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.
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