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LONDON (Reuters) - An exclusive club of banks that has long dominated commodities trading is opening up as some big players shrink, allowing rivals to expand their trading teams in anticipation of better profits when the global economy picks ups.
Higher costs due to tighter regulations and rapidly inflating pay for dealers have combined in recent years with an overcrowded market and low price volatility to undermine profitability in trading oil and metals.
But some cost pressures are now easing as salaries drop to more realistic levels, while the banks are no longer trying to emulate major energy groups or specialist trading houses and are instead strengthening their services to commodities clients.
Banks such as Citi (C.N), which had to retreat during the financial crisis, are now building up their commodities teams. The top five established players - Goldman Sachs (GS.N), Morgan Stanley (MS.N), JP Morgan (JPM.N), Barclays (BARC.L) and Deutsche Bank (DBKGn.DE) - face a challenge to their supremacy.
Despite a recent exodus of staff to trading houses that pay more and are regulated less, banks believe commodities can still generate healthy returns when the regulations become clearer and markets turn in their favour.
"The gap between top and second tier players has narrowed significantly, benefiting the banks with a large and diversified client base and access to balance sheet, and making it a much more level playing field," said Jose Carlos Cogolludo, managing director and head of commodities sales at Citi.
After a string of a taxpayer-funded bailouts - including of Citi - authorities imposed tougher global rules on proprietary trading, when banks trade with their own money rather than their clients'. At the same time commodities price volatility, which allows traders to make much of their profits, has been low.
These factors have led to a drop in banks' annual revenues from commodities to $7 billion from the peak of $14 billion in 2007-2009.
Over the past year, several banks have abandoned sectors such as EU power and gas, shipping and agriculture, citing poor returns and a miserable revenue outlook.
Morgan Stanley will cut 30-35 people or 10 percent of staff from its commodities unit by quitting certain sectors. [ID:nL5N0EW3RF] Deutsche is estimated to have reduced staff to 225-250 from 325 after a reshuffle last year.
Goldman and JP Morgan have not shrunk their operations significantly, industry sources say.
But Citi, which had to scale bank its commodities trading ambitions after its U.S. government bailout, is estimated to have rebuilt a team of 250 people, comparable in size with some of its rivals'.
As Deutsche and Morgan Stanley retreated from European power trading, new players are taking on the challenge, including Bank of America Merrill Lynch (BAC.N).
"Where other banks have reduced the size and trading book of their European power, gas and coal operations, Merrill has remained stable, and they are benefitting from the gap left by their competitors," a source at the bank said.
Brazil's BTG Pactual wants to start trading commodities from London and New York, according to industry sources, after hiring Ricardo Leiman, a former chief of the trading house Noble Group.
"A lot of overcapacity has gone. And costs have gone down dramatically," said a senior banker, who asked not to be named as he is not authorised by his employer to speak to the press.
"Traders have become much cheaper. Before we were hostage to employees calling every six months for a salary increase. Sales people were massively overpaid too," he added.
Apart from some trimming by major banks, mid-sized players such as Credit Agricole, UBS and Spanish banks have effectively closed or drastically slashed commodities units in recent years.
The former head of Deutsche's commodities unit, David Silbert, is setting up a venture worth $500 million-$1 billion with U.S. group Riverstone in a rare foray by a private equity firm into commodities trading.
Silbert says the venture will be relatively risk averse, with the emphasis on servicing commodities producers' needs rather than proprietary trading. "There are loads of upstream producers who need capital. We will be telling them - pay us back in production, not cash".
Silbert will compete with banks in some respects.
"Ultimately our focus is on facilitating client transactions," said Mike Bagguley, who heads both the foreign exchange and commodities trading divisions at Barclays.
Barclays wants to build "a repeatable business of client flows", he said, aiming to help clients limit their exposure to market fluctuations or to finance the holding of large stocks of commodities.
Typical customers are airlines needing jet fuel, refiners storing oil products and vehicle makers buying palladium for catalytic converters. Such deals are, however, much less profitable than proprietary trading used to be.
"Even with financial margins on flow businesses declining, there is a steady stream of clients that have lots of activities they want to achieve," said Bagguley.
Barclays, which has sold carbon trading firm Tricorona and a shipping unit over the past year, says the savings have allowed it to invest more in electronic trading technology.
Bagguley says he is hoping to repeat soon a large UK working capital oil transaction of 2012 by funding similar deals in energy and metals.
Cogolludo said Citi is expanding its oil, metals, gas and power and liquefied natural gas teams to do more flow deals.
Some bankers say overcapacity might build up again. "When there is a client deal in the market, the competition is severe. Some top U.S. banks, which abandoned businesses such as airline hedging ages ago because of low margins, are now all forced to compete," one banker said.
Cogolludo expects the barriers to entering the sector to remain quite high. "You need to have global footprint, a healthy balance sheet and the ability to trade physical commodities. It doesn't mean Citi will accumulate physical assets but you have to be able to move physical commodities around to complement our risk management and financing-related product offer," he added.
Banks such as Morgan Stanley and JP Morgan have accumulated assets such as pipelines and storage facilities over the past decade to help in their trading. However, the possibility that U.S. authorities might order banks to sell such assets as part of a clampdown on non-core activities is prompting many players to think about how to adjust their models.
Additional reporting by Simon Falush; editing by David Stamp