Commodities Lectures Series - Physical commodities trading vs. Exchange based commodities futures trading

Physical commodities trading is buying commodities from producers, transforming the purchased commodities to maximize their value and selling it to consumers getting maximum margin out of these structured trades. How the trade settles and how the quality of a commodity is assessed relies on the physical commodity itself as they are extraordinarily diverse in terms of location (of both producers and consumers) and physical characteristics. For instance, energy, including crude oil is traded with constant demand and refineries are optimized to process particular types of crude oil - light, heavy, sweet sour, and different refineries are optimized differently for derivative products such as Diesel, Petrochemicals. Purchase of energy commodities is a complex process which involves negotiations of contract floating of tenders, shipping arrangements, unloading at ports, transporting to refineries, refinery complexity and most importantly the discounts offered by the sellers. Given the complexity of the possible transformations, and the ever-changing conditions that affect the efficient set of transformations, physical commodities trading is an inherently dynamic, complex, and highly information-intensive task involving information gathering, analysis and the operational capabilities necessary to respond efficiently to this information.

Physical commodities trading requires matching numerous diverse producers and consumers with heterogeneous and highly idiosyncratic preferences directing resources to their highest value uses in response to price signals requiring strong relationships with market players (buyers and sellers of commodities). Physical commodities markets are mostly cyclic, have a seasonal trend and a convenience yield (the consumer wants it now and is willing to pay a higher price for it). Physical commodities traders search producer side and consumer side of the market to find sellers and buyers (bilateral “search” markets), and match them by buying from the former and selling to the latter in bilateral transactions in between adding value by transforming the commodities. Commodities producers are usually not end users and commodities need to be transported from source to destinations creating bottlenecks and an opportunity to make significant margins for traders. Physical traders can also profit through shipping, warehousing, and trade finance of the commodities. Physical commodities trading is also known as the “spot” or “cash” market.

Physical commodities trading is a human-driven business - Humans and relationships are predominant from the very beginning until the end of the trade. Humans will extract coal and assess the quality of it. Humans will test the quality of coal at loading port and discharging port. Human will negotiate premiums and discounts. Human will react against market movements and sometimes refuse to deliver or receive the commodity if prices go against market direction based on market intelligence.

Electronic Exchanges trading commodities futures are not suited to this matching process. They may be an efficient way to transact highly standardized instruments such as plain-vanilla front month contracts in large quantity, but are not well-adapted to predict the downward or upward price movement on commodities such as natural gas resulting from a pipeline explosion or the reaction of oil prices to a news events about an outbreak of war or comments from a Saudi oil minister. Little physical commodities actually change hands with futures trades, which take place on two main exchanges in the US, CME Group and the Intercontinental Exchange. In some commodities such as oil, futures trading has come to dwarf the physical trade, with as much as 13 times the physical amount of oil traded via these purely financial contracts which determines the price of oil. According to data provided by the CME Group, the amount of crude oil futures contracts traded daily on its platform rose in 2022 over 2021 and is nearly double that of a decade ago. For example, Total Energies, the French Oil supermajor may trade 7 million barrels of physical oil a day, but on the same day will electronically trade the equivalent of 31 million barrels of oil futures and options on an electronic exchange.