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Hi,

Can someone explain how exactly a physical commodity trading house makes money and why there is a need for independent comodty houses, whats there right to exist?

What are the risk when trading commodities physical and how can they be hedged, are there specific hedging strategies that are applied by physical traders?

Thanks for the feedback.
Cheers.

Comments (49)

  • Gekko21's picture

    Physical Commodity houses make money by trading commodities that actually exist. Even though a futures contract is physically deliverable, most positions are closed out before physical delivery needs to be made. They are not just trading a piece of paper that is worth 1,000 barrels. They literally trade barges of oil or oil in a pipeline that NEEDS to go somewhere.

    There are a few risks for physical commodity prices, but the two biggest are price risk and credit risk. You hedge the price risk with futures and you hedge the credit risk with CDS.

    The physical trading of commodities is done between different counterparties and there is a time delay between when the deal is done and when oil is delivered. I believe it takes 40 days or so (depending on how full the pipeline is) for oil to flow from Canada down in to PADD 3 (Gulf Coast). There is a credit risk during that 40 day delay. Even though it is not likely that a counterparty defaults, in the unlikely event that one does, a trader could lose 10+ million. It is much safer just to hedge it with CDS.

    Unlike a paper trader, a physical oil trader has to worry about supply and demand in different regions of the US (as well as what Brent and other grades of oil are doing abroad). They also have to look at transportation cost, storage costs, refinery set ups, ect.

    "Greed, in all of its forms; greed for life, for money, for love, for knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA."

  • vanquan's picture

    Thanks. Can someone explain what location arbitrage is, and which commodities are used for it, some classic examples.

    But the question regarding the right to exists of independent commodity houses still remains, what's the advantage of dealing with them instead of completely integrated companies like the oil majors?

    Cheers,
    Alain

  • In reply to vanquan
    monty09's picture

    vanquan wrote:
    Thanks. Can someone explain what location arbitrage is, and which commodities are used for it, some classic examples.

    But the question regarding the right to exists of independent commodity houses still remains, what's the advantage of dealing with them instead of completely integrated companies like the oil majors?

    Cheers,
    Alain

    for me its exporting power from the midwest when prices falls and importing the crap out of it into cali as prices skyrocket.. aka enron

  • In reply to vanquan
    Gekko21's picture

    vanquan wrote:
    Thanks. Can someone explain what location arbitrage is, and which commodities are used for it, some classic examples.

    But the question regarding the right to exists of independent commodity houses still remains, what's the advantage of dealing with them instead of completely integrated companies like the oil majors?

    Cheers,
    Alain

    Different commodities can have slightly different prices based on their geographic location and the supply/demand in that area. There could be a lot of supply of crude in one pipline, but less crude in another geographic area which has a higher price (also different grades of crude have different finished product yields depending on the refinery set up). Those price differences allow for an arbitrage opportunity provided the transportation costs are less than the spread between the prices. traders will conduct this arb until the spread disappears. In the oil market arbs can last weeks or even months because you are dealing with the actual delivery of a commodity. There are also global arbs. The Brent-WTI (Atlantic Arb) is the most commonly traded oil arb in the world with traders being able to take North Sea Brent and ship it across the Atlantic depending on WTI prices and freight costs----the trade can also go the other way with WTI going to Europe. There is also different supply and demand characteristics with finished products, Asian economies use Naptha as a blend stock for petrochemicals while American companies use Ethane and Propane----there is higher demand for Naptha in Asia than the US and refineries in the US can earn a profit by shipping their Naptha production to Asia.

    Why do commodity houses exist? They exist for the same reason that hedge funds exist--they provide increased liquidity and someone decided to start trading commodities with their own money that eventually became a large operation. They also invest in and build storage capacity which they use in their operations or can rent out. At the end of the day, they exist for the reason that any corporation exists....because they can make money.

    "Greed, in all of its forms; greed for life, for money, for love, for knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA."

  • pillz's picture

    it is illegal to ship WTI out of USA. Plus it is a landlocked crude.

    In theory it is easy to say "traders will conduct this arb until the spread disappears". This doesn't always happen in reality. Also the arb might be open for one person and closed for another.

    Otherwise not a bad post.

  • In reply to pillz
    Gekko21's picture

    pillz wrote:
    it is illegal to ship WTI out of USA. Plus it is a landlocked crude.

    In theory it is easy to say "traders will conduct this arb until the spread disappears". This doesn't always happen in reality. Also the arb might be open for one person and closed for another.

    Otherwise not a bad post.

    It's illegal to ship WTI out of the US? I was under the impression that WTI was deliverable under the ICE contract just as WTI, Brent, Bonny Light, and a few other crudes were deliverable under the NYMEX contract.

    Also, can't they ship it through a pipeline, load it onto barges and then put it on a Super Tanker off the coast of New Orleans (I think?) or get it onto barges and ship it up to NY?

    "Greed, in all of its forms; greed for life, for money, for love, for knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA."

  • EarTotheStreet's picture

    The ICE WTI contract is financially settled there is no delivery on it.
    I haven't heard of the atlantic arb before but it could be possible i guess. Aren't there Grade differences between WTI and Brent?

    Also phys commodity shops exist purely because the market demands for it. The forward curve for each commodity(contango or backwardated) shows the supply and demand out on the curve.If the mkt is in contango and it is wide enough it maybe advantageous to store the commodity and earn the carry of the curve. This is very common in the Nattie/CL and Ag mkts.

    How can they be hedged?
    -You can hold physical grain and hedge on the CBOT(CME).
    The diff between Spot - future = Basis. If you run a hedged book your ultimately trading the basis.

  • In reply to Gekko21
    pillz's picture

    Gekko21 wrote:

    It's illegal to ship WTI out of the US? I was under the impression that WTI was deliverable under the ICE contract just as WTI, Brent, Bonny Light, and a few other crudes were deliverable under the NYMEX contract.

    Also, can't they ship it through a pipeline, load it onto barges and then put it on a Super Tanker off the coast of New Orleans (I think?) or get it onto barges and ship it up to NY?

    Ear is right ICE contracts are financially settled. They cease trading on the penultimate. Delivery only has meaning on the NYMEX contract.

    You are right that WTI, Brent, Bonny Light and a few others are deliverable, provided they meet certain specifications. Brent which is inferior requires the seller be paid at 30c discount whereas for superior grades sellers are paid a premium, Bonny Light (+15c).

    Delivery point is at Cushing which is landlocked (as mentioned in the above post), and you will need access to the pipelines to deliver. So not any Tom Dick or Harry can do so.

    And no they cannot pipe it to the coast and sell it outside of the US simply because like i said it's illegal. Not that it cannot be piped or ship, but simply because it is against the law. If you are referring to NY, then it's doable (because it is domestic, not outside of US), but i don't think there are any crude streams in the US being priced off Brent.

    Someone correct me if i'm wrong.

  • ad2345's picture

    I work for a physical Energy trading shop. The arbitrage described above is what our bread and butter business is, We transport crude oil, distillate, gasoline, Ethanol and NGL's using barges, pipelines etc.

    I have never heard of it being illegal to ship WTI out of the USA. It most likely will never happen, as the US is still one of the biggest crude oil user and importer in the world. Thus, its hard to make a profitable trade to ship it abroad.

    The location that someone spoke about in regarding to loading ships is LOOP. Stands for Louisiana Offshore Oil Port. You can offload VLCC's and ULCC's at this location and bring it into the Gulf Coast refineries systems using pipelines and barges.

    WTI is landlocked but is also accessible to marine locations using pipelines. Specifically, the Pegasus pipeline which flows from Cushing to the Gulf Coast and Capline which goes from Louisiana to the Mid-Continent.

    LLS grade crude oil is produced in the Gulf of Mexico and the new Bakken Field in ND (this crude really is a LLS lookalike but is traded using the LLS "basis" as a benchmark). LLS derives its value from the Brent-WTI relationship.

    One of the other drivers of Brent prices (other than European demand) is the sulfur content of Brent crude.

    Brent Crude frequently finds its way to the refineries in the Eastern coast of Canada. I would not be surprised if some of Valero's refineries at Paulsboro and Delaware city haven't used this grade before.

    I look at a lot of offshore cargoes coming in daily to the GC, that use various different benchmarks. There are a lot of Saharan blends, Russian blends and South American crudes that find their way into the US.

    As far as the OP's question about how these companies make money. Lots of producers and end-users are restricted in their ability to hedge and trade their systems. I am defining their "systems" as storage, pipeline shipping commitments, production and long-term supply/offtake agreements. Thus, companies like ours step in, take on long term commitments at index values (in case of physical product) and commitments on assets such as pipeline space and storage. Contango is ideally the preferred market structure for storage owners. We also make money on intermonth rolls on the NYMEX contracts etc. There is also a theory on physical players having better insight on NYMEX pricing and structure. But, that relationship seems to keep getting destroyed as energy becomes more of a mainstream asset class.

  • MarkyMarkWahlbergWasAwesome's picture

    Just so everyone knows, LLS stands for Light Louisiana Sweet.

    ------------------------------------------------------------------
    "I just want to be a monkey of average intelligence who wears a suit. I'll go to business school!"

  • vanquan's picture

    Thanks for the explanations. Are there other well known physical arbs that are traded beside the Atlantic arb, does the same exists within the metal space?

    As much of the world's resources are based in political insecure countries, how do the commodity house trade with that problems? Do they just take this risk?

    Is it right that within the commodity market a contango situtation is preferred by the traders as they simply can store and sell foreward? How do they deal with backwardation?

    Cheers.

  • ad2345's picture

    Depends on product. Each product has a distinct arb depending on S/D dynamic worldwide. For ex : Naptha is one of the biggest feedstocks in the Asian Pacific petchem plants. The biggest driver of Gulf Coast naptha pricing is the Asian arb. So, the point is arbs are infinite if you have the capability of transporting said commodity and taking on the risk of pricing and hedging.

    It's an interesting dynamic. Even the most volatile countries have a tendering process where companies bid to either buy or sell commodities. I would assume Letters of Credit and prepayments are the norm depending on country. This is also one of the reasons, why commodity houses exist. To take on the risk and deliver products to users who do not have the ability to/don't want the risk of trading internationally.

    In backward markets, you try to dump your storage, go short and buy the back of the curve and hope to god that the curve flattens.

  • In reply to vanquan
    poorengineer's picture

    vanquan wrote:
    Thanks. Can someone explain what location arbitrage is, and which commodities are used for it, some classic examples.

    But the question regarding the right to exists of independent commodity houses still remains, what's the advantage of dealing with them instead of completely integrated companies like the oil majors?

    Cheers,
    Alain

    As the others have said, location arbitrage is exploiting discrepancies between different geographical markets. For example a product at New York Harbor might be trading over (premium) or under (discount) to a product in say Chicago. If you can buy the cheaper product in lets say Chicago and transport it to New York, you can capture the differential between the margin.Your margin will be dictated by transport (freight, rail, barge) rates and since these can also vary based on distance, time (prompt), fuel surcharges or even negotiations, there can be quite a bit of logistics involved in breaking up loads or re-directing loads to capture price differentials.

    The advantages that these shops can offer are liquidity, pricing and flexibility with your goods--you don't want to be tied to one supplier since if anything happens to their logistics, for example a train delay, you should be SOL. Since you are delivering physical goods there is a very strong emphasis on relationship between you and your counterparties--if you are reliable and don't run someone dry, you'll see more repeat contracts and business.

  • rjroberts1's picture

    Another strategy that was very popular last year is playing the contango in crude. I think the last # I heard was about $0.90 per barrel per month to store crude offshore in a tanker. If the contango (future price - current price) is higher than that, then you buy crude today, store it and sell it later on when the price is higher. Not sure how much of that is still going on now with contango spread being much tighter.

  • mickey mnemonic's picture

    Industry volume and nature of transactions.

    Great thread. Does anyone have some colour they can shed on the size of physical commodity trading in North America as well as key markets. Namely, what I wish to know is the size of physical commodity trading in Canada versus the US. Also, is the nature of transactions typically booked on an exchange via standardized contracts or if this largely takes place off-exchange between supplier-producer.

    Any insight is greatly appreciated.

  • ad2345's picture

    Canada produces approx. 2.5 MM bbls/day of Crude. There is approx. 17 BCF of wet gas and 13-14 BCF of dry gas produced in Canada. Some of the gas is used in Canada while the rest goes South to Chicago and then onto New York. Gas also flows west to California and Oregon. Crude is primarily all flowing south to Chicago and then to Cushing and then even to the Gulf Coast. There are also imports of NGL's, crude and gas produced in the US that flows north into Canada.

    Lot of gas trades on NGX clearinghouse from what I am told. I am sure tons of OTC stuff gets done too. Majority of crude and NGL's trade OTC and starting to somewhat trade on the NGX clearinghouse platform in the last 12 months or so. ICE, Argus, Platts are all trying to make inroads into the Canadian market.

    Markets are nearly not as liquid as gas or refined products in the US. Relationships matter and traders still help each other when one finds themselves in a sticky situation.

    I am in the energy trading biz in Canada if you have further questions.

  • marcellus_wallace's picture

    Natty in Canada is all traded on NGX. They will trade Midwest markets some day too.

    The risk is also not just price and credit, but also getting the damn crap there. There is liquid pools and illiquid pools, each has its own pros and cons. But bottom line phsyical trading is not just paper money, you all learn in school. Shit actually blows up, weather actually changes, ppl do die,

    Even financial points once we reach cash/pysical aka day-to-day this shit becomes real son, the goldmans of the world cant just beat it down like they do on financial products.

  • In reply to ad2345
    mickey mnemonic's picture

    ad2345 wrote:
    Canada produces approx. 2.5 MM bbls/day of Crude. There is approx. 17 BCF of wet gas and 13-14 BCF of dry gas produced in Canada. Some of the gas is used in Canada while the rest goes South to Chicago and then onto New York. Gas also flows west to California and Oregon. Crude is primarily all flowing south to Chicago and then to Cushing and then even to the Gulf Coast. There are also imports of NGL's, crude and gas produced in the US that flows north into Canada.

    Lot of gas trades on NGX clearinghouse from what I am told. I am sure tons of OTC stuff gets done too. Majority of crude and NGL's trade OTC and starting to somewhat trade on the NGX clearinghouse platform in the last 12 months or so. ICE, Argus, Platts are all trying to make inroads into the Canadian market.

    Markets are nearly not as liquid as gas or refined products in the US. Relationships matter and traders still help each other when one finds themselves in a sticky situation.

    I am in the energy trading biz in Canada if you have further questions.

    Very informative! Any ideas on how to size up the total volume of physical trading that occurs for crude, NG and gold in Canada.

    Perhaps the NGX is indicative of dry gas trading but then there is the NGL component in the OTC space which might bring total annual trading to ~ 30000 PJ?

    As for crude, any way to measure the size of trading in OTC? How would one measure totals for Canadian trading volumes in this space?

    Looking to gold, are there any markets / clearinghouses in Canada that you are aware of or would most Canadian trading in this space be captured on the COMEX?

    Lastly, anyone have any thoughts out there the amount of activity that the Big 5 banks may have in the physical trading space in general?

    I apologize for the scattered thought process of mine behind this but your feedback is greatly appreciated.

  • ad2345's picture

    Last month NGX traded approx. 410K BPD of Crude amongst 9 different grades. This is 15% of Canadian crude production. The rest is sold on term contracts and OTC as well. Think about it this way, atleast approx. 2.5 MM bpd trades every day notionally as these barrels have to leave Canada or go to a refinery to be processed. Some barrels go to storage. No idea on how to measure OTC volume.

    No idea on NGL's as most trade OTC. C5 trades approx 15k bpd. Pipeline brings in approx. 40k bpd into Canada.

    No idea on how much gas traded. Maybe someone else can pull that data.

    Never ran into big 5 banks on the phys side. Have a Canadian bank that brokers financials a bit. Run into JPM, MS, Barclays, GS every now and then.

  • ibintx's picture

    Great thread guys. I don't want to sidetrack this thing, but a quick side - Can someone give a brief description of what a physical energy trader actually does on a day-day basis?

    And what skills do you think are most important for the job?

  • In reply to ibintx
    monty09's picture

    ibintx wrote:
    Great thread guys. I don't want to sidetrack this thing, but a quick side - Can someone give a brief description of what a physical energy trader actually does on a day-day basis?

    And what skills do you think are most important for the job?

    very high level move things from a to b for a profit

    relationships is the strongest skill in my eyes and being able to form them

  • In reply to monty09
    JSA's picture

    monty09 wrote:
    ibintx wrote:
    Great thread guys. I don't want to sidetrack this thing, but a quick side - Can someone give a brief description of what a physical energy trader actually does on a day-day basis?

    And what skills do you think are most important for the job?

    very high level move things from a to b for a profit

    relationships is the strongest skill in my eyes and being able to form them

    Would you say energy trading a bit like derivatives market making in that you make money off the spread, albeit in a longer term than most liquid derivatives (if it takes 40 days to deliver)? but on the other hand, it is different in that there are way smaller number of participants in physical energy markets that the personal relationships with the clients actually matter a lot as opposed to a derivatives market maker who has plenty of anonymous customers(market participants) that buys/sells constantly without knowing who the buyer/seller is personally?

  • In reply to JSA
    monty09's picture

    JSA wrote:
    monty09 wrote:
    ibintx wrote:
    Great thread guys. I don't want to sidetrack this thing, but a quick side - Can someone give a brief description of what a physical energy trader actually does on a day-day basis?

    And what skills do you think are most important for the job?

    very high level move things from a to b for a profit

    relationships is the strongest skill in my eyes and being able to form them

    Would you say energy trading a bit like derivatives market making in that you make money off the spread, albeit in a longer term than most liquid derivatives (if it takes 40 days to deliver)? but on the other hand, it is different in that there are way smaller number of participants in physical energy markets that the personal relationships with the clients actually matter a lot as opposed to a derivatives market maker who has plenty of anonymous customers(market participants) that buys/sells constantly without knowing who the buyer/seller is personally?

    short,mid or long you always know who your counterparty is

  • Le Capitalist's picture

    There's currently a decent spread between WTI and Brent that's wide enough to cover transportation and other associated costs involved in getting the stuff from Cushing (where you buy WTI and take delivery) to the Gulf (where you sell WTI at Brent prices). This spread obviously won't last and is in fact narrowing. Supposed one wanted to get into the trade - this is small stuff here, using trucks to transport a couple hundred barrels (per truck) at a time - is there a way to lock in the price differential, using futures, even though both activities will be unrelated for want of a better term. Basically, right now, there is an $18 spread between the two. Maybe this spread will be much narrower next year this time. How I can lock in the $18 difference?

    Thanks

  • axlfrisco's picture

    Hi,

    Interesing thread....

    A couple of questions:

    1. Is a license required to trade physical oil, fuels, and petrochemicals within the U.S. or internationally?

    2. Are there any courses on this that you know of?

    Thanks