Physical Commodity Trading
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?
physical commodities trading overview
Physical commodities trading is a business that exploits the arbitrage that exists when selling oil (or any commodity) for physical delivery in different markets or at different times. Our users explain below.
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.
Geographic Arbitrage in Physical Commodity Trading
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.
Example Physical Commodity Trading Scenario
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.
You can see a picture that demonstrates the process of physical commodities trading below. You can read more about it on the Trafigura website.
- Physical Trading: Best Commodities To Be In?
- Physical Commodities Trading In NYC Proper
- Commodity Physical Vs Financial Trading
Want a Career in Trading?
To begin preparing for your interview, WSO Prop Trading has everything you need to know for prop trading interviews, including a myriad of questions with thoroughly explained answers.
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.
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.
Supermajors are more bureaucratic, have a less "urgent"/fast-paced culture, are relatively limited in what they can pay, focus more on asset optimization / trading around their assets and using their trading operations to optimize their other operations, slower to promote people or give more responsibilities, and maybe a bit less competitive to get into.
Trading houses are less bureaucratic, have a faster paced / more "risk taking" culture, aren't nearly as limited in what they can pay their people, focus on making as much money as they can - period, will promote as fast as they have to and when a person is ready and not much later, and probably a good deal harder to get into, at least out of college.
Before any of you say anything, notice how that is a RELATIVE comparison. Supermajor trading floors will still have a fairly flat structure/feel/culture, take on lots of risk, etc.
In terms of training, what people really need to understand about this industry is that you are going to get the best training, at least out of the shops you listed, at the shop where you are going to fit and work the best. If you can't take lots of heat, you probably shouldn't even consider Trafigura. If you can't stand a culture that makes you hold the hand rail and focuses more on diversity than ability, you might want to avoid BP. And so on.
don't forget Trafigura, Noble, Gunthor and dozen other low profile sharks.
yeah it could be profitable. Physical trading is much more different from financial trading. You take on a much more administrative and people oriented role. It's not like clicking the buy and sells on a trading platform after doing some due diligence from public information. No, you talk to people and hunt for market information, develop relationship with counter parties, make sure the paperwork gets signed, and logistics do their job in getting the transport for your goods from A to B, when the pipeline breaks down or your trucks ain't going from point A to point B, you get on the phone and sort it out with the field guys. Lots of informal contracts done over some emails and words of mouth. and on and on. not for the faint hearted.
Price Discovery: Each region of the globe has different supply/demand dynamics that are not easily known, unlike stocks or futures. Prices within one hundred miles can vary wildly without every market participant knowing this. Traders who can understand these regional differences are able to capitalize on them and profit. This is done by forging relationships with counter-parties in order to gain information that others do not have.
Specifications: Although physicals are commodities, buyers can often vary in what specifications they are willing to accept and sellers vary in what they can offer. Traders are able to capture these differences. This goes hand in hand with price discovery; as the old saying goes, one man's trash is another man's treasure.
Logistics: Anyone idiot can buy and sell physicals. The real meat of the trade is in the execution. Understanding freight, storage, and opportunity cost is the hallmark of a good physical trader. Your reputation in physical trading is determined by the volume of profitable trades you execute successfully, not the trades that you put on paper that look good but can't be executed. Traders who can execute consistently can command higher margins.
Relationships: Price is not the only thing that drives the decisions of buyers and sellers. Traders who can ingratiate themselves with their counter-parties by knowing where the market is (price discovery), understanding the buyer's or seller's needs (specifications), and executing reliably for the counter-party (logistics) can often protect their markets from interlopers and command higher margins on their products.
Large firms can offer informational advantages simply because of their reach, but there are also smaller companies that do extremely well by working within a niche market (either product or region) and knowing the ins and outs of that market better than anyone else. Physicals continue to look bright because of growing markets and huge logistical issues that offer tremendous opportunities for skilled traders.
Would like to add 4 specific PL drivers:
It costs aprox. $10 less per wmt to ship 15k wmt of copper concentrates from point a to point b than it does 5k wmt.
If you buy 15k wmt of mineral in Chile and then line up three different smelters in Asia for 5k wmt clips, you pocket this freight differential.
This is most simple example I can think of, but there are many other pays: taking tonnage on COA or time charters and then using it to cover spot shipments, taking directional positions on freight market, cost savings from operating own fleet, etc.
You buy 1,000 wmt of shit, and 1,000 wmt of super clean concentrates. Blend that and you end up with 2,000 wmt of OK grade material. Since the difference between OK and super clean materials is MUCH smaller than difference between shit and OK materials, you make money by blending.
Trading houses have much lower costs of financing than most commodity producers and suppliers.
Additionally, trading houses understand the risks involved in producing and processing commodities much better than banks.
Consequently, traders can borrow cheap and lend at higher rates to their clients and suppliers.
They further benefit from this interest rate arbitrage by being in a much better position to monetize collateral (as opposed to a traditional lender).
I.E. It is much easier for a trader to take the couple thousand tonnes of raw ore which a mine posted as collateral on a defaulted loan, pay someone to process it into concentartes or metal, and then sell that than say a bank would. Same goes for productive assets etc (a trader might even want to keep the mine or plant on its books after having executed the guarantee, whereas a bank is probably not even allowed to hold the mine and will have to sell it for cents on dollar).
My two cents.
Because as Propane/Natty/Heating Oil/Power have shown this winter, there is massive VAR and risk that most people do not understand. Historically volatility in these markets was very high for a period of time then it went away over the last 4months its back and its ugly back, many sleepless traders and marketers out there. You may ask why is so much VAR unknown the reason is because "real life happens", black swan events in the physical world happen all the time from accidents/strikes/weather/new technology/new discoveries etc... There is so much imperfect information.
At the most basic level when you model risk in Physical world you do not even use a B-S or style model, its usually a very compliated binomial or monte-carlo style.
Lastly, WSO glamorizes shit big time, its only profitable if you have the right assets, connections or win there is lots of losers out there, lots and lots.
I don't know how old you are / what previous experience you have. For sophomores and juniors who perhaps would be overlooked for roles at physical shops i would HIGHLY suggest trying to land an internship with one of the myriad support / service sectors, or with a commodity prodicer / consumer first.
Competition for places is much lower, they are not used to receiving as many cold calls / emails for people asking for internships, and you will learn a lot of actually useful information / make your CV stand out when you do go for a trading position...
For example, an aspiring coffee trader could get experience -and boost his CV prior to applying to a position at a trading shop- at any of the following type of companies: