***This post is courtesy of frequent commenter Houston Natural Gas Analyst***
Physical Commodity Trading 101
The physical commodities trading space is a particularly niche segment of the overall Wall Street variety of career paths. It is extremely different from the paper trading that banks largely stick to in that you actually take delivery of the product you are trading, thus logistics come into play and you own large parts of the value chain to increase trade margins.
My area of expertise is in the North American gas trading space and the international LNG markets. However, given the fact that these transactions aren’t as exciting as those that take place in speculative crude oil trading, the example I will provide below will follow the sale of oil to a utility in Taiwan by a commodity trading house.
As you will see, there are many moving parts to a deal, this is why commodity trading floors are large and have multiple units or ‘desks’ all working on the same trades as it takes many people specializing in many different fields in order to complete a single physical transaction. Physical transactions are not heavily ‘screen based’ and most deals are completed via instant messaging and over the phone. These types of trades are impossible to complete as a one man show.
Before we jump in I’ll attempt to pre-emptively answer what I believe will be the most common question…
Compensation: Small salary. The upside comes from annual bonuses, which is formulated from my team’s y/e P&L, which is paid part cash (and mostly not deferred unlike at the banks) and part stock. Last year (which was one of the most lucrative years yet… despite the drop in commodity prices) the typical gas trader at my firm made something to the tune of $1.1MM all in. A lot of times this can be substantially lower if there isn’t as many opportunities to exploit arbitrage windows and I’ll go ahead and peg the typical gas trader compensation at ~300k – 600k all in YoY on a long term basis.
Last year the volatility in commodity markets presented many opportunities to exploit time arbitrage windows and thus the compensation figures for traders were substantial.
And with that out of the way, let’s get into it:
The time separating the purchase of oil from its sale increases the price risk. The counterparty default risk and the specificity of each transaction introduce additional challenges to oil and freight hedging and make trade risk management complex.
To discuss the elements of oil and freight hedging, let’s have a look at the hedging components in the timeline of a typical crude oil transaction:
Day 1: TRADE AGREEMENT
– An oil trader at a commodity merchant has agreed to buy 1MM barrels of Saharan blend crude oil FOB (free on board) from an international oil company loading in 41 to 45 days at Skikda, Alegeria at a USD -1 per barrel negative differential from the Brent benchmark. (The Brent crude oil benchmark is used for pricing physical oil in the Atlantic Basin.)
– Simultaneously the trader has agreed to sell the oil CIF (cos, insurance and freight) to a refinery in Taiwan for delivery in 101 to 105 days at a +4 positive differential from the Dubai benchmark. (The Dubai crude oil benchmark is used for pricing crude oil exports to East Asia.)
– Immediately after the trader got his oil trade agreement confirmation the freight paper trading desk covers the risk exposure that the freight represents with a composite of long freight forward agreements (FFA)
– Typically, a commodity trading and shipping advisory tailors the composite to the specific needs of the transaction…. The correlation, volatility and the covariance of the instruments chosen are quantified to create a composite achieving decent liquidity while minimizing the basis risk
– The shipping desk at the merchant is now vetting candidates and negotiates a suitable vessel opened for the loading area with a laycan i.e. the period in which the vessel has to present herself at the port in question, in the next 41 to 45 days
– Immediately after the trader got the agreement, the oil paper trading desk buys 1000 Brent/Dubai swaps to cover the 1MM barrels under the trade agreement. They could also use a combination of Brent futures and forward month Dubai swaps to cover the Brent and East of Suez prices. But the Brent/Dubai swap enhances hedging due to how liquid it is
– Opening this position is to lock in differential values. A lot of math is involved here but at the end of the day what happens is that the hedge removes any market risk from the trade and the position is solely exposed to the spread between the price where the trade originated and where it will ultimately be discharged. (North Africa/Far East arbitrage)
Days 2 – 40: PRICING PERIOD
– Oil and the cost of freight are marked-to-market daily
– Tanker freight is volatile and needs to be marked-to-market just like the oil that they transport
– The sooner parties come to an agreement on a vessel the better. Typically the trader’s hedge desk will then close the freight swaps and chase paper confirmations for the trader
– In our example a suezmax tanker voyage is locked in at USD 3.50 per barrel with a realized hedging gain
– On day 1 the Saharan oil was traded at +1, thereafter it will be marked-to-market daily
– As a result the market sets the price of the oil during the pricing period
– The final price settlement however is determined by the average when the loading is completed
– For the purchase the Saharan is fixed in the trade agreement as the Brent average during the loading period
– For the sale, the trade agreement specifies the Dubai average price during the loading period
Days 41 – 45: LOADING
– When tanker hoses are disconnected from the ship’s manifold, the vessel has finished loading its cargo
– At this point, the merchant buys the Saharan blend crude oil at the average Brent price minus 1 (USD 100 per barrel in our example) and thereby defines its inventory cost (USD 100MM)
– When originating crude oil (day 1) the trader’s analyst requested a letter of credit (LoC) from an investment bank’s commodities desk
– Through this intermediation the company provides credit to this international clients in the form of offshore US dollars
– The oil company seller that the trader bought from draws on the LoC and the agreed amount becomes a secured loan of the trading company
– Thanks to the LoC the risk of the trader defaulting on the oil purchase is effectively transferred to the issuing institution
– Because the oil sales price with the refinery has been determined at an average Dubai loading +4 (USD 103 per barrel in our example) the trader has no price risk anymore
– Once the oil is priced, the oil paper traders sell their Brent/Dubai swaps with a realized hedging gain of USD 1MM
– If the average price was determined at the average Dubai discharge +4 the trade would still be exposed to price-risk and the would need to sell a forward month Dubai Swap matching the period when the refinery is finally pricing
Days 46 – 100: TRANSPORTATION
– The contract is for 1MM barrels, typically the loading is less than 98% of the volume capacity to allow for expansion
– The exact quantity of oil is determined at the loading port
– As a result the invoice quantity of oil is the quantity states in the bill of lading
– Ideally, the physical excess/deficit between the nominated quantity and the total barrels loaded would be zero but unfortunately this is never the case
– As such, the excess/deficit relative to the LoC is marked to market
Days 101 – 105: DELIVERY
– Once the tanker discharges in Taiwan, the merchant invoices the refinery the bill of lading quantity times the Dubai average +4 (USD 103 per barrel) as agreed in the trade agreement
– Until the trading company receives the payment for the cargo, the receivable is securitized by a bank’s commodities structuring group in a “Special Purpose Vehicle” (SPV) sponsored by the trading companythereby providing a supplemental layer of cash flow
– This allows the company to manage credit risks via securitization i.e. transferring them to the capital markets instead of assuming the transaction’s credit risk (that the refinery doesn’t fulfill its obligations in a timely manner after the cargo delivery)
– The bank bundles this and other notes like it into a zero-coupon fixed income security and transfers the risks to the capital markets
Summary: There you have it. The day-to-day work of a Houston/London/Singapore/Geneva commodities trader. The above explanation demonstrates how the commodity risk management of a straightforward transaction can become rather complex. Oftentimes, additional transaction layers make it very tough for the company’s internal hedge desk to audit the trading risks and as a result provide for an accurate hedging of the full transaction. This happens surprisingly often and forces guys like me to get trapped at the office pretty late. It’s particularly bad when edits to the risk management of a transaction have to be correlated between London Houston and Singapore’s trading desks.
I understand all of this is extremely hard to follow if you don’t work in the space and have included an extremely simple version of a position model that has been annotated so that it’s easier to follow along.
As mentioned above, any questions? Ask away.
Next, I’ll go ahead and describe a typical day in the life of someone who works on a phys commodities desk. Every day is relatively different given the nature of the job, but given the fact that the business is a bit slower paced than traditional wall streetfinancial trading roles it’s slightly more routine:
A Day in the Life
6:30 AM – Alarm goes off, check emails that came in overnightfrom our international desks, make sure there was no trouble when London and Singapore rolled their risk models on exposure for the group.
7:00 AM – Jump in car and drive to the office (Houston public transit system is awful and doesn’t go anywhere except around the city core.)
7:30 AM – Arrive on the desk, swing by the coffee shop downstairs for a coffee and small pastry.
7:45 AM – Start firing up my terminal (Bloomberg, Outlook, Excel, ICE trading platform, Yahoo Messenger, AIM, Symphony) emails begin flooding into inbox, mostly research reports. Instant message buddies at other firms, brokers, and other traders to get their thoughts on how the day is going to pan out. By now most guys are at their desks and some enter into positions. If you’re working at an oil & gas major this is the time that you’ll be reaching out to your ‘regulars’ to take some of the production that came in overnight off your hands. Typically – you must sell all of the commodity length at an oil & gas producing company before you’re allowed to take positions in the spec book. However there are a few oil & gas companies that differ in this regard and have dedicated desks which solely trade speculatively and don’t have to be bothered to sell the equity production at the beginning of the day.
8:00 AM – Check in with market intelligence services regarding any plant maintenance, pipeline damage/closures, power outages etc. Instant message my schedulers and ops guys to see if there are any problems taking place in end markets regarding logistics as well. Make sure weather is not impairing the movement of any of our energy.
8:30 – CME opens. Brokers start blasting my IM with wiresshowing bid/ask spreads, market starts to light up and I jump on the phone with brokers and sales & trading guys at the banks to sniff out any valuable information which could potentially be exploited for a profitable trade. The market is usually most active in the first 30 min of the day and the last 30 min of the day.
9:00 – Market is a bit calmer might make a few scalp trades in financial products here and there based on run of the mill technical signals. Fire up regression model my analyst built to forecast the EIA gas storage numbers which will be released in the next 30 min. Flatten any exposure going into the news release because although EIA reports aren’t particularly accurate they have the potential to cause massive movements in the market.
9:30 – EIA report drops, turns out there was an inventory build in gas with demand remaining flat. Gas futures drop 150 basis points; I analyze the movement and see the impact it has had on physical gas prices around the country. Try to find anomalies caused by the price action which can be exploited.
10:30 – Still on the phone/IMing counterparties, brokers, and buddies at other firms. Arb model lights up showing that gas at Chicago City Gates will perform stronger relative to the futures market. Buy 500,000 mmBtu July Natural Gas FOB Chicago City Gates @ $2.85 sell 50 Aug Natural Gas Futures @ $2.80. (I am no longer worried about where the price of gas goes because that risk has been offset by the position I took in the futures market, I am now strictly concerned with how gas in Chicago performs against the futures index.)
11:30 – Lunch time. Order food in via post-mates since I can’t leave the desk while I’m in this position.
1:00 – Markets are closing, volatility begins to spike. Sell 500,000 mmBtu July Natrual Gas FOB Chicago City Gates @ $2.86 buy 50 Aug Natural Gas Futures @ $2.75. Result: profit of $30,000 (5k on phys 25k on futures.) Turns out my thesis based on the arb model and some fundamentals proved accurate.
2:00 – Meander around the trading floor, shoot the shit with counter-parties and the guys on my desk, read a couple Wall Street Journal and Bloomberg articles. Enter into intense discussion about the quality of the guy’s suit that’s talking on CNBC and how hot one of the chicks are.
3:00 – Discuss the daily market action with other traders, follow up with reporters regarding market commentary etc. swing into a 15 min position report meeting to review exposure of the book and prep game plan for tomorrow.
4:00 – Write up all the trades made during the day, review contracts negotiated during the day, return calls, emails, and IMs I missed while intently watching my trade. Follow up with junior traders on their projects relating to updating/building new arbitrage models etc.
5:00 – Finished for the day. Head out for drinks.
