What is Commodity Trading?

In essence commodity trading moves the raw materials necessary for daily life from their place of production or extraction to their place of consumption.

The commodity value chain is long and complex, involving many different actors throughout the world. Traders act as the organiser of this chain – sending commodities as efficiently as possible to where they are in highest demand, ensuring the best outcomes for consumers and producers.

Commodity trading is a diverse industry. Trading houses can be small local operations of just a few people, or huge multinational companies with tens of thousands of employees across the world. Commodity trading in Switzerland has a number of large international companies but also many strong SMEs.

Commodity traders trade goods as diverse as cocoa, coffee, cereals, sugar, oil, natural gas and precious metals. The industry also comprises many companies that offer related services – shipping and logistics, inspection and certification, insurance and trade finance.

The margin of a trader is usually quite slim if compared to other industries or enterprises, usually between 0.5 and 3% and thus comparable, though not equivalent, to retail. This means that the volumes transacted must be very high – it is a volume business – and absolute revenue figures are a direct function of the volume. This margin, just the same, is the trader’s reward for the value added of transforming commodities in space, time and form.

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Commodity trading: transforming goods in space, time and nature

 

The role of the commodity trader is to match supply and demand, and to do so in the most cost-effective way.

Commodities are not necessarily readily available where the demand lies. Cocoa for example, used by Swiss chocolate manufacturers, is grown only under the Tropics, in Africa, South America and increasingly in South-East Asia.

The role of the commodity trader is therefore to bring the supply of cocoa in Africa and the demand for it in Europe together. They do so by organizing the commodity supply chain between places of supply and places of demand and managing the attendant risks.

In addition to bridging the geographical divide, traders also play a fundamental role in briding the different time horizons of growers/producers who often face seasonal factors and consumers who may want to consume products all year long.

Finally, traders also play an important role in processing raw materials.

As such, commodity traders are transformers: across space, time and form.

  • Space: transport from A to B

This is the core function of the commodity trader: transporting commodities from where they are produced or extracted to where they are used. Traders do so by organizing the shipment of commodities from A to B and managing the attendant risks: price risks, operational risks, financial risks.

  • Time: storage, market structure, forward sale

Mismatches in the timing of production and consumption creates a need to engage in temporal transformations such as storage.

  • Form: processing, refining, blending

Whether it is agricultural produce, energy or metals, most commodities need to undergo processing to meet the characteristics of final products ready for consumption. Just as crude oil requires refining and blending in order to be suitable for modern vehicles, soybeans for example are crushed to extract the useful vegetable oil and the meal that can be fed to livestock.

The fundamental concepts of backwardation and contango

 

Commodity traders pay great attention to the price curve. Significant differences in price levels over different time spans can offer physical traders arbitrage opportunities. Two particular configurations stand out: backwardation and contango.

Depending on the situation, traders will have to adopt different strategies. Not only do they have to buy financial instruments to hedge against adverse price variations that could wipe out margins or worse, but they can also adapt their operations to seize profit opportunities, for example by storing crude oil if the contango is sufficient to offset storage costs over the period.

Backwardation

Backwardation, or normal backwardation, describes a situation in which the spot or cash price of a commodity is higher than the forward price, i.e. the current price is higher than the future price.

In many cases, the development of a backwardation is associated with supply shortage, for example if there is a disruption in the supply chain, such as unplanned refinery closures for oil products in a tight market. Price differentials for perishable goods between near and far delivery are typically in normal backwardation.

Contango

Contango is the opposite of backwardation and describes a situation in which the future price of a commodity is higher than its current spot price.

A contango is normal for a non-perishable commodity that has a cost of carry (e.g. warehousing fees and interest forgone on money tied up).

Technical vs fundamental analysis

Commodity traders -just like any other financial trader- rely on two different approaches when it comes to taking positions in a particular market.

Given that Swiss commodity trading companies focus on physical trading and therefore have longer time horizons than "paper" traders, fundamental analysis plays a particularly important role and requires the fundamental analyst to know his particular market intimately.

In practice however, many market players use technical analysis in conjunction with fundamental analysis to determine their trading strategy, especially when trading on their own accounts.

  • Fundamental analysis is a method of forecasting the future price movements of a commodity based on economic, political, environmental and other relevant factors that will affect the basic supply and demand of whatever underlies the commodity (or financial instrument).
  • Technical analysis is a method of predicting (short term) price movements and future market trends by studying charts of past market action which take into account commodity price, trading volume and, where applicable, open interest.

Trade lifecycle: activities of commodity traders

Sourcing / origination

The purchase, sometimes the production, or cooperating in the production of commodities. This step often requires commodity traders to have agents in the areas of production, particularly in the case of rare commodities or speciality products such as coffee or cocoa.


Purchase and sale

Typically FOB purchase and CIF sale (see Incoterm definitions). Purchase and sale operations usually involve financing the transactions, organizing the transport and managing the associated risks.


Transport and shipping

Typically by ship: tanker, bulk carriers or -increasingly- containers. Ships can be chartered or shipping can be done using container lines.


Storage and market structure

Traders transform commodities in time by storing them – purchasing them now and keeping them for future sale or delivery. Therefore they own or operate storage facilities, tanks and the like, sometimes going as far as chartering ships for floating storage. This is determined by market structure: is the future price of a commodity greater or smaller than its spot price? If greater: contango – it pays to purchase, store and sell at a later date. If smaller: backwardation; it pays to run down stocks and sell them spot.

Importantly, no single trader is ever capable of storing a substantive share of the deliverable supply and so market manipulations are nearly impossible.


Processing

Traders can transform commodities in form by processing them: distilling crude oil in a refinery to create distillates (‘products’), crushing oilseeds in a mill to produce oil and then sell it, or purchasing ore and selling steel, organizing its transformation in the process.


Inspection & Certification

Modern commodity trading requires that quality and nature of goods remain constant and known at all times. To this end, traders employ inspection companies which assess and test cargos at ports, for example to determine compliance with phytosanitary standards. In parallel, certification organisations are increasingly called upon to verify that commodities comply with e.g. fairtrade rules.


Trade financing

Traders are usually highly leveraged as a result of the low margin and high volume nature of the business and often rely on banks to provide the funding necessary to strike deals. Given the specificities of the various commodity markets and their different risk profiles, trade finance specialists and traders tend to work closely together. In many ways, providers of trade finance are amongst the trader's most important stakeholders.


Commodity trading

Commodity traders engage in two types of trade: physical trading and paper trading. While physical commodity trading requires traders to engage in a number of different actions (as describe din this section), "paper" traders only focus on managing the financial risks associated with trading commodities, typically through exchanges. paper traders play an important role in the functioning of markets as they bring a significant of liquidity to commodity markets, but can have an important impact on price variations by amplifying price movements, particularly if a given product is actively traded.


Hedging and risk management

Managing the financial risks associated with commodity trading is a key function within commodity trading firms. Traders hedge their exposure to risk by buying financial products (such as options). Companies have group-wide policies in place defining the amount of risk that they are willing to take on.


Asset acquisition

Besides trading commodities, trading companies can acquire assets, either "upstream" in which case they buy mines, oil producing assets or agricultural land or "downstream" for example by purchasing storage facilities, refineries, processing plants and distribution networks.

The commodity trader's challenge: managing multiple categories of risk

Commodity trading involves managing different categories of risk. As risk taking directly links to profit opportunities, traders aim to have the clearest understanding possible of the risks involved with each trade. In turn, traders will seek to limit their exposure by transfering certain risks to third party entities.

Similarly to other business, commodity traders are exposed to a wide range of operational risks that are managed through a combination of approaches, including insurance, IT, and health and safety audits.

Commodity trading is a low margin, high volume activity. Profits are largely based on the volumes traded and the margin between purchase and sale prices. As margins are thin, poor risk management can turn a viable business opportunity into a loss-making trade.

Contrary to a popular belief, commodity trading firms have little exposure to commodity price risk, also referred to as flat price risk. This is due to the fact that traders normally hedge physical commodity transactions with financial derivatives, reducing or offsetting the impact of any sudden commodity price swing.

By hedging, traders transform flat price risk into basis risk, which is the risk of change in the differential between the price of a commodity on the market and the hedging instrument. When there is a timing mismatch between the buying and selling orders for physical commodities and the hedging instruments, traders can also be faced with a spread risk. Commodity traders have significant expertise in managing these risks and can use a number of financial instruments to do so.

Because trading firms operate in a low margin, high volume environment, they face various kinds of liquidity risks. Securing funding for business operations and individual trades is of vital importance. In the same way, illiquid markets can be problematic as traders might not be able to sell or buy a commodity at the time or price point that would turn a profit.

Finally, traders also face other types of risks such as political risk, legal/reputational risk, contract performance risk, and currency risk.



Options to reduce risk

Commodity trading firms have two main options to reduce risk, besides hedging and purchasing financial instruments:

  • They can diversify and build up a portfolio of commodities that are typically uncorrelated and thus reduce exposure to market shocks for one particular commodity.
  • They can integrate vertically by acquiring assets along the commodity value chain. This approach avoids suffering from negative impacts due to e.g. supply chain bottlenecks and reduces the need to hedge through financial markets.


Incoterms rules

Given that physical traders are in the business of moving goods around the globe, they rely extensively on standard contracts and pay close attention to the respective duties and obligations of the selling and buying parties. The so-called Incoterms are incorporated in contracts for the sale of goods worldwide and provide rules and guidance to importers, exporters, lawyers, transporters, insurers and students of international trade. As such, the Incoterm rules have become an essential part of the daily language of trade.

Visit the website of the international Chamber of Commerce to learn more about Incoterms.