Physical Oil Trading Basics (Part 1 of 2)

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.

Energy Trading Basics for Crude Oil Traders

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 for Physical Commodity Trading

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 for Commodity Trading

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 - Terms for Title Transfers

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 Details for Physical Trading

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.

Understanding the Pricing for Commodity Trading

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.

Learn more about physical trading in the video below.

Read More About Commodity Trading on WSO

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Comments (72)

Mar 7, 2013

Awesome post, would SB if I had any.

Mar 7, 2013

Great post!

Mar 7, 2013

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

Mar 7, 2013

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

Mar 7, 2013

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

Mar 7, 2013

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.

Mar 8, 2013

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

Mar 8, 2013

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

Mar 8, 2013

Thank you, this was great.

Mar 9, 2013

Great post. Knowledge dropped.
Thanks,

Death is certain; Life aint.

Mar 9, 2013

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

Mar 10, 2013

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

Mar 11, 2013
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.

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Mar 11, 2013

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?

    • 1
Mar 11, 2013
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.

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Sep 12, 2016
Dr. Shakalu:

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.

hi there i'm a bit confused. If u buy physical, won't u have to take delivery, since it's erm... essentially a physical good?

Mar 18, 2013

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

Mar 22, 2013

Great stuff!

Apr 19, 2013

This is a very helpful article. Thanks for posting.

May 19, 2013

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

Nov 18, 2013

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?

Nov 18, 2013

really great stuff!! thank you

Apr 6, 2015

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.

Nov 23, 2015

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.

Nov 23, 2015

Thank you for both of your posts !

Nov 23, 2015

Great articles....SB.

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

Nov 23, 2015

Really great posts, thank you.

Nov 23, 2015

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

Nov 23, 2015

Great Post, thank alot

Nov 23, 2015

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

Nov 23, 2015

Appreciate this post. Very insightful.

Nov 23, 2015

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

Nov 23, 2015

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.

Jan 3, 2017

Very fad explanations on pricing.

Korea to USA.
RON 95 vs Carbob ! no one in Korea will accept to get paid on Rbob pricing. Opsss

In the real world this trade cannot be settled by a differential + or minus RBOB.

Seller will want the pricing 3 days around the loading around Ron95, buyer will want 3 days around the discharge on Platts Carbob.

Array

Nov 23, 2015

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...

Nov 23, 2015

great post

Nov 23, 2015

great post

Nov 23, 2015

The first step finally went through today!

http://www.businessinsider.com/us-approves-landmar...

Jan 3, 2017

I was in until i saw the part 3 which is word for word taken, potpourri from

Navigating The Commodities Markets with Freight and Spreads.

Array

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  • Anonymous Monkey
  •  Nov 23, 2015

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

Nov 23, 2015

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

Nov 23, 2015

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!

Nov 23, 2015

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

Nov 23, 2015

@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.

Nov 23, 2015

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

Nov 23, 2015

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

Nov 23, 2015

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...)

Nov 23, 2015

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

Nov 23, 2015

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

Nov 23, 2015

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

Classic.

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Nov 23, 2015
contagoman:

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

is any of it available online?

Nov 23, 2015
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

    • 1
Nov 23, 2015

thanks - if only i could understand half ot that haha

Nov 23, 2015

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.

Nov 23, 2015
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

Nov 23, 2015

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

Nov 23, 2015

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

Feb 20, 2017

Trading ideas arise on the go, when you are everyday on the market and talk to buyers and sellers. You see the price differentials, you know transportation costs, so you see where is a potential for physical arbitrage.

Profits can be also made based on management of paper position in relation to physical position and on quality, by playing with specs (blending).

From materials available for free I can not recommend enough Barrels Blog on Platts website.

For all the inspiring physical traders, there are two interesting initiatives that I try to support:
Master in Commodities Trading at University of Geneva and Commodities Academy in London.

On Twitter you can follow #OOTT hashtag, its an extremely interesting "open source" initiative depending on volunteer traders, journalists and aficionados covering physical oil market. Picture of physical oil market that they paint happens to be very accurate.

Nov 23, 2015

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.

Jan 3, 2017

This is what I was about to say.

There is a lot of contraints in the physical product markets (qualities taxes, logistics and intermediary processes, information).

Rarely in the U.S, you hedge and ship a straight product, deliver it straight and an arbitrage will work.

The CARBOB is worth more than the RBOB because it costs more to produce.

Once it also marked in the Platts e-windows that a trader is bringing a cargo on a tanker to Torrence, California for a future delivery, pricing will also react.

Array

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Nov 23, 2015

.

Nov 23, 2015

My understanding is that they do trade physical but mostly to market their own North American production. Not sure if the NY office would handle hedging or head office in China.

Jun 4, 2018
Jun 5, 2018