Goldman Sachs Restructures Its Commodities Business Amid Regulatory Pressures

NEW YORK (TheStreet) -- When Goldman Sachs' (GS) reported its first-quarter earnings last month, it appeared that the controversial decision to stay in the physical commodities business had paid off.

Yet, regulatory scrutiny and logistical management may make some aspects of the business too cumbersome for Goldman Sachs to manage.

Goldman Sachs became a player in the commodities business after its 1981 purchase of J. Aron & Company, a commodities trading firm. Goldman Sachs CEO Lloyd Blankfein started his career at J. Aron and its CFO, Harvey Schwartz, is also an alumnus of the firm.

In 2014, Goldman Sachs generated $15.197 billion in net revenue in its institutional client services division that houses the bank's fixed income, currency and commodities activity, with that division contributing $8.461 billion. Total net revenue for the bank was $34.528 billion.

Much of the bank's commodities revenue comes from market making or trade facilitation activities. In addition to facilitating the trading of commodities, Goldman Sachs has at various points taken physical ownership of commodities as well as the means of production and storage. 

In recent years, that practice has come under scrutiny following several high-profile cases. The bank held a position in Metro Trade Services International, a Detroit-based warehouse company that stored aluminum. 

A 2013 New York Times investigation of the banks' aluminum business claimed that the bank manipulated prices by creating artificial shortfalls in supply. The bank shed its position in Metro soon after the report. While the bank was not penalized for its involvement with Metro, the report was used in November as evidence in a Senate investigation into the appropriateness of banks' roles in the commodities business.

Federal Reserve Governor Daniel Tarullo testified at the Senate hearing about the environmental and logistical risks posed by banks engaged in the physical commodities business. He also said the Fed plans to issue rules for banks later this year that would address the risks he sees. These rules could take the form of higher capital requirements that would make the business less profitable.

Goldman Sachs is now in talks to sell its two Colombian coal mines -- perhaps even at a loss -- after a series of labor, environment and regulatory issues made the position untenable. Goldman Sachs bought the first mine in 2010 for $151 million and the second one in 2012 for $407 million.

Professor Saule Omarova, a law professor at Cornell University who testified at the November Senate hearing, sees two possible interpretations of Goldman's decision to sell off part of its commodities business: A sale could suggest the bank is heeding congressional and regulator concerns. Or Goldman's retreat from Colombia may be a temporary fix to meet short-term economic needs and not represent a longstanding policy position.

Without regulations, Omarova fears, the bank may re-enter the physical commodities business when conditions are more favorable and profitable.

"When financial institutions operate coal mines, it creates interdependencies in the system," Omarova said. "Are banking regulators equipped to handle these interdependencies?"

In addition to fulfiling the tall order of monitoring traditional banking activity, Omarova pointed out, the Fed would have to surveil the whole economy and be acutely attuned to the international commodities market -- not a task the regulator appears equipped to handle.

For its part, Goldman Sachs acknowledged in its annual report some of the difficulty of remaining involved in the physical commodities business: "Our commodities activities, particularly our physical commodities activities, subject us to extensive regulation, and involve certain potential risks, including environmental, reputational and other risks that may expose us to significant liabilities and costs."

While the bank is exiting some of its more controversial positions in the physical commodities business, a spokesman has said the bank may at times take ownership or possession of commodities so as to complete certain transactions.

Even though banks might not have legal ownership or physical possession of commodities, they can still control output and exert influence, Omarova noted.

During an earnings call with analysts last month, though, Goldman Sachs' management seemed committed to staying in the commodities business, especially since trading in the fixed income, currency and commodities arena served as a revenue driver and Goldman Sachs benefited from being one of the few players left in the space.

"It really reinforces the needs for firms like Goldman Sachs to be in a position to provide our clients with liquidity, with financing capacity, and so for us, as you know, we have been in the commodity business forever," said CFO Harvey Schwartz. "We know how valuable it is to our clients. We are hugely committed to it. In terms of regulation, we will see how the regulation evolves, and again we will stay in active dialogue with the regulators."

Omarova is not convinced by this argument, though, saying that banks possess "so many levers of influence because they control the money." A financial institution can exert pressure "as a primary creditor to a region, an underwriter of securities or as an analyst covering certain securities."

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