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?
Leveraged metals houses were popular a decade ago, and a few might still be around. They make their money on margin interest and storage fees. They were usually the last stop for guys who got kicked out of the commodities business, because selling the physical didn't require a license.
So you can imagine that most leveraged metals houses were bucket shops. Portable leverages metals house. 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, barrels.
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.
There is a credit risk during that 40 day delay. 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. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA. Can someone explain what location arbitrage is, and which commodities are used for it, some classic examples.
But the question regarding the right to exists of independent commodity houses still remains, what's the advantage of dealing with them instead of completely integrated companies like the oil majors? 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.
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. 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 Propanethere 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. At the end of the day, they exist for the reason that any corporation exists 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.
In theory it is easy to say "traders will conduct this arb until the spread disappears". This doesn't always happen in reality. Also the arb might be open for one person and closed for another. Also, can't they ship it through a pipeline, load it onto barges and then put it on a Super Tanker off the coast of New Orleans I think?
Ear is right ICE contracts are financially settled. They cease trading on the penultimate. You are right that WTI, Brent, Bonny Light and a few others are deliverable, provided they meet certain specifications. Delivery point is at Cushing which is landlocked as mentioned in the above post , and you will need access to the pipelines to deliver. So not any Tom Dick or Harry can do so. And no they cannot pipe it to the coast and sell it outside of the US simply because like i said it's illegal.
Not that it cannot be piped or ship, but simply because it is against the law. If you are referring to NY, then it's doable because it is domestic, not outside of US , but i don't think there are any crude streams in the US being priced off Brent. I haven't heard of the atlantic arb before but it could be possible i guess. Also phys commodity shops exist purely because the market demands for it.
The forward curve for each commodity contango or backwardated shows the supply and demand out on the curve. If the mkt is in contango and it is wide enough it maybe advantageous to store the commodity and earn the carry of the curve. How can they be hedged? If you run a hedged book your ultimately trading the basis. I work for a physical Energy trading shop.
The arbitrage described above is what our bread and butter business is, We transport crude oil, distillate, gasoline, Ethanol and NGL's using barges, pipelines etc. It most likely will never happen, as the US is still one of the biggest crude oil user and importer in the world. Thus, its hard to make a profitable trade to ship it abroad.
The location that someone spoke about in regarding to loading ships is LOOP. Stands for Louisiana Offshore Oil Port. WTI is landlocked but is also accessible to marine locations using pipelines.
One of the other drivers of Brent prices other than European demand is the sulfur content of Brent crude. Brent Crude frequently finds its way to the refineries in the Eastern coast of Canada.
I would not be surprised if some of Valero's refineries at Paulsboro and Delaware city haven't used this grade before. I look at a lot of offshore cargoes coming in daily to the GC, that use various different benchmarks. As far as the OP's question about how these companies make money. Lots of producers and end-users are restricted in their ability to hedge and trade their systems.
Thus, companies like ours step in, take on long term commitments at index values in case of physical product and commitments on assets such as pipeline space and storage. Contango is ideally the preferred market structure for storage owners. But, that relationship seems to keep getting destroyed as energy becomes more of a mainstream asset class. I'll go to business school! Thanks for the explanations. Are there other well known physical arbs that are traded beside the Atlantic arb, does the same exists within the metal space?
As much of the world's resources are based in political insecure countries, how do the commodity house trade with that problems? Do they just take this risk? Is it right that within the commodity market a contango situtation is preferred by the traders as they simply can store and sell foreward? How do they deal with backwardation? Naptha is one of the biggest feedstocks in the Asian Pacific petchem plants.
The biggest driver of Gulf Coast naptha pricing is the Asian arb. So, the point is arbs are infinite if you have the capability of transporting said commodity and taking on the risk of pricing and hedging. It's an interesting dynamic. Even the most volatile countries have a tendering process where companies bid to either buy or sell commodities. I would assume Letters of Credit and prepayments are the norm depending on country. This is also one of the reasons, why commodity houses exist.
In backward markets, you try to dump your storage, go short and buy the back of the curve and hope to god that the curve flattens. Another strategy that was very popular last year is playing the contango in crude. If the contango future price - current price is higher than that, then you buy crude today, store it and sell it later on when the price is higher.
Not sure how much of that is still going on now with contango spread being much tighter. Does anyone have some colour they can shed on the size of physical commodity trading in North America as well as key markets. Namely, what I wish to know is the size of physical commodity trading in Canada versus the US. Also, is the nature of transactions typically booked on an exchange via standardized contracts or if this largely takes place off-exchange between supplier-producer.
Gas also flows west to California and Oregon. Crude is primarily all flowing south to Chicago and then to Cushing and then even to the Gulf Coast. Lot of gas trades on NGX clearinghouse from what I am told. I am sure tons of OTC stuff gets done too. Markets are nearly not as liquid as gas or refined products in the US. Relationships matter and traders still help each other when one finds themselves in a sticky situation.
I am in the energy trading biz in Canada if you have further questions. Any ideas on how to size up the total volume of physical trading that occurs for crude, NG and gold in Canada.
As for crude, any way to measure the size of trading in OTC?More...