Commodity Trading Volatilities
I would like to break into commodity trading, and try to get a better understanding of how commodity markets work to be better prepared to interview.
In recent times we have seen, very volatile prices in the Grain commodities such as Corn, Wheat and Soya. What are the main causes for this volatility?
In the oil market, we also see a lot of price swings. So is there also higher volatility in the Oil trading market, and why?
Lastly, if there is a higher volatility is that a good thing for traders, and does it differ for specific categories of trading? (Investment banks, Commodity Traders (Glencore, Cargill) and retail investors that are speculating?
I know it is a lot of questions, but it would be nice to have a discussion regarding this? Hope to see a lot of comments, so that everyone gets a better understanding.
Volatility is traders bread and butter.
"Volatility is traders bread and butter." This. And for oil in particular, one of the best threads on this site: //www.wallstreetoasis.com/forums/energy-trading-101-the-crack-spread
Traders live off volatility. Commod trading doesn't involve your usual buy/hold strat that you'll find elsewhere in S/T (unless market is backwardated and you are able to lease tank space for several months) . Most of the profit is basis trading (price differentials between hubs/nymex/citygates etc. or risk-free arbs (delivering a spec from one location to another)... E.g. supply glut in natty right now from various shale plays around the country has gas in a holding pattern between $3.50 and $2.50 per million BTU; 5 years ago it was common to see swings of $10 or more.
However, probably more important is the shifting dynamic of the industry at large. Midstream shops are getting pinched by massive increases in storage capacity (Cushing, OK had net capacity of 20mil barrels 10 years ago--now close to 80 mil) and macro-liquidity (think QE 1 and 2). Rise of electronic trading means E&P guys and refineries can hedge straight from ICE or NYMEX exchanges and markets have been increasingly disoriented by HFT activity (nothing good happens when the chip-leader who doesn't know if a flush is higher than a straight goes all in on every hand). Overall, fin and phys trading are becoming much less profitable... structured deals where you can deploy sidelined capital and end up putting on a trade hand-in-hand with owning phyisal plant assets/storage facilities and merchant banking are the new rain-makers for hedge funds and oil majors
Interesting comment. You mind elaborating on this? What are examples of these structured deals with "sidelined capital" you are talking about? Buying an asset, trading around it and showing that it can make you money?
Sure. Basically, any trading shop is limited in how they participate in the market as a result of their capital structure and entity location. Just know that most American banks won't provide inventory financing as part of debt covenants... they will only finance your business with letters of credit and margin requirements. Europeans, however, have been in the commodity business for a while--so if your main credit facility is negotiated with a European bank, you'll probably be able to actually finance the purchase of wells (oil/gas), tolling agreements (power) or anything else leveraging your borrowing base and bilateral credit facilities. Also, the level of hedging risk acceptable outside of North America varies depending on the context but is normally far less than can be comfortably tolerated in the American context for a number of reasons.
This is important because it takes a sizable balance sheet in most cases to finance the acquisition of plant assets (rigs, mines, refineries, oilfields, unproved wells... you name it) and to develop them over time (copper mines are at least a 10 year investment). This is why most hedge funds don't own physical assets and banks do (GS with their aluminum fiasco and JPM with their electricity assets).
However, certain trading shops can structure deals for clients where they provide structured debt financing for, say, the development and expansion of the Salinas Gold Mine in Brazil while purchasing the of gold and silver off-take. Another type of deal involves volumetric production payment (VPP) transactions. In a VPP the holder of the instrument provides the producer with an upfront cash payment in return for receiving specific volumes of oil or gas (not a specific amount of cash) from specifically designated fields over a specified period of time. In most cases an agreement transferring the specified reserves to the VPP holder is executed as part of the transaction. In order to mitigate the price risk that has been transferred to the holder of the VPP, the VPP will often have a hedge in the form of swaps associated with the production volumes integrated into the commercial structure of the agreement. And that's where the "trade" comes in to complement the transfer of title.
I said geography is also important because this structure is unique to the US because VPPs transfer ownership of a specific volume of oil or gas to the buyer in return for capital. The transfer of oil and gas ownership of reserves when "still in the ground" is not something that can be done in many places outside of the US as reserve ownership tends to be in the hands of the state with oil and gas companies receiving the right through a license or contract to extract and sell the oil (ownership of the oil or gas itself transferring at the wellhead).
Anyway, hedge fund operators understand its time to adapt to a changing industry dynamic. Just like equities are almost "capitalism as advertised" in the sense that there are few--if any--efficiencies left in the market to squeeze out profit, so too has this started to happen in the commodity sphere, and to survive will take some rethinking on the part of trading desks to unconventional strategies in their search for yield.
Ok I have a better understanding now. What about oil storage terminals do they fall under plant assets? It would seem that investing in storage facilities would be a positive move to make with the recent directional drilling emergence. Logistics, trade, and geography as you mention all come into play.
What are examples of these structured deals with "sidelined capital" you are talking about?
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Didnt take that into consideration.Delay and products never go good together in same sentence
Sorry for the delay. Apologize about that. But yea, I've been at a physical commodity merchant hedge fund in Connecticut for a year and a half now doing fundamental analysis for their crude, products/distillates, and gas desks. They do both physical and financial trading, as well as the other stuff I mentioned as well. Those are just observations and realities that guys on the desk now have to deal with in 2013.
It's all about skating to where the puck is going to be, not where it's been. Capitalism is changing, and what you see on the news is just the beginning. For example, the Financial Times (if you want a truly global business newspaper, FT is far better than WSJ) has been following a story that Brussels has plans for a financial transactions tax that, if implemented, could drive up costs significantly, slash volumes and reshape the financial industry across Europe. Think about that for a second -- it would almost eliminate the advantage from high-frequency and algo trading... the edge afforded by quants and guys who can just turn the lever on their models won't be there anymore.
How do you get that edge today? Guys at Gunvor, Mercuria, and Trafigura have real-time cameras set up on cocoa and coffee plots in South America to monitor potential supply disruptions. Vitol singlehandedly controls the entire petroleum output of some OPEC countries. At another shop I worked at all the power guys had power plant backgrounds, which becomes incredibly important at knowing how and when to trade around plant turnarounds.
If you ask me, that's why commodities are fun to play with. It's a lot to deal with, and its truly a global game with few regulators dancing in and out of your market. My favorite anecdote to illustrate that point is that Gazprom (a company that accounts for 10% of Russia's GDP) has twice shut off the natural gas supply to Ukraine over billing disputes, leaving its citizens without heat in the dead of winter.
People on this site post a lot of pathetic shit about whether its better to have brains or personal skills... in this industry, you absolutely need both, and the future is really gonna separate the men from the boys when it comes to who can best find a way to market and deliver crude to downstream marketers and distributers
That's an awesome insight into those worlds. I'm an engineer looking to transition into finance/trading. I would've never known about the real-time cameras set up to watch distributions. It's pretty amazing. How long were the citizens without heat? Are there any measurements that a company could take to avoid the happening a third or are pricing disputes inevitable?
I'm in the industry and am the author of a few energy articles here, including one referenced above. Gotta say... damn good stuff and you couldn't have articulated yourself better. Would like to talk NGLs with you over a beer next time I'm in connecticut (disclaimer: I have never been to connecticut)
Neither Gunvor, Mercuria or Trafi trade cocoa...
Great post Kevin-Cannon, as an aspiring energy monkey I'm always glad to see more thorough energy posts on this forum. Thanks!
From a metals perspective: Volatility in exchange prices is kind of a hassle, volatility in spreads is definitely negative (means arb opportunities are shorter lived, which makes exploiting them riskier / profit windows shorter), volatility in the different forms of physical premiums/discounts are definitely positive to a smart trader; it's where they make money.
Typo... meant ADM, Noble, Louis Dreyfus, Bunge, Cargill, etc
i think most of those guys are a lot more focused on grains & oilseeds than cocoa (except maybe Noble). not an expert, but I think the biggest cocoa players are prob Armajaro, EDF man, Wilmar and Olam.
Cocoa is run by Cargill, ADM, which Cargill is in the process of buying (antitrust might be tough there), and Barry Callebaut. The rest are fighting for scraps.
Cargill is rumoured to be after ADM? whatt? link?
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