Physical Trading (Part 1): What it is and What it isn’t

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GoodBread - Certified Professional
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I've been getting quite a few questions on what a typical day in the life is like at a physical trading shop. Other members of this website were very helpful in giving me an idea of what the field is like so now that I've "broken in," I'd like to pay some of that forward.

Part of the difficulty of giving much advice on the field is that while there are broad similarities across commodities and firms, each product/firm has enough idiosyncrasies that going into too much detail is risky given the size of the field. Nonetheless I'll try to paint how some major groups of commodities are different from others.

This post has been sitting on my hard drive for 2 years so no promises as to what or when a part 2 might come out. If you have any suggestions, please let me know.

For my first part though, I just want to clear up some of what physical commodity trading is and isn't:

What it isn't:

1. Physical commodities is not a rocketship to being a billionaire.

This will seem obvious to anyone in the industry, but after the Glencore IPO, a lot of people (not least on this forum) were starting to paint commodities trading as the ultimate pathway to wealth. Forget exotic credit derivatives, forget being a PM at a global macro fund, being a partner at Vitol/Glencore/Trafi/Gunvor/Mercuria was the ultimate goal.
But the fact is that commodity trading riches are like any other field in finance: pay for traders is on average higher than in many other fields, but the really outsized paydays are cyclical and having a career that puts your net worth above mid-7 figures before you turn 60 is going to take being the right person, at the right time and the right place.

2. Physical trading isn't the work-life balance sweet spot.

Yes, physical traders spend a lot less time in the office than IBD analysts or certain PE partners. But that's not exactly a fair comparison. Being a physical trader requires you to be 'on' all the time, and it requires a ton of travel as well. So while you may be going home at a decent hour from time to time, you're still working very, very hard during the day and thinking about your market non-stop. Working at a global macro fund might be an adequate comparison although the stuff that will keep you up at night will have more to do with the execution of a trade than with the absolute price of your commodity. Which brings us to...

3. Physical trading isn't about directional risk (for the most part at least), it's about the basis.

So long as there are derivatives to hedge price risk (any cash sale is matched by a futures long, any cash buy is matched by a futures short), as a physical trader you'll be trading the basis, which is essentially any divergence between the cash price and the most appropriate futures. You are thus focusing on a much more limited set of factors affecting your market, typically local supply and demand dynamics as well as the cost of freight. How volatile the basis is has a big impact on the opportunities the market offers, but obviously carries risks as well. There is a third factor that can affect the basis big time, and that is futures spreads. In a contango market, you are rewarded for holding inventory, while in a backwardation, you will be punished for rolling your futures position. As a result, the basis tends to drift up in contango markets while the basis will likely drop in times of backwardation. The caveat about directional risk's importance is that higher prices tend to be correlated with higher volatility, and will likely benefit any assets a trader owns.

What physical trading is:

1. 4D Chess.

I think it was Bruce Kovner who was saying global macro was 3D Chess. While physical trading will usually make you focus on a more limited set of instruments (your primary commodity and variants of it), the amount of things that go into each trade is massive. Aside from logistics issues (and man are there a lot of those), you need to make sure your commodity meets the specs your customer requires, make sure your customer will pay on time (credit risk), make sure your supplier will deliver on time, keep every one of your suppliers and customers happy (from the CEO down to the accounts payable/receivable person). All this while making sure you are doing deals that make sense given where you think the basis is going and the expected margin of the deal.

If you have any sort of assets or want to be doing volumes on a meaningful level, you will also be doing deals that last a year or more. That requires a much broader framework which will determine the way you approach each and every year (how long or short are you planning to be, what customers are worth keeping...). It's incredible what goes into a year's P&L. But luckily...

2. It is almost always a team effort.

I honestly cannot think of one time a larger size deal was agreed to on my team without some sort of discussion among the senior traders and ops people. There are just too many variables to think about on any deal that will make you go significantly longer or shorter. Outside of a few very obvious trades, you always need someone to play devil's advocate and help you look at things from a different angle. Physical trading is very much a team sport, and ops people are major players on that team.

3. The bedrock of the economy.

The old school nature of physical commodities might seem quaint sometimes. Moving large volumes of more or less undifferentiated products is not exactly glamorous nor is it really rocket science. But the amount of jobs that actually depend on your efforts is staggering. Any time you smooth out some major supply disruption because you had inventory at the right place at the right time, it really puts in perspective the importance of what you are doing. Just think about this for a sec: there are shards of obsidian (a volcanic glass cave men used before metals really took off) that have been found thousands of miles from where they were mined. Cave men traded rocks before anyone even bothered coming up with a way to write. In fact, some of the first "strong men" got legitimacy for their power simply from the fact they had a better pile of rocks. Where do derivatives come from? Commodity trading. Trade finance? Commodity trading. Corporations? Commodity trading. Government finance? Commodity traders with deep pockets. This website would not exist if it were not for guys like the Rothschild, Fugger, Medici, or the first dude to offer some food to get a nice sharp piece of flint.

Interested yet?

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Comments (16)

Sep 3, 2018

Awesome post GoodBread, definitely bookmarking this.

I'm not actually in the space yet (couple of internships in physical, still applying to entry-level roles), but a big reason why I decided to pivot away from S&T and towards the world of physical trading, were some of the fascinating conversations going on in this forum, between yourself and other solid guys like monty09 and marcellus.

Love the nature of this business, the complexity that goes into each deal, and as you alluded to - how important it is to human economic activity in spite of it being such an opaque field. Certainly far more excited about starting a career in physical trading compared to traditional S&T.

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Sep 4, 2018

Great post!

Sep 4, 2018

"while in a backwardation, you will be punished for rolling your futures position."

This part didn't make sense to me. Aren't you able to capture roll yield when rolling futures in a backwardated environment?

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Sep 5, 2018

If you were long futures that would be the case, but if you hold physical inventories you are typically short futures to offset your price risk. So when time comes to roll your position you buy back your futures position at a higher price than you sell the forward month if there is a backwardation.

All else being equal, a grain elevator is incentivized to hold inventories so long as contangos cover his carrying costs. Same goes for someone warehousing metal if the contango pays for rent and financing. In a backwardation, rolling your positions in the futures market inflicts further pain on you, increasing your odds of dumping your physical position. In metals, guys frequently try to squeeze the physical longs using the LME.

This is also why in oil markets, where backwardation is the norm, a contango is a huge opportunity for traders to sit on their inventories and print money.

The theory is that contangos encourage people to sit on inventories when physical supply is plentiful, while backwardations force people to bring their inventories to market alleviating physical scarcity. The issue becomes whether the market the futures are based on accurately reflects the broader market (ie declining LME warehouse inventories increase the ease of squeezing the short end of the curve).

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Sep 5, 2018

Great post! Looking forward to what a Part 2 might cover

Sep 5, 2018

Great read. Looking forward to Part 2

Sep 5, 2018

Nice one GoodBread thanks for taking the time - I guess this means I finally have to contribute via a topic in the near future...

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Sep 6, 2018

Good stuff @GoodBread

Sep 7, 2018

Saved, one of the best post on this forum by far.

@GoodBread I would like to ask you an information, though. How do you think that physical commodities trading differs between shops and banks?

Nicest haircut than Bateman

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Most Helpful
Sep 8, 2018

Appreciate it. Keep in mind that as far as commodities goes my experience is limited to metals on the trading shop side but I have dealt with banks a good bit.

Banks that are involved in physical typically only do so on the very liquid end of things. There are some exceptions like Morgan Stanley and Goldman which bought assets in the oil space and reached the point of being called "Wall Street refiners." But even then, those are large, liquid (no pun intended) markets. In natty and power at times banks have been very important to market liquidity.

For metals however, banks really only explore the very liquid end of the market. If it's not the LME deliverable grade of that commodity, you can probably forget about it, and really anything outside of aluminum or copper is going to be a bit of a stretch. There have been a lot of regulatory factors which have reduced banks' involvement in metals, not least of which was the LME nixing the whole queue game banks were playing.

Since generally speaking banks are fighting in the most liquid markets, the margins are also thinnest there. Payment terms are the biggest ace up banks' sleeves and if you hear of someone giving one of their shorts 120 days to pay, it's probably a bank.

Goldman is probably the only bank deeply involved in physical commodities that I can tell of. They can compete with the big guys on most commodity-grade deals (not all) but once you are looking at more esoteric stuff it is heavily dependent on the past experience of the guy running the desk.

Where banks are more interesting is the paper side. Commodity derivative sales at a bank is a very interesting job and probably pays you the beaucoup bucks quicker than a physical shop. Trade financing is also a big field and a lot of banks are involved in that all over the commodity spectrum even if selling these commodities if they ever do end up with them as collateral is not necessarily their forte (to be fair neither should it be).

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Sep 8, 2018
GoodBread:

Where banks are more interesting is the paper side. Commodity derivative sales at a bank is a very interesting job and probably pays you the beaucoup bucks quicker than a physical shop.

Why so interesting?

Sep 8, 2018

If you are covering corporates, you are coming up with creative ways to hedge commodity risks for them which is both very concrete and allows for creativity on the structuring side. New situations (say trade wars?) require new solutions, and the S&T guys are supposed to be the people coming up with those.

Cargill is very active in this space as well.

Sep 11, 2018

Cargill's Risk Management arm is leading the field alongside banks like Macquarie. Some of the structures they provide for hedging are genuinely fascinating/creative.

If you can get your hands on a few of their structured product memos i've found it good practice to reverse engineer what combination of options and what style of options they use to build the structure.

Sep 8, 2018
Real Marcus Halberstram:

Saved, one of the best post on this forum by far.

@GoodBread I would like to ask you an information, though. How do you think that physical commodities trading differs between shops and banks?

In NG, at least, banks are less physical say except Goldman, Macquarie, and in some areas MS. But even their physicality differs from an EDF, Tenaska, Sequent, Direct. BP, Shell, Conoco, Chevron, etc. have assets to support their production and maximizing marketing capabilities, and some to a degree to serve their own other native businesses.

Banks gather the assets for spreads, the Tenaska gathers the assets as a cut for managing it, Direct gathers the assets to cover retail load(carry and pass the costs).

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Sep 8, 2018
Butterbean:

Banks gather the assets for spreads, the Tenaska gathers the assets as a cut for managing it, Direct gathers the assets to cover retail load(carry and pass the costs).

Could you please explain this in a bit more detail?

Sep 8, 2018
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