1/3/17

Most commodity markets tend to be driven by a few basic factors which are freight on one side, price on the other side and qualities.

Each commodity market has its own particularities. Most of what I will generally talk about applies to oil and the liquids in particular which is a little bit different from the gas market. Why ? Why is the gas market different from the oil market ?-** The Logistics are different. **

Transport is one part of the logistics chain but the logistics chain involves everything that happens from once you get the basic commodity out of the ground. When it's natural gas, you have to treat it differently as it comes out of the field, you need different type of containments and operators. It's slightly more complicated because natural gas tends to move by pipeline, oil moves in a big bucket.

Why oil does get traded ? What is the utility of people in Physical Commodity Trading?
The basic question about why does oil get traded, because you could imagine a scenario where a producer like Chevron, BP, Saudi Aramco, Conoco Phillips, Hess, Suncor ... whoever pulls it off the ground, and then does every single step itself to end up selling gasoline in its own branded gas stations. In the real world it doesn't happen that way.

When you go at Shell gas station in your town or you when you buy heating oil from CITGO for your heating system at home, you may be buying a branded CITGO product but most of the time that product wasn't produced in a CITGO refinery. It was maybe produced in a P66 refinery, it was produced at the IRVING OIL or maybe produced in a European refinery (although Europe tends to import more than to export). Just because it's written Shell, BP, P66 or Exxonmobil on the gas station sign doesn't mean that the gasoline is actually produced by them.

There are a number of continued imbalances in the market that continually need to be re-balanced.
Energy traders are the experts at optimizing the logistics from the well head to the gas pump.
Their main role is to identify discrepancies and then re-balance markets.
So what do you think is the primary factor to identify imbalances ?**- It's prices. **

Prices are magic; if there is not enough of something, price goes up. If there is too much of something, price goes down. Anytime you are going to listen so-called experts in the commodity market who tend to be self-appointed experts, especially when it comes to regulations, is sophisticated arguments to explain to you why this and that and why that needs to be regulated. Sometimes they have good arguments; sometimes they have less good arguments.

In general, when you regulate something, what you end up to do is putting impediments to the functions of market dynamics. e.g what you really do is that you skew the functioning of commodity pricing.
Pricing is what makes commodity move. Oil is always moving on the way down, it never moves on the way up. It's simple; it's a law of physics, gravity. The only thing that is 100% reliable in the world is gravity. It's the only thing in this world that is an hundred percent right. The other thing is pricing. Prices mechanisms are an hundred percent right.

Price rises ?

Somewhere in the world, some genius is going to figure out "how to get stuff" to a high price place.** Price falls ?**some genius will figure out "how to take it low" and bring it to a high price place.
Why does crude oil has to move around the world ? The very first reason is that it's a naturally imbalanced market. What happens is that parts of the world have various amounts of crude oil and some other places produce zero crude oil. Regions, countries consume various amount of energy.
Imbalances are also located inside countries.

Canada, one of the world's largest crude oil producer, has the production concentrated in its western provinces (AB, SK) while its eastern parts (Ontario and Quebec) produce zero crude oil and need this energy to fuel their economy.
In China has a massive deficit while in places like the Middle-East, Russia have a surplus of energy.

In America, relatively speaking, the market seems balanced but the consumption profile is different from Europe (more light ends).

[See the Image Attachment]

If I show you this chart in 5 years from now, I guarantee it will look differently. The market changes all the time. It is increasingly dynamic; 10 years ago, the North-Sea (Denmark, Norway, UK, Netherlands) were big producers of crude oil. Brent was the crude standard bearer of the U.S Atlantic Coast and Eastern Canadian refiner. The primary refining capacity for the U.S and Canadian market has been built for the Brent (quality) but a lot of that has disappeared now.

The supply doesn't match geographical demand and the crude qualities rarely correspond to the requirement of the local refinery.
You can immediately see why these commodities need to flow.

With quality, you have different crude prices. When we talk about heavy crude, generally speaking, the heavier they are, the more sulfur they have and the more impurities and noxious substances they contain. They also tend to be harder to refine.

The heavier a crude is and the more sulfur, the more you need processing to make it into usable products. This tends to trade at bigger discounts. The processing costs of these high sulfur heavy crude cost more than the light sweet crude. In order to maximize the value you need to optimize these crude.

A 5%S heavy Cuban crude (5% sulfur) will trade at a discount of somewhere between 10 or 20 dollars a barrel below some of the Venezuelan crude discounted between 10 -20 dollars to the Brent reference price on a FOB vessel. Some of the crude oil are traded at a premium to the Brent reference price, so again it's a question of price is going to buy different crude.

If you invested 10B$ in a refinery, you will want to buy a lot of these heavy things with a lot of discounts because you invested a lot of money in building this complex refinery. If you invested no money at all and simply owned a simple distillation refinery, you will be quite happy to pay a premium to Brent, extracting the gasoline out of this grade.

There is a large matrix of sourcing possibilities. As an example, a refiner like MARATHON trades 30 to 50 grades on a regular basis.
LITASCO, a pure energy trader, makes a market for at least 50 to 70 crude on a regular basis. Each crude has its own specifications; its transportation and its location are directing the commodity trading.

Transportation.

Obviously each mode of transport offers its inherent risks and benefits and carries a cost to bear for it. The industry will carefully balance these two variables and chose how to move those molecules at the lowest cost possible with the lowest risk. Pipelines are by far offer the most secure and lowest cost possible option for their continuous flow, followed by tankers for the larger capacity and then by rail, barges and trucks.
In some places like Saudi Arabia, "it's very simple", TOTAL shows up with a VLCC, they accept their vessel (provided that it is aged less than 15 years, has no any maritime liens...) . The vessel loads 2 million barrels in its holds and it takes about 60 hours of loading. There are never complications (such ice, weather etc) and the logistics is straightforward.

When KOCH loads Western-Canadian Crude in Vancouver, they nominate the oil into the Kinder Morgan pipeline between Edmonton and Burnaby (Buys the line capacity from a regular shipper), schedules a smaller vessel because of the draft limitation, sail through Panama to reach the Gulf Coast. KOCH will possibly transload two cargoes (Aframax) into a larger vessel (Suezmax). The logistics are incredibly complicated because this oil is produced landlocked in the northern part of Alberta or Saskatchewan and the trader has to take it from the oil sands production area, mix with diluent to make it transportable in a pipeline.

The location, the quality, the logistics define the price of the crude.

The Albertan crude has a different yield of kerosene, asphalt, light products and a different price (discounted between 30 and 45% below the WTI reference). Because of these price discounts, there is also sometimes blending possibilities also because of a particular customer likes a yield that is richer in intermediate and heavier products.
It implies that a crude slate with its inherent characteristics is carefully balances before entering the refinery units so the processing margins are obtained at an optimum cost.
This will also depend of the timing and the availability of the qualities on the market because most of the time, believe it or not, all refiner customers are very timing-sensitive.

Time is money.

Why is it so ? First you never ever want to have an unit running out of crude but what's the second and main reason ?

The second reason is about time of working capital. Have you hear about something called just-in-time ?
Crude oil is currently traded in the $50 per barrel handle. A 350Kbbl per day refinery @ 90% utilization rate requires excessive amounts of cash to be operated. You can figure that there is never excessive cash and that it is highly inefficient to hold more than 10-day production coverage (unless there is sizable economic justification in the term-structure).
Part of the energy trader job is to be "on-specs", "on-time" and provide the best price(lower). Those are the three daily functions that matters the most. Refiners don't want nice guys, they want "on-specs", "on-time" and best prices.

This should be good pointers for those who are interested about the Energy and Commodities path.

I have a last question for you: How do energy traders optimize of the stream value with the physical and logistics assets with these imbalances to capture the P/L and what can go wrong ?

In the part II of this contribution on WSO I will discuss on the imbalances and risk-arbitrages in the physical energy market.

For now, I will wait for your reactions and/or questions.

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Comments (11)

12/17/16

Great post. There are so many variables involved and it truly is a complex process.

Geopolitical events, market shifts, trade issues, etc. Plus the amount of capital required is insane.

Questions:

How do different refineries handle different blends: Do certain refineries only process certain grades of crude? (IE West Texas Intermediate vs Brent). Also API 30 vs API 70 for example.

Also, how do you protect against fluctuations in oil price during transport since it can take months to move crude across the globe. Do you use puts/calls in the market to protect against fluctuations or do you pay a firm to hedge prices?

I'm working in physical trading of a different commodity on the marketing side -- I also have a background in oil and gas.

Is it possible to go to the oil side? Also assuming I have deep domain knowledge of O&G as a whole.

Financial Modeling

12/17/16

Have you hear of the Global Association of Risk Professionals and their Energy Risk Professional (ERP) program. The designation is fairly new (2009) the focus is Energy and it is the only of its kind in the world.
I would highly recommend the ERP for someone like you willing to cross into Oil/Gas/Power/Commodities to register. The Early Registration for the May 2017 ERP Exam is open.

12/17/16

Albertan hear.

Fantastic post, will definitely reference it before my interviews. Looking forward to part 2.

12/17/16

Albertan...
I volunteer at the Rotman trading competition and recall Gordon Sick from UCalgary.
He takes it very seriously, his students are always extremely well-prepared. That's why Haskayne won the BP commodities challenge "hands-up".

12/17/16

You don't happen to run a blog as well?

12/19/16

^ I was thinking the same thing

12/21/16

Great Post, there is so much great info here I had to read the post 3 times to fully internalize the whole process. Looking forward to part 2.

1/3/17

On WSO someone asked

*Can someone explain how exactly a physical commodity trading house makes money and why there is a need for independent comodtiy houses, whats there right to exist?
*
The best reply is from @cotangoman"
**I have Enjoyed reading it, it eloquently sums up the reasons for the existence of commodity traders.

Would like to add 4 specific PL drivers:

1. Freights plays:

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.

2. Blends

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.

3. Financing

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).

4. There are some strategies you can ONLY do if you have access to physical (i.e. physical warehousing deals when contango on metal is higher than insurance, interest and storage costs).

1/3/17

Can someone explain how exactly a physical commodity trading house makes money and why there is a need for independent commodity houses, what's there right to exist?

1. Freight plays,
Likely they would have a cargo from Chile another cargo, another type of copper concentrate from Indonesia. They reduce berth congestion by blending in the south-china sea and then deliver on smaller vessels adapted to Chinese port restrictions, on-time and on-spec to a Chinese smelter creating efficiencies saving up to one fifth of the freight.

Traders balance the cost of freight and commodities. They also reduce the cost of shipping and commodities for the global economy.
In the example, when they sail back to the Americas a dozen of time per month, they can lift a cargo of cement/coke back at a cost lower than the prevailing rates that a client could get alone on a single voyage.

2. Blend, each smelter works on a very narrow range of specific requirements with desirable concentrate for different treatment charges that might be out-of-reach.

3. Financing
You nail it, can finance at much lower cost the trade flow that otherwise producers would be trading on their on own.

4. Cash-Futures convergence strategies,
not limited to the contango.
Commodity traders are continually balancing the supply with the demand in time and space and by this process, they make sure that PRICES! reflect the reality of the market.

Best Response
1/10/17

Physical Energy Trading And Logistics Part II

In the part II of this contribution on WSO I will discuss an imbalances & risk-arbitrages in the physical energy market. How do energy traders optimize of the flow the physical and logistics assets/contracts with these imbalances to capture the P/L and what can go wrong ? (Risk)

This example is partly inspired by Fletcher J Sturm (1997) Trading Natural Gas: Cash Futures Options & Swaps. If you don't already have this book, get a copy of it.

It also inspired by Off-Exchange EFP cash settlement & buying/selling that I've done as a trader on another pipeline.

For the sake of simplicity, please allow me to relax some assumptions ( no bid-offer spread, the current market prices are obviously different). I also assume that illiquid physical markets aren't fixed by 5 or 6 traders.

Background: NGPL is the largest transporter of natural gas into the high-demand Chicago market and one of the largest interstate pipeline systems in the country.

Goldman Sachs has currently firm pipeline transport capacity on NGPL from from Katy, Texas to the Exxon Mobil refinery in Joliet, Il (delivery point). see attachment. NGPL Is the Bank short or long the basis spread ?
The Bank analyst sees an imbalance in the supply and expects the spread between South Texas and Chicago to widen, essentially will they buy or sell the spread ?

Transportation costs

* A demand charge, which recovers a portion of fixed costs, is paid on all contracted volumes, regardless of the amount of gas actually purchased.

* The commodity charge, which covers remaining costs and all variable costs, is paid only for volumes of gas actually sold.
* The demand charge on NGPL is $0,23/MMBTU and the commodity charge is $0,28/MMBTU.
* The bank owns firm pipeline transport capacity on NGPL and now expect the South Texas/Chicago basis spread to narrow

The index for Katy, (South Texas) is $4.05/mmbtu,
The index for Joliet, IL (Chicago) is at $4,45/MMBTU.
Prevously, GS has hedged the basis spread at $0,46/MMBTU.

'A trader question to his analyst'
What is my all-in cost to pipe the South Texas gas to Joliet ?

The index for South Texas is now $4.25/mmbtu while Chicago is at $4,00/MMBTU.
'A Risk question'
What has gone wrong ?

'A trader accountant question':
What is the unrealized P/L for the Goldman Sachs ?

Let's crunch numbers and discuss the possible answers.

9/21/17
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