How to Play JPMorgan's Commodity Selloff

 | Oct 10, 2013 | 3:30 PM EDT
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JPMorgan (JPM) circulated offering documents on Wednesday to try and sell its physical commodity operations in copper, oil and natural gas. Why is it leaving, who is staying, and is there something investable here?

First, it is critical to understand why investment banks such as JPMorgan got into the physical side of the commodity business in the first place, even though their natural role is on the financial side. The first investment bank to enter into physical commodity trading was Morgan Stanley (MS), with its purchase of terminal and storage units for gasoline and heating oil in New York Harbor.

What became clear to the folks at Morgan Stanley and to the rest of the investment banks was that an insight into physical trading of a commodity helped enormously in trading the connected commodity futures markets. While many of the investment banks will claim that their physical assets allow them to deliver clients an edge in risk-management services, that edge is largely delivered to the bank traders themselves.

Or at least it was. Since the collapse of financial markets in 2008, the steady flow of commercial-based trading for risk control has largely dried up. Commodity producers in oil, grains and metals have also cut their trading operations, preferring to concentrate on core business during the slow industrial recovery since the financial crisis. Many of the complaints from the investment banks about increased regulatory scrutiny on physical operations is a feint from the real issue: Clients have overwhelmingly taken their ball and gone home.

The sale of physical commodity operations, along with the slimming down of the banks in their financial commodity operations, has left a vacuum of trade volume that I thought created an opportunity for someone to fill.

I expected to see that trading slack taken up by the privately held commodity trading firms, and that was the primary reason I have had so much optimism about the shares of Glencore, an until-recently private commodity trading house that went public in 2011 on the London Stock Exchange. Glencore's move from private to public hands had a specific goal: to raise capital to continue to buy physical assets, mostly in copper and other industrial metals, for much of the same reason that the banks did: to augment financial trading operations.

But one look at the Glencore chart will tell you (as it told me) that this plan hasn't quite worked out as well as it (and I) expected: The wind-down of customer risk and trade operations has hit the commodities firms almost as hard as it has hit the banks -- Glencore trades much like a mining stock and has mostly discounted its trading profitability in its share price.

I think that assessment will ultimately prove to be wrong. There must be a winner in the disbursement of physical commodity assets from the investment banks, and no one is better positioned than the commodity traders like Glencore (and Vitol and Trafigura) to take advantage of that drop in competition.

Sure, the financial and physical commodity business isn't the same waterfall of easy profits that it was in the first half of the 2000 decade -- and the banks are moving back into those more efficient profit centers. But the money in the commodity trade continues to be excellent -- and growing. Particularly when emerging markets find the need to engage in financial commodity trading to augment their growing need of oil, gas and copper, you'll see another rapid surge in the need for physical commodity operations and a concurrent profit surge from the financial traders who are able to take advantage of it.

Glencore should be a long-term core holding.

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