Commodity Financing Has Turned Creditworthy

Financing the commodity sector until a year was a nightmare. But all that is a thing of the past.
Opportunity beckons, and lenders are now eyeing the segment. Fresh exposures are being taken
up, companies in the sector have refinanced expensive debt. The story is playing out not just on
the incremental factor. Banks have also gained by selling off their investments in the commodity
sector.

What explains this sudden change?

ICICI Bank executive director S Mukherji cites restructuring as one of the factors besides the
upswing in commodity prices. “The restructuring of companies in the commodities sector
especially steel, chemicals and textiles happened at an opportune time and these companies were
derisked,” says Mr Mukherji.

At the Industrial Development Bank of India, (IDBI) executive director AK Doda is a very
optimistic person: “The risks associated with exposure in the commodities sector have come
down considerably after restructuring,” says Mr AK Doda, adding: “Some of them have asked
for pre-payment... there is a premium attached to pre-payment, but still, many are coming
forward.”

Sharing Mr Doda’s mood is Life Insurance Corporation (LIC) managing director RN Bhardwaj.
“The commodities sector has been performing exceedingly well over the past few quarters and
and we would like to exploit further opportunities,” says Mr Bhardwaj.

Restructuring was undertaken to insulate these companies from the downturn in commodity
cycles. Indian Banks’ Association chief economic advisor N Nagarajan is also of the opinion that
the commodities sector is looking up. According to Dr Nagarajan, banks may now consider
taking further exposure in commodity manufacturing as against their earlier stand of paring
exposure to these sectors.

For example, restructuring for steel companies was done in such a manner that hot-rolled (HR)
steel manufacturers can service their debts even if steel prices were to fall to as low as Rs 15,000
a tonne. With HR prices reaching above Rs 21,000 a tonne level, steel companies have now
started pre-paying and refinancing their expensive debt. The winners include, Steel Authority of
India, Tata Steel, Jindal Vijaynagar Steel Ltd, Ispat Industries Ltd and Essar Steel.

What was done for steel is now being replicated in other commodities sectors. Financial
institutions sought advice from global consultants, and the restructuring was based on sound
premise of making players globally competitive. These involved placing checks and balances
like appointing lenders engineers, having trust and retention accounts, and taking control of
enough stake to make promoters behave. In fact, in case of most stressed cases, banks and FIs
hold stakes equivalent to promoters.

The commodity-price upswing — which is one of the major reasons for a change in fortunes —
has begun and is expected to continue for few more years to come, at least two years for steel.
For petrochemicals, the upturn has just begun and is expected to last for five years while the
textiles market is expected to explode post-WTO in 2005.

“The outlook for the commodities sector is getting better by the day,” says Crisinfac head of
research Sachin Mathur. He points out that in a number of these sectors, capacities are
underutilised and demand is rising. “Prices will peak simultaneously with the increase in
capacity utilisation and addition of capacities, which will take a couple of years from now,”
notes Mr Mathur.

A pertinent question here is: will exposure in commodity industries be viable in the long-term
when there is a downside?

According to Mr Mathur, companies in the steel sector have the worst capital structure barring
Tata Steel, while the largest player, Sail does not have the best of production efficiencies, which
may take a toll on them in a downcycle.

The current level of steel prices will have to sustain for atleast five years, feels Mr Mathur, if the
sector has to turn around and repay their debts, while the growth in the petrochemical industry
will continue and has just begun. The exposure of banks to the petrochemical sector is expected
to be safe and providing a good rate of return over the next five years. One of the major reasons
is the cost competitiveness of big players like Reliance Industries (RIL), Indian Petrochemical
Corporation Ltd (now part of the RIL fold) and Mangalore Refinery and Petrochemicals Ltd,
which is now under the management control of the Oil and Natural Gas Corporation.

International competitiveness is also a key. For example if Arvind Mills is the lowest cost of
producer of denim, it will stay viable even if prices are at its worst and will continue to service
debts and remain afloat.

Lenders on their part are insulating themselves by going in for syndications. The idea is to trim
exposure and to constantly derisk portfolios by bringing in a large number of lenders. The
situation is such that banks can now have further exposure in the commodity manufacturing
sector with prospects turning brighter. While the total investment catalysed in the sector is huge
when put together but this does not translate into large individual exposures. “What is more
important is that substantial money has already started coming in from these borrowers,” says Mr
Mukherji when asked about ICICI Bank bringing down its exposure to the commodities sector.
Lenders are of the opinion that in the next two years as the sector further improves, there will be
a large number of refinancing opportunities in sector. Banks are also making money on the
exposure taken in equity during the the process of restructuring. For example in the case of
Arvind Mills, ICICI Bank is known to have cashed in after equity in the company was offloaded.

Earlier, in cases of stressed assets, a part of the debt would be written off. As per the
restructuring, debts were converted in to equity or as zero-coupon bonds. These have paid off as
these instruments have gained in value with the improvement in the financials of the companies.
Lenders have opened doors to the new paradigm of laying less emphasis on the sector and
looking at whether the companies are globally cost competitive. The standard is not demand and
supply, but on cost competitiveness, market share in the domestic and international market.
The above observation is particularly true for steel companies. Bankers who have exposure to
steel believe that steel companies saddled with huge expensive debts can wipe it off their balance
sheets if they don’t expand for two years, pay off the debts, and try to bring down their cost of
production. Currently, non-performing assets (NPA) in the steel sector are the technologically
and financially unviable mini-steel plants. In textile, the smaller units have turned NPAs while in
petrochemicals, downstream units are a problem area due to its fragmentated nature.

With legacy issues more or less a thing of the past, and with credit offtake still in sluggish
territory, commodity financing is all set to become the next big thing in corporate banking.