy

production is perhaps turning a spotlight on commodity trading

that is not altogether flattering. Companies and entireindustries must manage not only their business but also

their reputation. In the present environment, this must alsobe seen as a strategic priority.

Trade financeThe choice of trade finance partners is also a critical manage-ment issue for commodity traders, since restricting a traders

financial ability to carry out a transaction effectively limitsits options to do business.

Sharp price increases mean that traders often need additionalcredit lines now to finance the same volume of cargo theybought for much less money as recently as one or two years ago.

Several banks may become involved in a single deal, increasingadministrative costs for the traders and making the entireprocess much more complex to manage.

Ten years ago, if the market moved50 cents a barrel in a day, we allthought Wow! Whats going on?Now we have moves of four, ve

ten dollars a barrel and everybodyyawns. Exposures are much biggertoday, so we really have to understandthe risks that we are facing.

Gati Al-JebouriChief Executive Officer,

Litasco

Fig. 14: Master of Arts in International Trading, Commodity Finance and Shipping

In collaboration with the Geneva Trading & Shipping Association (GTSA), the University of Geneva now offers a Master of Arts program

Semester 1 Semester 2 Semester 3

Components of Trading Commodity Hedging and Price Risk Commodity Finance andFinancial Risk Management(Financial Liquidity and Trade Flows)

Basics of commodity trading,worldwide trade flows

Hedging tools and techniques Insurance

Commodity price mechanisms Options Accounting and internal auditing

Energy products market Commodity price risk issues Financial instruments overview

Agri-commodities market Applied statistics and probability Credit analysis

Metals, ores, minerals and non-tangiblecommodities (emissions trading, electricity) market

Technical analysis Types of financing

Shipping, transport (rail, barges) and logistics Shipping market Credit risk management

Environmental and ecological issues Legal aspects The organization and human resources

Business game / simulationSources: Geneva Trading & Shipping Association (GTSA), UBS outlook


28/38


As one of the worlds leading financial institutions, UBS isable to call upon a very large array of resources and expertise worldwide to custom-tailor solutions for its clients in

commodity trading and allied businesses (Fig. 15).

In this context a banks role in Commodity Trade Finance (CTF)is to provide transactional financing for the purchase of goodswhich loan is directly reimbursed by the proceeds of sale.

In general this type of financing is made on an uncommittedand case-by-case basis. It therefore differs from the classicalCorporate Banking financing, in which credit is offered based

on the borrowers own and durable free cash flow (balancesheet approach).

When it comes to structuring the financing UBS analysis focusesin particular on the following aspects.

Does the client have a clear business strategy and a real tangibleadded value on the market it is active in? Follows an assessmenton what are the main risks involved in this business, (for example

performance risk of suppliers and buyers, price fluctuation risk,internal risk management and other risk factors such asenvironmental risks)?

Particular focus is made on the counterparts risk management.What limits are used, for example daily maximum Value at Risk?What types of control tools are used? Who controls and

implements these rules?

In addition, the banks direct counterpart should have

a reasonable level of equity and financial resources to be able

to cope with inherent transaction losses and/or other damagesthat could occur within a financed transaction in a worst-case

scenario, without the financing banks taking any first/ total loss.Stress scenarios then evaluate the size of a worst-case scenarioloss, and assess if this amount is digestible for a given

counterpart.

Then the bank establishes a clear risk appetite level for each

counterpart, regardless of commodity price increases and/oradditional business opportunities.

What UBS has to oer


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What UBS has to offer

On a macroeconomic level, UBS also uses a global exposurereporting system encompassing in particular exposuresper commodity, geographic region, type of exposure

(cash, contingent, prefinancings, and so on), all of whichare compared with the preapproved banks strategic business

guidelines.

Commodity trading for private and corporate clientsUBS can bring together different parts of the banks business

(in synergy with Commodity Trade Finance) to contributeto a full suite of business solutions, among them:

Derivative flow sales, providing standard and lightly structuredderivatives direct to clients, as well as market reports, researchand other up-to-the-minute market information and intelligence;

structured products, involving derivatives and nonhedgeablerisks not to mention their often significant size and tenor;commodities finance and capital investments expertise,

specializing in asset-based financing transactions for equitytake-out, refinancings, and acquisitions that provide the clientwith direct access to UBSs balance sheet; market-making

both warehousing and syndicating risk.

In precious metals, the bank offers trading and clearing

of gold, silver, platinum, palladium, rhodium, as well as coins.It counts among its clients producers, central banks, fundsand private clients.

UBS looks for counterpartswith a clear business strategy,solid internal risk managementand an acceptable equity base.

Mark GubbayHead of Commodity Trade Finance,UBS AG

Preproduction

Production

Transportation

Transformation

Postproduction

Transportation

Port storage

Transportation

Free On Board (FOB)

Transportation

Port discharge

Port storage

Sales Agent delivery

Prefinancing

Tolling

Postproduction financing

Postshipment financing

Reimbursement

Fig. 15: Transaction chain

Source: UBS outlook


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In a word: demand. Until very recently, commodity prices werelargely determined by supply issues and constraints. What affectedprices were such things as harvests and hurricanes, wars and

work stoppages events that had an impact on the supply ofthe raw material in question, or at least on the reliability of

its distribution.

These potential supply constraints are still important, but theyhave been overshadowed by the sheer power of demand to bid

prices ever higher. And without a doubt, the greatest influenceon the demand for raw materials today, and for the foreseeablefuture, is the growth of the Chinese economy (and to a lesser

extent, Indias).

According to one study, Chinas urban population will grow

by nearly 300 million people by 2025. The countrys ravenoushunger for building materials, energy, food, and consumer goodswill continue, meaning that many of the worlds basic raw

materials will continue to be gobbled up by Chinese importers,or by companies using them to manufacture goods for exportto China (Fig. 16, 17).

During most of 2008, it seemed that

nearly every day, newspaper headlinesscreamed out more news related to or caused by rising commodity prices:

the price of gasoline forces people to

rethink their need for bigger cars;airlines need to cover their higher fuel

costs so they begin charging passengersfor luggage; political leaders expressanger at speculators behind the run-up;

meanwhile, in some countries food pricestrigger rioting in the streets.

What was happening?

A look ahead

Fig. 16:

China aluminum consumption long-term projection

China aluminum consumption profile based on western world per capita trends (mt)

25

20

15

10

5

0 2000 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024

Sources: United Nations, UBS estimates

Fig. 17:

China copper consumption long-term projection

China copper consumption profile based on western world per capita trends (mt)

15

12

9

6

3

0 2000 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024

Sources: United Nations, UBS estimates


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A look ahead

In fact, Chinas foreign policy is largely dominated by the search

for oil and other natural resources. This policy is pushing Chinainto the arms of some unsavory providers of oil and metals, suchas Zimbabwe and Sudan, which sells 64% of its oil to the

Chinese. In 2006, Chinas president went on a highly publicizednatural resources shopping safari across the continent of Africa,resulting, among other outcomes, in a 45% stake in a Nigerian

offshore oil block and a deal to mine up to 12 billion US dollarsof copper ore in Congo a sum which is more than three timesCongos annual budget. China is also competing for oil

exploration opportunities in Canada and Venezuela; has boughtan iron ore mine in Peru and a stake in another in Australia;and the list goes on.

So based on this extraordinary dynamic, what is the outlookfor the commodities trading business? On one hand, trading canonly benefit from this increased demand. And as we have seen,

new opportunities are also emerging, such as carbon trading.

Moreover, investors have always wanted to play volatile markets,

so long as commodities remain volatile, they will attract trading

and hedging.

However, on the horizon there are some risks to be considered:

If China (or possibly India) would be affected by a worldwide

economic contraction, this could lead to a dramatic correctionin commodity prices, especially oil and metals. As we go topress in October 2008, an economic downturn is almost certain,

but it is not yet clear how severe a scenario might actuallymaterialize.

On the other hand, China and various other developingcountries may end up cutting demand levels on their own:For several years, these countries have subsidized the price

of petroleum products, to the aggregate tune of some 150 billionUS dollars a year. Is this sustainable? Chinas annual subsidyof 50 billion US dollars may seem small compared to its budget

surplus, but not every country will be able to afford to maintainsuch expensive support. Indonesia and Pakistan, for example,have already reduced their subsidies, and it is highly likely that

after the 2008 Olympics are over, China may make a similarmove. Faced with an election in 2009, India would probablyfollow suit when the political dust has settled. Will cutting

these national subsidy bills dramatically change the demandgrowth in the region?

Some observers believe that with the recent rise in commodityprices, investors have increasingly taken notice of opportunitiesin this asset class, moving huge amounts of money

into investment funds anticipating (or some would say,speculating on) further price increases (Fig. 18). The structureof futures contracts, plus low margin requirements, have added

to the volume invested. The result is that, in the opinionof some investors, a bubble has been superimposedover the legitimate fundamental factors, and bubbles do tend

to burst at some point.

Higher prices mean that the value of individual deals is alsoon the rise. This increases risks for insurers and trade finance

partners.

As prices rise, governments that subsidize certain commodities

(especially oil and its derivatives) may experience strainedbudgets, which could lead to political destabilization.Some countries will weather this better than others.

Likewise, since higher food and fuel prices take up a larger

percentage of the discretionary income of the poor, comparedto the rich, should we expect more destabilization in developingcountries that are more vulnerable to popular unrest?

Obviously, not all of these risks are related to trading activities,but rather to the long-term price trend itself. Trading opportunities,even given these riskier scenarios, continue to be bright.

Fig. 18: Noncommercial account positions in futures*

Number of contracts

2,100,000

1,800,000

1,500,000

1,200,000

900,000

600,000

300,000

0

300,000

600,000

900,000

1,200,0001997 2000 2003 2006

Sources: Commodity Futures Trading Commission (CFTC), Bloomberg, UBS Wealth Management Research

* Noncommercial accounts are investors who hold futures or options froma nancial investment perspective (speculative accounts). In historicalterms, these positions reached record high levels in the rst half of 2008.Counterparties have been commercial accounts, which hedged

their production due to higher commodity prices. The shown valuesare an aggregation of contracts from crude oil, to copper andagricultural commodities.

All Long All Short All Net


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Theses

During 2007 and 2008, the prices of almost every categoryof commodity saw a dramatic swing upward, causing havoc inthe markets and real pain for many consumers around the world.

Since the sensational headlines announcing these ever higher

prices could easily distract one from understanding thelonger-term trends and developments that underlie thesemovements, UBS outlook took a step back from the soundand fury of the day-to-day news, and identified in this document

a number of theses which we believe will frame the futuredynamic of the commodities business.

Thesis 1: Energy oilHigher oil prices are here to stay. That means pain in the shortterm, but high prices may be the incentive needed for the serious

development of alternative energy sources, such as biofuelsand other renewables. For commodity traders, this will lead toenormous medium and long-term opportunities.

Thesis 2: Energy biofuelsThe high price of oil, combined with various subsidies and tax

incentives, has led to an unprecedented diversion of commoditiessuch as corn and sugar cane out of the food chain and intobioethanol production. Although this is not directly responsiblefor food shortages, politicians may place the blame here, and

insist that biofuel programs be reduced.

Thesis 3: Energy carbon capture and sequestrationThe costs of implementing Carbon Capture and Sequestration(CCS) on a large scale will be considerable. Until it becomeseconomical on its own, subsidies will have to finance the

progress required. If CCS is to succeed, therefore, it will be just

as important to have the political will to push such projectsforward as the technological know-how.

Thesis 4: MetalsThanks to the booming economies of the BRIC countries,their demand for industrial metals for housing, infrastructureprojects and consumer durables will continue to surge,

far outpacing supply. Prices will remain high.

Thesis 5: Precious metalsGold and silver should benefit from the weak dollar, high priceof oil, and fears of inflation.

Thesis 6: Agricultural (soft) commoditiesAgricultural output has always been subject to the hazards ofthe real world drought, floods, bad harvests, etc. as wellas supply distortions brought about politically. Now we are

entering a phase of world agricultural production in whichan additional one billion people are demanding an improved diet.Prices will rise until new production methods allow supply

to catch up with demand.

Thesis 7: Critical issues facing the industryIncreased risk is, from a strategic point of view, an obstacleto growth, given that smaller companies may not be adequatelyequipped or capitalized to handle it.

Recapping our thesesat a glance


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The following individuals took part in an expert panel on thefuture of commodity trading, provided valuable information andadvice to the editors of this report, or in some other fashion

added to and enriched its content. The final document may notnecessarily reflect their personal views in every detail, but it

was the contributions of these experts and professionals whichmade this report possible, and the editors would like to expresstheir sincere thanks for their time and input.

Gati Al-JebouriLitasco, GenevaEric BoudierThe Boston Consulting Group (BCG), Oslo

Gilbert BrunnerFair Energy SA, Geneva

Bertrand ChampionPSA International SA, GenevaDominique CurratBunge SA, Geneva

Geert DescheemaekerGeneva Trading & ShippingAssociation (GTSA), Geneva

Roland EigenmannLia Oil SA, Geneva

Ramon M. Esteve IIIEcom Agroindustrial Corp. Ltd., Pully

David FransenVitol SA, Geneva

Alexandre HirschSGS SA, Geneva

Marc LecoanetRiverlake Shipping SA, Geneva

Philippe LinderAllseeds Management SA, Geneva

Christophe MarquotIRIA SA, Geneva

Dr. Philippe R. ProbstAddax Petroleum Corp., Geneva

Vincent de SpoelberchIRIA SA, Geneva

Gilles ThieffryGTLaw, Geneva

Tim TurneyCargill International SA, GenevaCornelis VrinsAllseeds Management SA, Geneva

A word of thanks


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PublisherUBS AGMarketing Corporates

and InstitutionsKathrin Wolff Schmandt

P.O. Box, 8098 ZurichSwitzerland

Senior EditorMichael Oetzel

Editorial teamMark GubbayDr. Daniel KaltAndreas Maag

Markus Suter

Principal authorJames Wade

Editorial deadlineOctober 2008

Publication dateNovember 2008

LayoutPeyer-Bhler Kommunikation GmbH

Zurich, Switzerland

PhotosPage 1 Istockphoto/Jrgen JacobsenPages 9, 13, 19 MasterfilePage 31 Istockphoto/Andrey Volodin

PrintUD Print AG

Lucerne, Switzerland

[email protected] +41-44-234 53 25Fax +41-44-234 51 97

Order addressUBS AGPrinted and Branded Products

P.O. Box, 8098 Zurich, [email protected] / outlook

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DisclaimerThis publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sellany investment or other specific product. Although all information and opinions expressed in this publication were obtainedfrom sources believed to be reliable and in good faith, no representation or warranty, expressed or implied, is made as toits accuracy or completeness. All information and opinions indicated are subject to change without notice. This publicationmay not be reproduced or copies circulated without prior authority of UBS or a subsidiary of UBS. UBS expressly prohibitsthe distribution and transfer of this publication to third parties for any reason. UBS will not be liable for any claims orlawsuits from any third parties arising from the use or distribution of this publication. This publication is for distributiononly under such circumstances as may be permitted by applicable law.

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