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by Yacoub E. Sifri
Complexity of Operations and Vast External Risks
Over the past few months, we have been exerting focused efforts to highlight the complexity of trade finance operations and the vast risks inherent in its transactions.
Recent history has proven beyond doubt that the survival of any commercial bank is dependent in first place on the soundness of its trade finance operations.
Oil transactions are riskier and require much more attention than other types of LCs. This is mainly because of its large values and the special requirements of its operations. From a banker’s point of view, the oil transaction is peculiar in nature. Having been involved in advising, negotiating and settling export oil LCs for quite a long time with world class international banks, I would like to explain the special nature of the LC transaction.
Letters of Indemnity for Missing Documents (LOIs):
Cargoes of oil are frequently sold several times to different buyers during the same shipping voyage, although voyages can be measured in few days. Nevertheless, documents must be prepared and physically checked for compliance following each ownership transfer. This of course means that the oil cargo often arrives at the port of destination before documents. The carrier will not be able to hand over the cargo if the related Marine Bill of Lading is not available (for simplification purposes, this article only discusses the cases where shipment is covered by Marine/Ocean Bill of Lading and not by other documents). Now a problem may arise; the cargo is in the port of destination but can not be delivered because the documents needed are not yet ready. This delay certainly means extra costs on the buyer. To overcome this costly operational shortcoming, oil companies are accustomed to use Letters of Indemnity for Missing Documents (LoIs) to allow payment to be collected for a cargo and to enable the Carrier to release the cargo to the ultimate buyer.
As a solid guarantee, the applicant normally requires the nominated/confirming bank to countersign the LoI. The applicant would seldom accept an LoI issued by the beneficiary alone, after all, the LoI is only as reliable as the issuing company.
It is essential to note that whilst the LoI, from a banking point of view, is a fairly straight forward instrument, legally it is a very complex one; such complexity, amongst other reasons, stems from:
• LoIs are normally unlimited in time or value.
• There is always the risk of some one - in a chain of oil dealers - going insolvent after payments by a buyer against an LoI. Problems could arise.
Hence, the LoI is a very risky tool and do cause serious worry for those involved in a transaction using it. History though has proven that - even with the potential problems, LoIs are sometimes essential to facilitate an export transaction.
One could imagine that with the global move towards electronic data interchange, slow though it may be, and with the introduction of systems such as @GlobalTrade for electronic documents including Bills of Lading and Bolero.net with its 'central registry' the LoIs will be put to end. The age of electronic documents, although has not yet taken of, will certainly guarantee the elimination of LoIs once started.
Value Escalation / De-escalation Clauses:
Crude oil prices are linked to the prices of Dated Brent and WTI (West Texas
Intermediate) and not fixed. This is because of the constant fluctuations in price. Actual prices are based on the prices recorded after or before certain number of days from the bill of lading date.
We have noted the dramatic rise in oil prices following the recent nuclear crisis between the USA and Iran during the past few months. This is an example on the reasons for the need to include an ‘escalation’ clause to determine the actual price. Escalation clauses mean that the value of the LC, will not be known until after the Bill of Lading date. But since the issuing bank has to record LCs issued off its balance sheet (contingent liability), it takes a "reasonable" value that is based on the value on the day of issuance and then add, about 10%. The issuing bank would then review this calculation say once a week to ensure there has not been a dramatic price changes.
It should be noted that a number of the more conservative banks, which do not specialise in oil LCs, will not issue an LC with a price escalation clause. In these cases the seller has to make a judgement as to whether or not an LC is for a sufficient value to cover the transaction, when the LC is received.
In many cases, banks open oil LCs on a 'back to back' basis, that is to say they will open an LC for an applicant, based on the fact that the applicant has already received an LC opened in its favour for the same cargo of oil, noting of course that the first LC by no means constitute a security for the second issued LC in a back to back transaction, it merely provides comfort to the bank issuing the counter LC. In transferable LCs, the bank has no price basis risk; the transferable LC is a mirror image of the original LC with the exception of few elements (due dates, latest date for presentation of documents and unit price; all of which may be reduced or/and curtailed). In Back to Back transactions, the value of the applicant’s LC will equal to the value of the corresponding LC from the applicant’s customer. Sometimes the applicant’s buyer provides a "Payment Undertaking" to the bank – instead of an LC – but the reasoning is the same.
Banks must exercise a high degree of caution before involving themselves in oil LCs containing an ‘escalation clause’. The risks here are immense; customer risk/financial constraints (bankruptcy), fraud risk… etc. Banks can manage this type of risk by having an expert knowledge of the transaction and the parties involved. Of course banks will only open LCs with 'escalation clauses' for those customers who have good experience in the market.
Conclusion: Oil Letters of Credit is a specialised area, as a result banks intending to deal with such LCs initiate considerable investments to equip themselves with the necessarily infrastructure and arm their cadre with technical expertise needed to manage the irregular risks involved.
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