Back to Back Physical Commodity Trading: Bearing Flat Price Risk

elnaz_sn's picture
Rank: Monkey | 52

Dear all;

I've been reading up on Craig Pirrongs Economics of Trading Firms published by Trafigura:
Very informative read. My understanding is that the flat price risk is hedged using future contracts and other derivative contracts. Questioning my fundamental assumptions that risk and return are directly linked, my question becomes what advantages are born if flat price risk had to be taken on, and hedging with derivatives is not an option? The context of my qurstion being Im trying to understand the risks measurement and management in physical commodity trades which are exclusivley back to back (buyer and seller both exist) and positions and future contracts are not allowed. Are there alternative methods of hedging flat price risk that do not involve future contracts?

Comments (13)

Jun 24, 2018

Even when you price something "back-to-back" that has a derivatives market, you typically get rid of flat price risk by aligning quotational periods. So you might buy tomorrow's settlement -1 and sell at tomorrow's settlement +1. So you will make +2 - freight essentially.

If there are no derivatives, you might go off a publication's index, or barring that, just agree prices on both legs ahead of time. The only context in which you would take flat price risk is if you actually want to take a view. If for instance you think prices are going up, you could fix your purchase today, and fix your sale tomorrow, in a week, in a month... You would do the opposite to go short although that might be a bit tougher to execute (whoever is selling to you might not understand fixing the price later, and you will probably have to pony up a provisional amount first).

    • 3
Jun 25, 2018

If you're truly back-to-backing a trade you aren't really taking on flat price risk. If you buy something and immediately turn around and sell it at a margin then flat price risk isn't really a concern because you've locked in both legs of the trades. At this point you're really more of a broker-dealer than anything else and your biggest risk is counterparty risk and credit risk.

    • 2
Jul 1, 2018

Thanks for the reply, technically speaking yes it is back to back. However, my understanding (from international bank of settlements) is that back to back means same day transfer. As it stands, we don't receive payment from buyer and transfer to seller, we pay from pocket. The back to back part is in the fact that we are not allowed to secure a buy until a sell is secured. The time frame between the two (bill of lading to delivery) is on average a month, prices are set by publication formulas (average high and low + set amount).

Most Helpful
Jun 26, 2018

Very simplified example:

If you sell 60000mts of flat price September delivery Brazilian Soybeans you have a flat price short position of 60000mts of BRZ Soybeans.

To hedge your flat price risk you need to do one thing - buy 60000mts of flat price BRZ soybeans.

Two common options:

1) You buy the equivalent cargo of brz soybeans (lets assume its for the same period of time, so you have no embedded time spread risk), your short position now gets 60000mts longer, and goes back to 0. You have no flat price position, you've hedged your flat price risk. The PNL of this position largely comes down to the difference between your sales price - purchase price - execution costs.

2) Alternatively you buy 60000mts of CBOT soybean futures, negating your flat price risk, buts leaving you with brazilian basis risk (a whole different story).

In case 1) you are in a relatively low risk, low reward situation.
In case 2) you are foregoing a flat price risk but maintaining a basis risk - higher risk than situation 1, but with the right knowledge and experience making money trading the basis risk can be done.

Given that you cant do situation 2) it looks like you can only do situation 1). If you are B2B every bit of business, you don't have any flat price risk anyway. Just try not to fk up the execution, also be aware of any embedded time spreads in your position if you don't buy and sell September shipment/arrival (which normally you cant, as you need to take into account transit time etc).

Jul 1, 2018

thanks for the reply, can you elaborate somewhat on the b2b part "every bit of business"? the b2b aspect is solely in that we are not allowed to secure a buy until a seller is present, we are not allowed to buy with the view to sell once opportunity arises later. Payment wise, we pay from pocket and settle both accounts, time wise, it takes about 1-2 months between order and delivery. We provide the shipping and distribution.

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Jun 26, 2018

You just answered your own question, you are going to B2B all business - i.e not buy anything until you have a seller lined up to take the other side. You cannot take a position or speculate, based on what you have said to me.

So you are not taking any real flat price risk, for all intents and purposes it feels like you are acting as a broker for the deal.

Is your company providing the shipping itself along with distribution (what does it mean you provide distribution - are you not just discharging to an end users warehouse?) or are you arranging the shipment with a freight forwarder and the sellers/buyers operations teams?

Jul 1, 2018

Could you elaborate a bit on what you're asking. If you're just doing back to back business, you're not taking on any flat price risk. You just have credit and execution risk.

Back to back doesn't mean same day of transfer, it just means you've locked in the purchase and sale of the commodity at (more or less) the same time. You're always going to need working capital to fund trading.

The margin in back to back business isn't so much a risk reward thing in the traditional sense. It more comes from a combination of an opaque market, and economies of scale in freight/physical execution. When you are b2bing cargo, you're probably pricing in a certain margin to leave enough fat for any execution screw ups, as well as making sure your appropriately compensated for the credit risk your taking in the long run.

    • 2
Jul 1, 2018

Thanks for the reply, the execution is back to back, the products being bought and sold are petrochemicals, fertilizers, and steel. The main question of risk for me is in the pricing, the pricing is based on 3 weeks average before bill of lading. the average timeline between agreement and bill of lading is a month. Are we not faced with a risk that the prices will fluctuate in the meanwhile due to volatility? i.e. will the change of price between now and three weeks before my bill of lading have me locked into a trade that is ultimately not profitable. Does tax risk also not feature? specifically when trading in new territories like MENA with new taxation rules...?

Jul 1, 2018
elnaz_sn:

Thanks for the reply, the execution is back to back, the products being bought and sold are petrochemicals, fertilizers, and steel. The main question of risk for me is in the pricing, the pricing is based on 3 weeks average before bill of lading. the average timeline between agreement and bill of lading is a month. Are we not faced with a risk that the prices will fluctuate in the meanwhile due to volatility? i.e. will the change of price between now and three weeks before my bill of lading have me locked into a trade that is ultimately not profitable.

What is the pricing structure to the buyer for this trade? If this was purely a B2B trade then your purchase and sale would be linked basis 3 weeks avg pricing before B/L with a margin applied on the sale side. As others have mentioned above previously, an example would look something along these lines:

Quantity: 30,000 litres
Purchase: 3 weeks avg ICIS petrochem index +1
Sales: 3 weeks avg ICIS petrochem index +6
Margin: $5 per litre
Profit: $150,000

It eliminates any flat price risk as you are locking in sale and purchase relatively at the same time. Looks easy but majority of times things dont always align because of timing or other risks.

    • 3
Jul 5, 2018

Deleting my comment as I re-read your thread and I think we need to back up further.

Has anyone at your current shop ever executed a single physical trade?

Jul 1, 2018
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