Commodities Lectures Series - Commodity Trading Companies vs Investment Banks and hedge funds vs - a new competitor - Commodity Producers

Without price transparency in physical commodities markets with clear and accessible reference commodities prices, physical commodities traders are in a powerful position to profit as they have a virtual information monopoly. Commodities Trading Companies such as Vitol, Trafigura, Glencore, Gunvor, Louis Dreyfus among others trade physical commodities taking advantage of this price opacity, investing in the physical and human capital necessary to transform commodities while simultaneously hedging their physical trades through financial (paper) trading on exchanges thus taking positions in the futures markets and the physical markets. Commodity trading firms do not tend to speculate on the outright direction of commodity prices, but instead aim to profit on the differential between the untransformed and transformed commodity specializing in (1) the production and analysis of information, buyers and sellers active in the market, supply and demand patterns, price structures (over space, time, and form), transformation technologies, and (2) the utilization of this information to optimize transformations in terms of space, time and form. Commodities trading firms attempt to identify the most valuable of these transformations, undertake the transactions necessary to make these transformations and engage in the physical and operational actions necessary to carry them out.

On top of physical trading, Commodity Trading Companies possess prop paper-trading desks. Using market intelligence coming from physical trading desks and ‘classic’ paper trading skills, these companies make profits on swaps, options and futures. They also use these paper trading books to hedge their physical exposure, which subsequently reduce their risk.These companies develop their own strategies and models - quantitative, computer-algorithm-driven or macro-driven similar to the models used in banks or hedge funds for derivatives pricing and market forecasting. They invest in physical commodities fundamental research to get an edge over their competitors and figure out where the market is going. They have on-site associates at origin and destination (offices in exporting and importing countries) to get a flavor of the local market as well as strong middle and back office for physical trading operations. They are highly skilled at managing their risks and know how to create sustainable and win-win relationships with potential buyers and sellers. Due to rising competition and change in business trends, these companies do invest at the source in mines, Exploration and Production (oil), and also transportation infrastructure such as ports. Vitol/Trafigura physically send ships to collect the cargo from the sellers, the miners and the refineries. Some like Glencore own mines (after buying Xstrata). Glencore is now a mining and trading company besides being a Commodities Trading Company. Trafigura is trading with no mining operations. It buys ore, concentrates or even refined outputs, ships them to the buyers. Trafigura model helps even for smaller operations.

Hedge funds on the other hand rarely trade physical form of commodities or take delivery concentrating only on financial or paper trading. Macro-focused hedge funds seek a hedge against an economic slowdown priced in by the market. Unlike many of their equity fund peers, commodities macro managers of the likes of George Soros and Louis Baconare are not dependent on rising markets for their gains. Rather, they look for volatility in commodities markets through 'Asset backed Trading' - a style of commodity trading which is used to seek and exploit market volatility in order to optimise the operational assets, inventory and future produce owned by trading entities. This is their core activity. However more sophisticated funds would also get into taking proprietary positions, market making and offer structured products to their clients. Hedge funds and Investment banks are beginning to exit the financial trading of commodities making daily price swings far greater than in previous years.

Financial trading is becoming an ever more important part of Commodities producers such as International Oil Majors Shell, BP, Total driven by fears that global oil demand could drop in the next few years as climate change concerns reshape society’s—and investors’—attitudes toward fossil fuel producers. The immense scale of the commodities producers' trading units gives them outsize clout. They have massive trading floors that mirror those of Wall Street’s biggest banks. Being a commodities producer gives an inherently bigger advantage with more reliable market information in trading strategy than commodities traders suchas Vitol/Trafigura. This is also the reason why in recent years, Vitol has started looking for refining and storage assets worldwide to control a bigger chunk of the supply chain. BP controls exploration and production as well, so BP obviously has advantage over oil traders who are unable to control costs associated with these projects and an oil company like BP will make more money when the production cost remains stable while prices rise. The problem for a crude oil trader like Vitol is to anticipate the price rise and buy oil from producers at sufficiently lower price to make a profit. Sometimes, the trading strategy for Vitol is so complex that the wafer thin margins made through a trade are actually made through minimizing on transportation costs of the oil instead of the oil price itself. On one occasion in 2016, for example, Shell bought roughly 70% of the cargoes of North Sea crude available for a particular month, triggering wild price gyrations while squeezing out commodities traders who privately complained to Shell. Commodities producers are also moving into the space formerly occupied by the commodities desks of Investment Banks. Shell, for example, in 2016 became the first nonbank to help the Mexican government hedge its exposure to the price of oil. BP's customers now include banks, hedge funds and private equity firms. Exxon is also hiring experienced oil traders to start making bets with the company’s money.

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.

Two decoupled energy blocs with India and the Gulf in the middle

Australia’s Strategic Policy Institute opined on the emergence post Russia’s invasion of Ukraine, of two decoupled energy blocs with China and Russia on one side, and Europe, North America, and the Indo-Pacific democracies, on the other side. Prior to Russia’s invasion of Ukraine, in 2020 almost 30% of EU crude oil imports came from Russia and over 40% of natural gas imports came from Russia while more than half of solid fossil fuel (mostly coal) imports originated from Russia (54 %). European nations are now seeking new sources of gas, oil and diesel fuel from the Americas, Africa, the Middle East, and India, as well as an increased focus on local energy production to wean themselves off Russian energy sources.



With Russian oil banned in the United States and Europe, India finds itself in the middle of the two decoupled energy blocs buying Russian crude at substantial discounts, powering its energy-thirsty economy at a lower cost, and refining into products like diesel and jet fuel to sell at better-than-usual margins abroad. Ironically, Europe is eager to buy the same Russian crude after it is refined in India into diesel shipping the fuel to Europe since March 2022, with increased trade flows expected over the coming months. China buys 50% of its oil supplies from the Gulf.

The Strait of Hormuz is the most important chokepoint between the two decoupled energy blocs accounting for about a third of the world’s sea-borne oil (and a fifth of the world’s total oil exports), linking oil and gas Upstream producers in the Middle East with Downstream consumers in Europe, North America, China and Indo-Pacific.

In 2016, according to America’s Energy Information Administration, the waterway carried some 19m barrels of crude and other petroleum products a day. This volume will accelerate through 2030 because of new mega refineries in the Gulf China and India and growing demand in Europe and emerging markets. According to Bloomberg, State-run Qatar Energy’s six new gas-liquefaction plants are set to produce 8 million tons of LNG per year for export to Europe. Morgan Stanley forecasts global LNG consumption to rise by 60% through 2030.