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After Goldman's oil burned, banks face day of reckoning on commodities

By David Sheppard

NEW YORK (Reuters) - On a sunny summer morning last month, a quiet Sacramento suburb was suddenly shaken by an explosion at the Elk Grove refinery, a small industrial plant that produces asphalt.

Local firefighters rushed to battle the blaze, which was generating a "substantial" plume of black smoke and alarming local residents living just a few hundred feet away. A number of them called 911 to report the incident, said Consumnes Fire Department Deputy Chief John Michelini.

None knew that the 181,000 gallons of flaming asphalt inside the roughly 50-foot tank wasn't owned by operator Paramount Petroleum Corp, or even its parent company Alon USA Energy, the refining and retail firm.

Instead, the asphalt in the tanks likely belonged to Goldman Sachs, one of the biggest commodity traders on Wall Street, according to the terms of its contract with Alon.

"We know it's called Paramount Petroleum, but other than that it doesn't matter," said Michelini.

For regulators and lawmakers, it may matter a great deal.

Though quickly extinguished with no impact beyond some damage to the tank itself, the August 15 fire highlights the kind of real-world risk that some in Washington fear may be jeopardizing Wall Street's powerhouses following a decade of aggressive expansion into physical commodity markets.

For the past five years, the issue has quietly smoldered in the background. This summer, it erupted with unexpected ferocity as lawmakers and mass media pressed the question of why financial titans should be so deeply involved in commerce.

It is fast approaching an inflection point.

As a powerful Senate banking committee prepares a second hearing to demand an explanation from the Federal Reserve in late September, the nation's top banking overseer is soon expected to make clear the future role it sees for banks trading in oil tankers and pallets of copper.

Goldman and Morgan Stanley, the so-called "Wall Street refiners" who helped create the modern oil market, are expecting to find out whether they will continue to enjoy much wider commodity-related activities than their peers, including the ability to own and operate assets as they like. A five-year grace period to sell or adapt their business following their conversion to regulated banks runs out on September 21.

Others are anxious for word on the Fed's surprise July announcement that it was "reviewing" a landmark 2003 order that first allowed commercial banks to trade in - but not to own assets related to - physical markets. Neither the Fed nor the banks have provided any timing or details on that process.

"There is a fair amount of political pressure on the Fed to carve back some of these activities," said, Charles Horn, bank regulatory lawyer and partner at Morgan, Lewis & Bockius.

"It is all coming together" this month, he said.

FED INVITED TO TESTIFY

Since early July, Wall Street's involvement in physical commodity trading has come under a harsh spotlight, as lawmakers and regulators debate whether they want so-called "too big to fail" banks involved in risky commercial industries.

Some lawmakers have focused on whether or not banks can be trusted to behave correctly in markets like oil that have a direct impact on the real economy, focusing on accusations that some banks and big trading companies that own metal warehouses have inflated aluminum prices. The banks deny those claims.

The larger concern for banking regulators is the reverse: whether real-world markets create large and unquantifiable financial risks that banks can't manage. Incidents like the Exxon Valdez spill, or even this summer's oil-train tragedy in Canada, can have multibillion-dollar consequences.

At Elk Grove, Goldman's commodity trading division J Aron stores asphalt and other oil products through a so-called "supply and offtake" agreement with Alon USA. Through the deal Goldman helps supply and finance purchases of crude oil for Alon's refineries in the United States, and assists with the marketing of everything from gasoline to asphalt at the plants.

It is unclear what, if any, liability J Aron might bear simply because it holds title to hold in Alon's tanks. Neither the bank nor Alon would comment on the incident, or who held title to the asphalt in storage on August 15.

The fire, which caused a seam at the top of the tank to rupture, has been deemed accidental, caused by a mechanical error in the heating system, Michelini said.

MORE COMMON

Yet, as such deals between banks and refineries become more common due to the high price of oil, the large volumes of crude oil the banks need to ship may increase the risk of them being involved in an accident or spill.

JPMorgan Chase & Co, for example, is importing more than 260,000 bpd of crude oil this year to supply refiners in Philadelphia and Minnesota, most of it arriving on big tankers from Nigeria or on trains from Canada.

At the same time, banks have struggled to maintain once-robust profit margins in the commodity markets due to flattening prices, moribund volatility, rising capital requirements, proprietary trading limits and an exodus of talent.

Some banks are not waiting to see what happens with the Fed.

JPMorgan will sell or spin off its physical commodities trading, the bank announced in late July just days before it reached a $410 million settlement with the Federal Energy Regulatory Commission (FERC) over allegations of power market manipulation in the Midwest and California.

Morgan Stanley has also been looking at a potential sale of its commodity arm since last year, although those efforts appear to have cooled as the bank awaits the Fed's verdict.

Earlier this year Goldman looked at selling its Metro International warehouses, but now says it is keeping the unit as a "merchant" investment operated at arm's length.

FRESH HEARING

The Senate Banking Committee has invited the Federal Reserve and other regulators to testify at a hearing on Wall Street's role in physical commodity trading, tentatively scheduled for September 24 - just three days after the five year anniversary of Goldman Sachs and Morgan Stanley's conversion to bank holding companies at the peak of the financial crisis.

It also marks the end of the grace period the Fed granted the pair to conform their businesses to the Bank Holding Company Act, which bars banks from owning physical commodity assets like pipelines, metals warehouses, and oil storage tanks.

The close nature of the two dates has led some to speculate that the Federal Reserve may make an announcement on its review soon, to get out in front of a grilling on the Hill.

"Whether it's before or during the hearing, I'm sure the Fed will be prepared to have something to say," said a U.S. attorney who specializes in banking regulation.

"There's no way I'd go into a potentially hostile hearing like that with nothing to say."

The Federal Reserve declined to comment for this article.

FED SPLIT?

Sources familiar with the matter say that regulators, including the Federal Reserve, are split over how to proceed.

Federal Reserve General Counsel Scott Alvarez, a Fed veteran who is considered a regulatory dove, is believed to favor a narrow legal interpretation of the Bank Holding Company Act that "grandfathers" the right of Goldman Sachs and Morgan Stanley to keep owning and operating physical commodity assets due to their long history of operating in these markets.

But it is not a view uniformly held across the Fed, with some senior officials expressing doubts about whether the banks they oversee should be allowed to ship tankers of crude oil or operate power plants, in case a major accident leaves them with huge liabilities that threaten their financial soundness.

Saule Omarova, a visiting law professor at Cornell University, testified at a Senate Banking Committee hearing in July about risks she sees from Wall Street's involvement in physical commodities trading.

"It's difficult to predict just how much damage a major oil spill could do to a bank," Omarova said last week.

"But financial markets don't know how to assess the risks of a bank being involved in an oil spill. How would their counterparties react? Could it have an effect on the stability of the financial system? One of the lessons of the financial crisis is that the extent of the risks present in the system aren't always clear until it's too late."

(Additional reporting by Josephine Mason and Jonathan Spicer; Editing by Jim Marshall)

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