Strategic Position of Physical Houses
How does a physical commodity trading house establish and maintain its strategic position within the supply chain. I understand that the industry is heavily dependent on relationships but what makes the relationship mutually beneficial for the producer? From my current perspective, it is very obvious that if producers were to higher bigger sales teams they could circumvent trading houses and sell to the customers at the end of the supply chain directly. This seems to be very logical as they would be able to charge greater margins as there is not a middle man/ market maker marking up the price. Any input from any commodity would be greatly appreciated.
Thankfully not all producers share the same logic when it comes to bigger sales teams and greater margins.
The quick answer is risk management and appetite. Would you prefer to generate x amount by selling to an international trader, or risk collecting receivables from Happy Lucky Pvt Ltd in New Delhi?
That makes sense. Obviously, I would prefer to generate x profit by selling to an international trader but is there anything that stops the supply side from impeding on market share and taking downstream clients given that at any given time they have the ability to undercut and even stop supplying downstream intermediaries like trading houses. Especially for trading houses that operate domestically, I would imagine this would be a strong disadvantage, no?
Also, based on your analysis do you see this to be a cause for concern for someone looking to build a 40 yr career in an industry
depending on how interested you are in the subject, reading "king of oil" may be worthwhile. The book is based on Marc Rich who created the secondary market for oil. Essentially all the suppliers ran the market, but Marc rich found ways to add value as a trader or as you refer to them "middle-men". Commodity markets are extremely dangerous without liquidity. Physical products are even more dangerous without liquidity. Suppose 'supplier A' in South America has a product sold to 'End-user A' in North America. All is good until the loading port goes on strike and there is no way to get the product out. End-user in North America calls the supplier screaming that without the product they cant operate. in this scenario, every other supplier in the world will happily watch as the trading relationship is ruined. You have to have liquidity. this is just one example, but there are a lot of reasons to prevent suppliers from trying this.
Think of American farmers. Back in the day, they tried this multiple times. one example where the farmer to end-user model fails is in terms of volume. If you are tyson and you have to fill Mcdonalds and chick-fil-a with chicken to feed this american obsession with fried chicken, you need some serious volume. When I started in the grain industry, I remember moving one farmer's entire year on one barge. I filled 12-18 barges a day. Sure there are co-ops, but those are typically geographically limited. Imagine a Co-op base in Illinois going to a Japanese tofu manufacturer and promising to supply all the soybeans that this tofu maker needs. illinois has had 5 great crop years so the volumes needed in Japan will be easy to fill based on historicals. But, suppose they have a bad crop that year. They cant fill the demand and Japan is unable to make their tofu. A trading house can come in and assure their Japanese counterpart that they are geographically diverse and thus lower risk. this is just an example and I understand that there are global Co-ops such as CHS.
I hope this helps. these are just a couple of examples, but that "king of oil" book will certainly give you additional perspective on the value of traders/intermediaries/middle-men.
There is also the service of dealing with logistics. Even if you can find a buyeer from the seller point of view, do you really want to deal with arranging transport and storage.
@CaughtShort is completely correct. Most of the time large buyers are not interested in dealing with logistics and dealing with the producers schedule. When you purchase from the farm for example, and your sale calls in the specific commodity (wheat, corn, etc.) they expect to take the commodity exactly when they need it to be delivered. If I short that sale and one of my producers farms is caught in a blizzard, I can pull product from somewhere else in the continent to satisfy the sale; if that deal were to be direct from the producer to buyer in large volume and the buyer is dependent on a product that is unable to be delivered, you can sure bet that penalties will be unleashed on that producer(depending on the contract agreed upon of course).
Another factor to take into consideration for your original question regarding benefit for the producer, think of it this way. A ginormous ethanol plant needs a lot of corn and the market price for corn is "x." A mid to large sized producer is most likely not going to get a better price than what is market because unfortunately what he has is not worthwhile to the buyer and although the buyer needs product he/she is not willing to show their cards because logically their goal is to buy as cheap as possible. Now, A good trader will come in and show thousands of tonnes of product to this buyer(that he may not even have) and guarantee that they will get it on time for future dates, and hopefully in turn negotiate a sale price much higher than corn price "x" thus moving the market. The trader would then go to the prior producer (and whoever he can while he/she has this window of opportunity) who may have been rejected and offer a slightly better than market price, purchasing that commodity and offering the best deal within 100 miles. Great traders can execute this type of deal seamlessly and spread their margins as wide as possible, while maintaining a great relationship on both sides.
In the end I believe trading physical's are not always about margins for the buyer and the seller in most cases anyway, it is about managing expectations and solving problems. You would be surprised how even a historically high commodity price sounds shitty to some producers if the value was just 5 cents higher a week ago.
"This job is 10% finding opportunities to make money and 90% figuring out how the hell you can make it happen"
Can't comment much on oil/metals but one point to add, in terms of the domestic agri trade it's essentially a zero margin business (when not factoring in assets). If we've jut purchased something, its because we were the best bid on the day, and if we sold something, it was because we were the best offer on the day.
The end users post bids at the exact same grain elevators that we do. We're often bidding farmers higher than what the end user is willing to bid on that day because we're either building a long position, or we're covering off shorts. It not like the farmer is going to get a better price selling directly to the mill/feedlot etc than they would to us.
Same for the end customer, if they're buying off us, its because we're cheaper than what farmers, or other traders are willing to sell on that day.
good explanation but you but how you hedge this trades by buying futures or ... ?
depends on the product. A handful of ag products are hedgeable. Corn, soybeans, wheat, soybean meal, and sou oil, can be hedged. but one big one for example that can't be hedged is dried distillers grain. Although Platts is working on a contract.
Not necessarily disagreeing with softtrader , but in the domestic grain markets there are a lot of way traders build margin without assets. Arbitrage is what traders live off of. If you build a deck of business you can begin to arb your positions and create margin by shuffling paper.
Further, at least in the grain market, freight is the biggest piece. I sit by some guys that trade the West Texas feed markets and they clip margin by keeping trucking company busy 100% of the time, so the trucking company gives them cheaper freight just because the consistent business.
The end user rarely has a deck on that he can arb. this provides opportunities for traders to the create margin expansion with freight and such.
Commodity merchants warehouse various types of risk such as: credit risk, product risk, temporal risk, etc.
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