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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Physical Oil Trading Basics (Part 2 of 2) (Originally Posted: 03/17/2013)
After Part 1 last week, I’m pretty pleased with the feedback I have received, both from comments and PMs. If you have not yet read Part 1, check it out here. I think last week gave a pretty good primer on the basics of physical trading and hedging. This week’s summary is going to be a little more technical and complex, but I believe it can be learned pretty easily with the right examples. I didn’t really have anyone teach me this because the person’s job I took had already moved on to a new desk, so I hope this will help any of you going into the physical trading world.
After looking at flat price and basis trading last week, this post will be focused on formula pricing and arbitrage. A few different products and modes of transport tend to be priced this way, but IMO the best examples tend to be the ones which look at large cargoes being priced. Without further ado, let’s get into it. As outlined in Part 1, pricing can be negotiated in a number of ways. One of these ways would be to do a “wrap” version of formula pricing. The “wrap” signifies that pricing will be based on some number of days surrounding a designated pricing event. One of the more common versions of this would be to price a cargo based on the Platts price three days around the Bill of Lading (shorthand: 3 @ B/L) or three days around Completion of Discharge (3 @ COD). At a basic level, that means you do not have an actual price for your product until those three days have been completed. Your purchase or sale price is completely based on the Platts settlements of those three days. Don’t let the Platts name confuse you. It is just a settlement price like any stock or future.
The arbitrage scenario from Part 1 was for buying a cargo from South Korea and selling into the West Coast US. We’ll examine this further below to really dig into the mechanics of how you execute a deal like this. After that, I’ll give another example to take it even one step further. As you think about this, the biggest factor you need to remember is that once the product is sold, you want to be “flat” in both your futures and your physical trades, meaning that all purchases have been matched up to an equivalent number of sales.
Example 1: Korea to US – Let’s repeat the scenario from last week that there are refineries going down in Los Angeles, either for turnaround or unexpected maintenance. As a result of that, you think the LA Market is going to shoot through the roof and you want to take on some pricing exposure. For the sake of using round numbers, let’s say that you agreed to buy 300,000 barrels of March gasoline on EFP at an FOB price of NYMEX April RBOB + 5 cents per gallon (a less long-winded way of saying this would be 300mb at April RB + 5cpg). Your initial trade would look something like this:
Buy 300mb March Gasoline @ $3.0500/gal Sell 300mb April RBOB @ $3.0000/gal (the actual prices don’t matter as long as the 5 cent differential remains)
Now you know exactly what your purchase differential will be. When thinking about a sale, you have a number of options. You can sell on EFP (Exchange Futures for Physical), sell based on a publication like Platts, or just roll with it and assume you can get a better price later. Since you believe the market is heading up, you will definitely choose not to sell on EFP right now because that cuts off your upside. Waiting until later would make for a boring example, so let’s say you choose to sell based on a Platts price. As we have discussed, when a deal is done based on a publication, it will usually be based on the average of a few days’ pricing surrounding an event, often the Bill of Lading date at a loading location and the Completion of Discharge date at an unloading location. The question from there is: how do you hedge that and manage the risk? Well, we know that we are effectively short 300 contracts of April RBOB already, so you will clearly be looking to buy back April RBOB at discharge. For simplicity’s sake, let’s say that you sold based on Platts LA CARBOB’s quote 3 days around Completion of Discharge with no differential. In a scenario like this your operations team will be very important because in order to hedge properly, you’ll need to accurately gauge which day discharge will be completed. If your cargo completes discharge on Wednesday, your pricing will be based on the average of Tuesday, Wednesday, and Thursday. As such, your exposure is based on the settlement prices on those days and those are the days you want to hedge. With a 300,000bbl cargo, you are effectively selling 100,000bbl of physical product each day. To hedge, you would simply buy 100 April RBOB contracts at settlement each of those days. Generally speaking, as long as that difference between the Platts sale and the RBOB purchase is high enough to cover the 5cpg premium paid at origin and the cost of freight (including demurrage and product lost in-transit), you’ll make money. Here’s how that would work:
Sell 300mb Physical @ Platts LA Carbob, 3 around Bill of Lading – For example, let’s assume this average is $2.9500 Buy 100mb April RBOB Tuesday at $2.8500 Buy 100mb April RBOB Wednesday at $2.8000 Buy 100mb April RBOB Thursday at $2.7500
On average here, you are selling 300mb physical at $2.95 and buying 300 futures contracts at $2.80, for a differential of 15cpg. You have now completely flattened your positions and managed your risk properly. Let’s take a look at the results. I’ll split them up into physical and futures so that you can see why avoiding flat price exposure is so important.
Buy 300mb physical at $3.0500 Sell 300mb physical at $2.9500 – This is a loss of 10 cents per gallon, or ($1,260,000)
Sell 300 April RB contracts @ $3.0000 Buy 300 April RB contracts @ average $2.8000 – This is a gain of $2,520,000
At this point, you have made a total of $1.26 million before costs. As long as your freight, demurrage, and other miscellaneous costs total to less than that amount, you have made a profitable trade. As you can see, the flat price exposure would have lost you over a million dollars in this scenario. The reason for the flat price fall could be any number of things. Maybe New York Harbor had a ton of product come in. Maybe the economy as a whole weakened. All that matters to you, as a trader, is that LA strengthened relative to the NYMEX price.
Now that we've taken a look at a pretty tame example, we can go one step further and look at different basises on the same trade. In arbitrage scenarios especially, you may not be able to buy and sell based on the same index.
Example 2 – Let’s say you know someone who wants to buy 50,000 barrels of a blendstock that will allow them to complete an in-tank blend. They want you to act as a middle-man and find them this blendstock. These are often hard to value, but you know what they’re bidding and decide to figure out if you can make a deal. You find a blendstock that works being offered on EFP at NYMEX WTI + $5 per barrel DELIVERED into tank in Los Angeles (how nice of them!). However, your contact who is in need of the blendstock is bidding on EFP based on a price of April RBOB minus 10 cents per gallon. Assume that RBOB futures are currently at $3.00/gallon and WTI is at $100/bbl
How can you manage your risk properly and lock in the profit? I think the easiest way to continue looking at “locking in” profits is to look at what your position will look like after the deal without locking in. Then you can work backwards to figure out what you need to do as you enter the deal. Here is what we know so far:
Buy 50mb Blendstock at $105 per barrel ($100 WTI + $5 Diff) Sell 50mb Blendstock at $2.90 per gallon, which equals $121.80 per barrel ($3.00 RBOB - $0.10 Diff * 42 gal/bbl)
Sell 50 WTI at $100 Buy 50 RBOB at $3.00
From looking at your ultimate position, you now know that you would be left short 50 contracts of WTI and long 50 contracts of RBOB. To close your position, you simply need to close those positions! Since you know that you are sitting in a profitable position, you would sell 50 RBOB contracts and buy 50 WTI contracts (called selling the “RBOB crack”). Once you have completed executing those futures contracts, you have finalized your profit. This is the definition of risk-free profit. It just may take a couple of steps to get you to where you want to be, but if it was easy, everyone would do it.
In practice, you may see a number of different publications and products, but if you simply work backwards from your final position, you will always know how to lock-in a profitable trade. Isn't arbitrage great?