3/7/13

I have seen a few posts on the Commodities Trading forum asking about how petroleum trading is priced, hedged, etc. I was reasonably high up in Risk Management for a "major" trading company in Houston for a few years and am now running a hedge book at a smaller company, so I thought I may be able to impart some knowledge (didn't burn out, just moved closer to family).

My focus has been primarily on gasoline, so that is primarily what I will discuss. However, I have also done some jet fuel, naphtha, and LPGs. There is some variance between those products compared to Crude, Bunker Fuel, and on down the line, but the concepts translate for the most part. A lot of this is easier to understand with back-of-the-envelope math, but I'll do my best to get the point across verbally.

The two main trading methods are arbitrage (obtaining risk-free profit by moving product from one place to another) and basis trading (often a bet that prices in a certain region will rise or fall faster than another region). For the most part with these specific commodities, trades are done with five things in mind: Publication, Incoterm, Timeframe, Product, and Price/Differential. Below is a recap of a few terms, along with some examples for the uninitiated.

Publications - There are four primary publications used: Platts, Argus, OPIS, and NYMEX. Platts, Argus, and OPIS are trade publications that report prices and basis differentials. OPIS and Argus both are have their settlements based on the 2:30pm NYMEX close. Platts has a "window" at 3:15 that their settlements are based on. The publications will also put out market reports that verbally recap what is going on in the market on a given day. NYMEX is mostly used just for the settlement numbers when the market closes.

Timeframe - The timeframes differ significantly based on the region and mode of transport. If you're trading based on Colonial Pipeline in the Gulf, there are six cycles per month. New York Harbor usually trades based on three "cycles" per month, which are the 1st-10th, 11th-20th and the 21st through the end of the month (also known as the "Anys"). If you're negotiating cargos, those can be based on any negotiated delivery timeframe. Usually when delivery times are further into the future, you can negotiate wider delivery timeframes.

Incoterms - These are predefined terms that allow traders to quickly decipher when title transfers, which volume reading to use, and who is responsible for paying costs associated with transporting goods. Below is a list of the five that I have seen most frequently.

FOB - Free On Board - Buyer takes title at origin, and will assume all costs after that point. Volume is measured at origin.
CIF - Cost of Insurance and Freight - The price the buyer pays includes insurance and freight. The volume is measured at origin. The buyer takes responsibility for in-transit product losses.
CIFOutturn - This is a slightly bastardized term, but means that the price the buyer pays includes insurance and freight. The volume is measured at discharge so that the buyer does not assume liability for in-transit losses, among other things.
DDU - Delivered Duty Unpaid - Seller covers all freight and costs, except duty. Volume is measured at discharge.
DDP - Delivered Duty Paid - Seller covers all freight and costs, including duty. Volume is measured at discharge.

Product - This is just a statement of the product's specifications. Sometimes it will fit into a fungible grade of fuel, sometimes it will be a blendstock which is more difficult to value.

Price/Differential - Many pipeline traders are actually "basis traders". This means that rather than worrying about the NYMEX Crude or RBOB quote going up or down, they have a view on prices relative to the NYMEX for a specific part of the country. For example, let's say that a trader has learned that the Tesoro refinery in Wilmington, CA will be going down for unplanned maintenance. The trader could view this as a major supply disruption in West Coast Gasoline. The trader has a few options on how to put his money where his mouth is.

The first option is to trade flat price. This means he would outright purchase some quantity of Los Angeles CARBOB (California-grade gasoline) while leaving the position unhedged. While this trade could still very well work out, he has taken on flat price risk, which in many ways is viewed as undesirable. From my experience, very few positions are entered this way unless you are working for a convenience store or something similarly small. Among your risks here is that the NYMEX futures could dive and bring the entire market with it. It's a pretty volatile way of going about your business.

Buy 25,000bbl March CARBOB Gasoline FOB Los Angeles @ $3.20
Sell 25,000bbl March CARBOB Gasoline FOB Los Angeles @ $3.21
Result: Profit of $10,500 (25,000bbl * 42 gal/bbl * $0.01 profit) before associated costs like paying broker commissions. This could very easily go the other way and leave you down a significant amount of money.

The next step up from there would be to trade the basis. While initiating a long position in physical gasoline, the trader would sell one futures contract for every 1,000 barrels of physical product they are buying, or vice versa. The futures would be sold one month further in the future than the month in which he was taking delivery (hence the term future). For example, you would buy 25,000 barrels of March CARBOB and sell 25 April RBOB futures on the Merc. Many brokers will do this for you as an EFP (Exchange Futures for Physical) and you won't have to actually go out and sell the futures, but they would just come as a part of the trade and need to have a price set by your clearing broker. When trading this way you don't really have to care about Merc direction, because it's offset. You only care about your region's price relative to the Merc.

Buy 25,000bbl March CARBOB Gasoline FOB Los Angeles @ $3.20
Sell 25 April RBOB Futures @ $3.15

Sell 25,000bbl March CARBOB Gasoline FOB Los Angeles @ $3.21
Buy 25 April RBOB Futures @ $3.10

Result: Profit of $63,000 before associated costs... $10,500 on the physical and $52,500 on the futures because you were right about the LA market being relatively stronger than the futures market.

The third way would be to trade "the arb". Traders would look to buy product from some other part of the world and bring that product to the West Coast. In this scenario, you would probably try to buy a South Korean or Japanese cargo to be brought to the US the following month. If the specs match up, you could just sell CARBOB one month further out and lock in your P/L.

Arbitrage can get much more complex than the pipeline trading. I will outline more about basic arbitrage and locking in differentials when using multiple pricing mechanisms in the next post. Hopefully this is helpful as a first look into the physical markets.

Comments (63)

3/7/13

Awesome post, would SB if I had any.

3/7/13

Great post!

3/7/13

Great post. I'm looking forward to part 2!

3/7/13

Good work and NYH has blown up in the past few years... so have some of the good BP guys who left to Traf, Glencore and Vitol did very well for some time. Lot has however changed in the last 12 months

3/7/13

Good point, Monty. I haven't been doing NYH for about 2 years, so I missed that move. That's good info to know.

3/7/13

Gasoline looks to be a strong product in coming years along with NGL/LPG........ the NG and Power space has def taken a back seat to more refined products across the industry.

3/8/13

SB, this is very good stuff. I was looking for something like that for a long time.

3/8/13

This is why I love WSO. Thank you for thr post

3/8/13

Thank you, this was great.

3/9/13

Great post. Knowledge dropped.
Thanks,

Death is certain; Life aint.

3/9/13

Great post. Thanks. A little over my head though.f

3/10/13

Please excuse my ignorance but I didn't quite get the basis trade with the futures would anyone be so kind as to elaborate on that? Are the futeres to buy of to sell at a futuere date? And why does the price of the future fall if the price of gas gets up?

ps waiting for part 2

3/11/13

TaTa:
Please excuse my ignorance but I didn't quite get the basis trade with the futures would anyone be so kind as to elaborate on that? Are the futeres to buy of to sell at a futuere date? And why does the price of the future fall if the price of gas gets up?

ps waiting for part 2

No problem, Tata. First, I should clarify a quick part of the mechanics of the futures. Let's say that you were making this trade today, March 11. The front-month futures contract is the April contract. At the most basic level, there will not be a March contract right now because that is the present, not the future. If you are buying physical, you would sell futures in the most nearby month. In this case, buy March physical, sell April futures. The main reason to do this in a different month than April would be if you are going to put the product in tank and hold it until another contract is the "front month" or "nearby" contract.

While the futures do give you the opportunity to deliver or take delivery, you're usually going to exit the trade before the futures contract expires, making it a simple paper trade.

3/11/13

Here is what I don't get. I am buying physical from whatever source I find(let's say in March) and at the same time I go to a futures exchange and write up futures contracts to sell the amount I bought? What is the negotiated price is it the spot? where is the quantity I bought stored until I sell it again? Do I have to arrange the logistics for tranfer and delivery?

3/11/13

TaTa:
Here is what I don't get. I am buying physical from whatever source I find(let's say in March) and at the same time I go to a futures exchange and write up futures contracts to sell the amount I bought? What is the negotiated price is it the spot? where is the quantity I bought stored until I sell it again? Do I have to arrange the logistics for tranfer and delivery?

The most common scenario would be that you will sell those physical barrels (and buy back the futures) prior to the delivery actually taking place. The percentage of the time that takes place differs based on the type of firm, but from my experience, probably 75% of our basis trades were booked out before delivery occurred. As long as you go that route, you will not have to arrange any logistics. If you are buying March "Anys", title will usually transfer on the last day of the month. If you don't want to take delivery, either sell outright and close the position or "roll" to the next month. If you choose to "roll", you would simultaneously sell March physical (plus buy paper) and buy April physical (plus sell paper). It all amounts to cancelling your March position and moving the same quantity into the following month.

If you choose to take delivery of the product, you're going to need to have assets or have access to assets where it can be stored. This means you will either buy/lease a tank or find someone who has a tank and sublease or pay a throughput fee to them. Tanking prices vary significantly throughout the country, as they are a market all their own. It used to be that the WC had the highest cost per barrel of tankage, but I don't know if that's still the case.

3/18/13

Great post, reading this and part 2 was very informative!

3/22/13

Great stuff!

4/19/13

This is a very helpful article. Thanks for posting.

5/19/13

great post doc, I am a little iffy in my understanding of basis trading, hoping you would elaborate.
Why would you buy physical in the current month if you are going to make your future sells a paper trade anyways? not really understanding the ideal between buying physical and selling in the futures market

11/18/13

Is the right way to interpret the example given is that the trader is selling the physical gasoline at a loss of $0.05 but gaining $0.11 on the futures market?

11/18/13

really great stuff!! thank you

4/6/15

Can anyone explain how to do this for say a fob purchase on basis for 50,000 mts corn and selling at a small profit at a flat pmt to buyer. i.e. we are a middleman providing the ocean freight.

11/23/15

If you're the middleman, you should be taking no pricing exposure if terms are back to back. Your profit will come from the premium you can charge the buyer for taking the shipping risk.

11/23/15

Thank you for both of your posts !

11/23/15

Great articles....SB.

"And to you, Doctor... clk clk cluk clak!......Oh. Sorry."

11/23/15

Really great posts, thank you.

11/23/15

Great post yet again. Hoping there's enough support to encourage another continuation.

11/23/15

Great Post, thank alot

11/23/15

Great ! Thanks again ! I'm looking forward another primer haha

11/23/15

Appreciate this post. Very insightful.

11/23/15

Very nice post. I was wondering how many of these trades do you usually execute? One a day or multiple a day?

11/23/15

Some days will have 5-10 trades in a day, while others will be 0-2. It depends a lot on volatility and liquidity. The one thing to be careful of is that you do not want to trade too much throughout the day. Commissions on these types of physical trades can be at least 5-10 points ($0.0005/gal to $0.0010/gal), but on 25,000+ barrel trades, it will add up quickly.

11/23/15

Thanks as always for the insight. Great stuff you put out there. For the newbies, if you haven't read the Dr's other posts, do so...

11/23/15

great post

11/23/15

great post

11/23/15

The first step finally went through today!
http://www.businessinsider.com/us-approves-landmar...

  • Anonymous Monkey
  •  11/23/15

Hi Wantibd,

Congratulations. Secondly, which program did you apply for and at which office? If i remember correctly Trafi splits it between metals / oil derivatives.. following that selection you choose your preferred location eg. Moscow, Singapore, Geneva etc and which part of the business you want to be a part of.. operations/deals desk/ Finance. If you give me some more info I could advise you accordingly as I went through the process in 2013.

Best,
Tim

11/23/15

Got an interview for Stamford - looking to do oil or refined products. Which locations go for that? Would gun for ops

11/23/15

Hi Tim,

I applied for the oil/derivates program as a senior undergrad. I'm interested in going for corp fin or the deals desk rotation. I applied for Montevideo and Geneva. Any insight is greatly appreciated!

11/23/15

gasoline and fuel oil as these are the major products that are blended. north sea crude bidding / chains are interesting as well.

11/23/15

@Ichimoku nailed it. Gasoline and fuel oil are where it's at for blenders. It's one of the only places where you can add value to a product so you're not operating in a zero sum game.

11/23/15

gasoline is high if you're in the us. something like 100 different grades

11/23/15

The BOB/Conventional gasoline. Many different specs (http://www.colpipe.com/pdfs/cplmansec3-01202014.pdf)

11/23/15

Look up Probo Kuala; that was fucking brilliant (until those penny pinchers at Trafi decided to use Cote D'Ivoire "waste mgmt" sub-contractors to get rid of the toxic sludge left over, instead of paying pros in Rotterda;; God knows the PL would not have been affected much...)

11/23/15

Interesting to see the difference between Trafi's side and the reported version of these events.

http://www.trafigura.com/media-centre/probo-koala/trafigura-and-probo-koala/
http://en.wikipedia.org/wiki/2006_Ivory_Coast_toxic_waste_dump

11/23/15

the email correspondence for Probo Kuala that came to light during the trial is amazing ahah

11/23/15

"Yes, but we need dogs. And cheap ones too"

Classic.

11/23/15

contagoman:

the email correspondence for Probo Kuala that came to light during the trial is amazing ahah

is any of it available online?

11/23/15

Tupac:

contagoman:

the email correspondence for Probo Kuala that came to light during the trial is amazing ahah

is any of it available online?

ask and you shall receive
http://image.guardian.co.uk/sys-files/Guardian/documents/2009/09/16/Final_emails.pdf

11/23/15

thanks - if only i could understand half ot that haha

11/23/15

Pretty interesting how Trafi's CEO was involved in some of the discussions. No matter how genius the whole thing had been up to that point, there probably was no cheap way to get rid of the slops.

11/23/15

GoodBread:

Pretty interesting how Trafi's CEO was involved in some of the discussions. No matter how genius the whole thing had been up to that point, there probably was no cheap way to get rid of the slops.

word on the street is that Claude actually participates in the running of the zinc book

11/23/15

there's a book called "Oil 101" that might help

11/23/15

I heard many times that scheduling is really important and gives priceless informations for paper trading.

In your opinion does this really impact paper trading ?
What to look for when you're starting in scheduling ? Which type of information should you gather or gain from counterparties ?
Any good reads to understand how traders reflects on current markets and find trade ideas ?

thanks

11/23/15

OP, to answer your question, I don't think it's really possible to answer the question of "which is the most knowledge intensive". The stream that will require the most knowledge is the one with the most specs ( because you will need to hit all of those specs to sell it as that stream).

When you're blending, you're trying to combine different streams that you're buying at a discount to hit the specs of something that you can sell for a profit. This is going to be extremely simplified but imagine we're trying to sell Stream A.

Stream A: 0-5 ppb Sulfur Range. Selling for $10.
Stream B: 5-10 ppb Sulfur Range. Selling for $5.

We buy 10 bbls of Stream A with a tested Sulfur of 1 ppb. Cost ($100)

We buy 10 bbls of Stream B with a tested Sulfur of 9 ppb. Cost ($50)

We blend this together and now presumably have 20 bbls of product that falls within Stream A specs. Our all in cost is ($150) and our selling price is $200.

The point of this is to demonstrate that you need to know all the specs and how they'll interact with each other of what you're buying/blending and what you're selling it as.

This is quick and dirty, but I wanted to get more physical trading discussion going on the forum again.

11/23/15
11/23/15
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