#7 June 2011 - Commodities Special Issue

Euler Hermes UK Risk Bulletin

Foreword

Kris Macauley

Head of Risk Information

Sectors under pressure An overview 1 Commodities focus Metals 2

Regional focus Automotive in the West Midlands 3

The risks of globalisation A new approach 4

Commodities focusFuel and Energy 6

Regional focus Commodity prices in the North West 7 Regional focus Republic of Ireland: New year - same old story 8

Welcome to the latest Euler Hermes UK Risk Bulletin. This edition will be focusing on the impact that rising commodity prices have had on the UK economy, the ensuing insolvency rates and how our risk management adapts constantly to such a dynamic environment. In order to do so, we have paid particular attention to both the Fuel & Energy and Metals sectors. These are two sectors which constantly have to deal with rapidly changing raw material costs and the ability (or otherwise) to pass these on to their customers.

I commented in the previous issue of the Risk Bulletin about the heightened Political and Country risk and the last few months have done little to dispel such concerns.

In this issue, we look at the risks of Globalisation and in particular at the impact of the turmoil in the Middle East and North Africa.

I would also like to take this opportunity to point out one statistic – insolvency rates in the UK increased by one third from Q4 2010 to Q1 2011. The harsh weather over the winter and tough high street retail conditions have been significant factors. The question going forward, is it a sign of worse to come?

Contents

1

Builders’ Joinery, for example, has moved into the number one position, from occupying number six in 2010; whilst Construction has made a considerable shift, jumping eleven places to become the second highest sector for insolvency rate.

Euler Hermes have been predicting for some time that contract work would prove more difficult to secure as we move from the recession to public sector cuts, and these figures would seem to reflect this.

Bars & Clubs have moved from from the top spot at the end of 2010, down to number four, whilst Printing now holds the number three position. This firmly suggests that over-capacity remains a problem within the industry, despite the number of failures seen over recent years. Paper price increases are a material factor as many printers are having to absorb an element of these rising input costs - which come in addition to increasing energy prices and restricted bank support.

The Metals industry is certainly more strongly represented in the first quarter of this year compared to 2010, accounting for 15% of the top 20 sectors from Fabrication through to Structural Steel. This is significant, when comparing with Q1 2010 when Structural Steel was the only Metals’ industry entry in Q1 2010, positioned at number seventeen.

Subdued demand generally in a number of the heavier industries has been well documented, but is clearly feeding into the Construction sector - a trend that has been evident for some time.

It appears that Commodity price pressure is beginning to represent itself in the failure statistics, as we see Fuel as a new entry at number thirteen. It is also important to note that at Euler Hermes, we have seen an 18% increase in overdue payment incident reports in the Fuel sector comparing Q4 2010 to Q1 2011, a potential warning sign that there may be trouble ahead.

Sectors under pressure: An overview

Q1 tends to reflect the peak insolvency period for a number of sectors, however, the mix of companies failing has changed significantly when comparing Q1 2011 to the same period in 2010.

Paul Trigg

Risk Underwriting Manager

Timber, Builders Merchants,

Paper, Print, Packaging and

Publishing

0.0% 0.2% 0.4% 0.6% 0.8% 1.0%

Insolvency rates by sector - top 20 of Q1 2011Builders’ Joinery

Construction

Printing - Other Activities

Bars & Clubs

Wholesale of Household Goods

Packaging

Metal Fabrication

Security and Investigation

Financial Intermediary

Recycling - Non-Metal

Sawmilling

Printing

Fuel

Floor & Wallcovering

Metals

Builders Merchants

Hotels

Manufacture of Food

Structural Steel

Restaurants

2

Using Steel as an example, prices have risen sharply since the end of last year on the back of restocking demand and raw material price increases. We have seen this reflected in the credit limit traffic and the need for larger limits. Credit limit applications processed by our Metals team are up by 35% on the same period last year. Risk exposure has risen significantly across the sector as we have looked to meet the need for increased cover.

Rising commodity prices can have both a positive and negative impact on our clients’ businesses depending upon their fuel policy, stocking position and forward contracts. However, what is clear is that their customers have not overnight become significantly stronger financially. In fact, the credit risk can increase as customers may be finding it difficult to absorb these sharp price increases. In a rising commodity market it is even more crucial to have up-to-date management information and to be in a position to analyse with great detail each customer’s financial position and ability to deal with its effects.

Steel Traders require a quick decision and the proprietary information we hold enables us to give a fast response. Our underwriting team have a good understanding of the market dynamics as we are out and about meeting clients and understanding their needs. We also look to be flexible by sometimes using temporary limits as a means of covering price rises or one-off deals.

Commodities focus: Metals - it’s hard out there!

Shannon Murphy

Risk Underwiting Manager

Metals, Engineering and

Automotive

Steel Producers’ main raw material costs are iron ore and coking coal and these have risen constantly this year with quarterly contract prices for iron ore increasing by a further 20% for Q2 2011. The extreme flooding in Queensland, Australia added to the spot price increases in coking coal, up 47% in Q1 alone. Other input price increases include scrap and fuel. The Steel supply chain has no choice but to take robust action to try and recover these rapid increases in raw material costs as they look to protect their margins. We have seen regular price rises across the various steel product categories. For example, we have seen main product categories such as hot rolled coil and heavy sections rise on average by 25% and 20% respectively this year.

Steel Stockholders had de-stocked during the downturn when demand and prices had fallen, but a large amount of re-stocking had started ahead of the price rises. From discussing the market with clients, no one is currently forecasting a repeat of 2008 when prices fell very suddenly and stockholders were left sitting with high priced steel causing large stock write-downs. Prices are more likely to flatten with a small correction but no price crash is expected.

We have witnessed great volatility in commodity prices in 2011. As such, we often look at events globally and the cause of this. But just as pertinent is to consider the implications for our customers.

3

From a West Midlands perspective, companies allied to Jaguar Land Rover are keenly anticipating the Indian-owned car maker’s ambitious expansion plans. Recent news that Vauxhall’s Luton site is to build the X83 van’s replacement will undoubtedly reinforce the order books of many companies in the region. Indeed GM Europe’s Chief Executive has made it a stated aim to shore up the firm’s UK supplier base.

With such positive noises coming from the Original Equipment Manufacturers (OEMs), it may come as a surprise that the West Midlands still heads up the table for insolvency rates in the UK Automotive sector. As can be seen from the table below, the West Midlands is suffering, especially in comparison to the other main Automotive manufacturing areas around the North West and North East. Of further concern is the deteriorating trend in the insolvency rate in the West Midlands automotive sector; rising from 0.37% in Q4 2010 to 0.40% in Q1 2011. This compares to a national sector average of 0.30% and a national overall insolvency rate for all sectors of 0.20% in Q1 2011.

Feedback from meetings carried out by our Credit Analysts in the sector provides a number of suggestions for this trend. A key concern highlighted over the past year is commodity prices. Metals; Steel, Copper and Aluminium have all seen sharp increases since the middle of last year.

West Midlands Automotive - a rough ride?

Matt Williams

Regional Risk Manager

Midlands, South West

and Wales

These price rises have been well publicised, making it possible to pass on costs to customers although margins are clearly being squeezed. A more difficult task is managing the significant working capital impact and increased volumes exacerbate the issue. Second tier manufacturers still cite difficulties in raising working capital finance or increasing existing facilities.

As for longer term fundamentals, the Automotive supply chain in the West Midlands is well placed to take advantage of our major local OEMs’ planned growth. However, success or failure will depend on a company’s ability to reach beyond the West Midlands and take on similar competitors clustered around the likes of Nissan, GM and Honda.

After three bruising years of de-stocking and weak demand, an improvement in the fortunes of global vehicle manufacturers is welcome news to companies in the Automotive supply chain.

Region Insolvency Rate

West Midlands 0.40%

East Midlands 0.39%

Greater London 0.39%

East of England 0.32%

Wales 0.32%

Yorkshire and Humberside 0.31%

North West 0.30%

Scotland 0.30%

North East 0.29%

South West 0.23%

South East 0.23%

Northern Ireland 0.21%

East Anglia 0.00%

Average 0.30%

Automotive SectorQ1 2011 Insolvency rates by region

4

Gone are the days when country risk was purely a structural measure of the economic and political risk of transfer and convertibility.

The risks of globalisation: A new approach

Mark Wyatt

Director

Risk Information and

Claims

The world has become increasingly more globalised. We have seen an increase in cross-border trade, the liberalisation of borders, the extension of global supply chains and the interdependency of countries. We have seen a shift in balance between emerging and developed economies and a rise in economic and financial exchanges between the two. It is therefore increasingly important also to assess a country’s short term financial and cyclical volatility.

To this end we have developed two short term alerts - the Financial Flows Indicator and the Cyclical Risk Indicator - to complement our existing country grades, which continue to focus on transfer and convertibility risk and the Business Environment.

Our new Financial Flow Indicator (FFI) is an indicator of a country’s vulnerability to exogenous shock and of its capacity to resist or avoid systemic shock, in particular with regard to its sensitivity to capital flows. It has a 3-level scale of risks, by increased order of risk: low, medium and high ( L, M and H).Our new Cyclical Risk Indicator (CRI) measures the risk of worsening payments (payment periods, non-payments) in relation to macroeconomic developments, irrespective of structural transfer and convertibility risk. It is also a 3-level scale; where 1 is the lowest and 3 the highest risk.

Together with the country grade the new Short Term alerts provide a comprehensive assessment of Euler Hermes’ overall country risk in four levels: low (1) medium (2) sensitive (3) and high (4) (see table on opposite page).

BB FFI CRI

Brazil L 1

Czech Republic L 2

Israel L 1

Korea (South) L 1

Kuwait L 2

Mexico L 2

Oman L 1

Peru L 1

Poland L 1

Qatar L 1

Saudi Arabia L 1

South Africa M 1

Trinidad & Tobago L 2

UAE L 2

B FFI CRI

Bahrain M 3

China L 1

Colombia L 1

Costa Rica L 1

Coatia M 3

Guatemala L 2

India L 1

Morocco L 1

Panama L 1

Phillipines L 1

Thailand L 1

Tunisia M 3

C FFI CRI

Algeria L 1

Bulgaria L 2

Dominican Rep. M 1

Egypt M 3

Hungary M 2

Indonesia L 1

Latvia M 3

Lithuania M 3

Romania M 3

Russia L 2

Turkey H 1

D FFI CRI

Argentina M 1

AA FFI CRI

Australia L 1

Austria L 2

Belgium L 2

Canada L 1

Cyprus M 2

Denmark L 2

Estonia L 3

Finland L 2

France L 2

Germany L 2

Greece H 3

Ireland H 3

Italy M 2

Japan M 3

Luxembourg L 2

Malta L 2

Netherlands L 2

New Zealand L 2

Norway L 2

Portugal H 3

Singapore L 1

Slovak Republic L 2

Slovenia L 3

Spain H 3

Sweden L 2

Switzerland L 2

UK M 2

USA L 2

A FFI CRI

Chile L 1

Hong Kong L 1

Malaysia L 1

Taiwan L 1

KEY TO OVERALL COUNTRY RISK LEVEL

Low Risk

Medium Risk

Sensitive Risk

High Risk

*All ratings correct at 10 June 2011

5

Middle East and North Africa

2011 has been characterised by significant political and economic turmoil in the Middle East and North Africa. We have seen regime change in Tunisia and Egypt. There has been violent and notable unrest in Libya, Yemen, Bahrain and Syria. Unrest on a lesser scale has also been seen in Algeria, Jordan, Oman and parts of Saudi Arabia.

Euler Hermes continues to monitor all countries in the region very carefully. This has resulted in a number of country downgrades: - Tunisia from BB to B, Libya from C to D and Bahrain from BB to B.Other countries were already in high risk country grades: Egypt (C), Yemen ( D), Syria (D), The CRI for Tunisia, Egypt and Bahrain has also moved into the highest risk category.

There are some commonalities among the factors behind the spread of unrest in the region:-

• Frustration at the lack of freedom and expression at the same time as modern communication systems make it easier to by-pass state censorship (mobile phones/internet).

• 30% of the region’s population is young,

aged between just 15 and 29. There is often a significant disconnect between them and their ageing leaderships.

• A wide use of government subsidies that that do help stem dissent but only confer short-term benefits that have diminishing effectiveness if not accompanied by policies to generate a more inclusive society.

• High unemployment, including many jobless who are educated, who are capable of informal organisation and unifying mass actions.

Yet there are significant national differences in political regimes and socio-economic environments, and so responses by the incumbent regimes and their outcomes will vary across the region. Some markets within the region have remained largely unaffected by recent events. Israel has also been largely immune from contagion notwithstanding recent disturbances in the Golan Heights and the increased discussion surrounding the creation of a Palestinian state.

We expect that the Middle East and North Africa will continue to see significant change over the rest of 2011 and we are committed to keeping you up to date with our analysis.

Country Population (m) % World GDP Bn USD % World GDP per capita USD Country Grade EH Country Risk level

Saudi Arabia 25.5 0.4 376.3 0.7 14,745 BB 1

Iran 74.1 1.1 325.9 0.6 4,399 D 4

UAE 4.9 0.1 223.9 0.4 45,614 BB 1

Israel 7.3 0.1 195.4 0.3 26,876 BB 1

Egypt 76.7 1.1 188.0 0.3 2,450 C 4

Algeria 35.0 0.5 139.8 0.2 3,996 C 3

Kuwait 3.5 0.1 98.4 0.2 27,833 BB 1

Qatar 1.6 0.0 98.3 0.2 5,984 BB 1

Morocco 31.7 0.5 91.4 0.2 2,882 B 1

Iraq 31.2 0.5 65.8 0.1 2,108 D 4

Libya 6.3 0.1 60.2 0.1 9,512 D 4

Syria 20.1 0.3 52.6 0.1 2,615 D 4

Oman 2.9 0.0 46.1 0.1 15,995 BB 1

Tunisia 10.4 0.2 43.5 0.1 4,171 B 3

Lebanon 3.9 0.1 34.5 0.1 8,952 D 4

Yemen 23.7 0.3 25.1 0.0 1,061 D 4

MENA: Population, GDP and Country Risk Ratings

6

High oil prices in the first quarter of 2011, feeding through to increased fuel and energy prices, undoubtedly had an impact on businesses in a wide range of sectors.

At Euler Hermes we expect high and likely volatile prices to affect the chances of economic recovery for some time to come.

The most obvious sector influenced by increased fuel / energy costs is Haulage and Logistics, which has been under continued pressure in the early part of this year. Our data shows that, in the UK, there are circa 14,000 active limited companies classified as Freight Transport by Road. The insolvency rate relating to these companies increased by 22% in Q1 2011, compared to Q1 2010. Compared to Q4 2010, the insolvency rate increased 17%. Insolvencies have largely occurred amongst smaller operators who do not have the same ability as the bigger players to pass on increased input costs.

The Haulage sector may have benefited from lower interest rates but, in addition to high fuel prices, it has also been plagued by continuing subdued demand and over-capacity. We have seen evidence that certain clients are taking advantage of their buying power by extending payment terms, placing further strain on the cash flow of Haulage and Logistics companies. Sadly, cash flow constraints often result in capital investment being delayed and there is concern this could hinder the ability of some companies to maintain service levels and take advantage of an eventual upturn in demand.

As a result of our extensive information network Euler Hermes has continued to support both Haulage & Logistics companies by underwriting more than 12% of additional credit in the first 4 months of 2011.

However, the impact of fuel and energy price increases stretch much wider than Haulage and Logistics. Price volatility in the “lifeblood of industry” affects virtually all sectors. In the economy as a whole, oil and other energy prices not only constitute a portion of the actual inflation measure, but impacts downstream on other commodity prices will have a lagged effect on overall inflation. The impact is most pronounced in businesses where energy costs form a large proportion of total input costs and where they have a restricted ability to pass the cost increases on to consumers.

Euler Hermes UK is a leading player in providing credit insurance to the Fuel and Energy sectors. In Q1 2011 we have demonstrated our risk appetite by increasing the levels of cover we underwrite on behalf of key suppliers in this sector. Despite the increasing risks faced by energy intensive businesses, we have managed to increase the level of cover that we underwrite on behalf of Fuel and Energy suppliers by 56%.

Looking forward, it could be argued that a drop in oil prices, would over time, reverse the negative impact from the spike in the early part of the year and, in part, this is correct. However, volatility is a key concern for consumers and business decision makers alike. Investment decisions are made based on expectations about prices. While there is ongoing volatility in the key input costs of Fuel and Energy, business investment decisions required to bolster the fragile economic recovery in the UK are bound to suffer delays.

Commodities focus: Fuel and Energy

Mark Gibbs, CDA Group Financial Director

Dirk Kotze

Risk Underwiting Manager

Fuel, Energy and

Advertising

7

There has been considerable movement in commodity prices in recent times with the broader issues discussed elsewhere in this Bulletin. All of this can seem a long way from the high street but the impact on the consumer is very real.

Nearer to home, companies based in the North of England are responding to the rising input costs. Nestle, with their UK operations based in York, expect to spend an extra $3.5bn globally on raw materials in 2011 given the increase in cocoa, coffee and wheat prices. Consider that the cost of a Kit Kat has risen 10% year on year and it starts to actually mean something.

Wm Morrison, based in Bradford, reporting on recent trading, made reference to the impact of increasing commodity prices, particularly oil, on shop floor prices and the effect ultimately on disposable incomes. The fact that circa 20% of British Food is imported, will clearly have an impact on UK high-street prices. On a similar theme, recent reports suggest that fish prices are rising due to the rapid increase in the cost of diesel for the trawlers. Doubtless the measures designed to restrict overfishing will also have an impact.

Kieron Franks, Risk Underwriting Manager for Food and Agriculture commented in a previous edition on the down-stream risks facing small and medium sized companies who are part of a wider supply chain dominated by the supermarkets. It is difficult to see where some businesses can

Value retailing: A view from the North West

Andy Hodson

Regional Risk Manager

North East, North West,

Scotland, Northern

Ireland and the Republic

of Ireland

Significant increases in the cost of coffee, cocoa, wheat and cotton translate very quickly into rising prices on the high street.

go in the face of top down margin pressure from customers and bottom up pressure from rising raw material costs.

Analysis conducted by Euler Hermes UK suggests that the insolvency rate in the Food and Agriculture sector has increased from 0.30% in Q1 2010 to 0.37% in Q1 2011, but interestingly the more recent quarter on quarter movement from Q4 2010 to Q1 2011 is from 0.28% to 0.37%. Whether this is a longer term trend remains to be seen. Equally, the movement in the Insolvency Rate within non-food retail has increased markedly from 0.17% in Q4 2010 to 0.32% Q1 2011.

The North of England continues to feature as the region where the worst insolvency rates are recorded. The North East and Yorkshire & Humberside once again top the table with an increase in the rate from Q4 2010 to Q1 2011 from 0.22% to 0.32% and 0.22% to 0.30% respectively.

With the recovery in the UK economy remaining weak for the forseeable future, the likely imapct of rising interest rates during 2011 and beyond is a concern.

The consequential increase in the cost of borrowing would be a severe blow for many businesses and could be terminal for the most highly geared. However, increasing fuels costs and commodity prices bring inflationary pressures. A tough call for the MPC for the remainder of this year.

8

Construction and related activities continue to be the worst affected by number making up 32% of all insolvencies. However, there is a more worrying trend evolving with an increasing number of insolvencies in Retail, Wholesale and Transport.

According to our in-house statistics the number of insolvencies of companies involved in Freight Transport by Road increased by 100% with an insolvency rate of 1.03%*, Non-food Wholesale insolvencies increased 103% with an insolvency rate of 4.40%* and Non-food Retail insolvencies increased by 113% with an insolvency rate of 1.36%*.

This deterioration can be attributed to the impact of another austerity budget which is putting significant deflationary pressures on the domestic economy. There are also other factors outside of Government’s control such as food and oil prices which are driving a return to overall inflation. The Central Statistic Office reported price increases of 3.2% in April but mainly due to increasing energy costs and interest rate hikes. This is creating a very difficult position for businesses in Retail and Wholesale as they continue to shrink due to falling consumer spend but have to contend with an increase in the cost of doing business.

There was a noticeable increase in the numbers of Haulage and Logistics companies forced to delay payments to trade suppliers during Q1 in order to try and manage through cashflow problems caused by the sudden spike in oil prices.

Republic of Ireland:New year, same old story

Mike Buggy

Risk Underwriting Manager

Ireland

Many of these companies operate on the basis of fixed price contracts which do not facilitate the passing on of such costs. Calls for fuel surcharges in the sector mainly fell on deaf ears given the pressures to keep prices low; however, it must be a consideration for the future. As an island nation, getting its exports to their destination is critical for its economic prospects, so it is imperative that we have a Transport sector that is placed to deal with these types of commodity movements.

Many look for relief by revisiting their cost base for further cuts, seek payment holidays on leasing commitments or request extension to credit terms from suppliers, however these are generally only temporary measures and unless they are able to pass on fluctuations in costs, then prospects for these types of businesses are uncertain.

We have observed a mainly commodity fuelled return to inflation in Q1 2011 but would expect this to ease somewhat in the latter part of year. In the last number of weeks there has been a general fall back in commodity pricing and a fall in the value of the Euro, concerning question marks over whether Greece will default on its debt. Ultimately Greece may prove to be the test case for how events evolve for Ireland, however, for the moment this fall in prices should have some benefit to Irish companies as lower prices filter down. Certainly Haulage companies and Exporters will welcome developments.

The trend in insolvencies continues to be worrying in the Republic of Ireland. The quarterly trend shows the insolvency rate as high as 0.32% (or 437 companies), this is 50% greater than in the UK which puts Irish difficulties into context.

*Annualised

Your suppliers are our clients. Providing Euler Hermes UK with your up-to-date financial information can help your business.

A positive credit insurance review can enhance business relationships with your suppliers, which in turn could result in more goods, better credit terms or additional discounts.

With the information you provide, we are able to make better informed decisions on the credit limits we are asked to consider and may increase the level of credit to our clients - your suppliers. In the UK alone we are giving an extra £3 billion of new credit to UK businesses every month.

Call our buyer line on 08444 122041 to speak to a Risk Analyst in your local area, or email your information to moreinfo@eulerhermes.com

Enhance your business relationships with your suppliers.

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© 2011 Euler Hermes UK Plc. The content of the report (which is subject to change without notice) reflects only our opinion, which is based on information received by us. Accordingly no warranty, representation or other assurance is given as to the accuracy or completeness of the report. The report is for general information and is not intended to address any requirements you may have, for which you must obtain independent advice. The report does not constitute any form of advice, recommendation or arrangement by Euler Hermes UK plc or by the Euler Hermes Group of Companies and must not be relied upon in the making of any decision, agreement or arrangement.

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Regional Risk Offices