The Economics of Commodity Trading Firms

The business of commodity trading is one that enables the fulfillment of basic human needs, yet misunderstandings and adverse opinions are common toward the industry that largely undergirds today’s global economy. On April 8th, 2014, the Atlantic Council’s Energy and Environment Program hosted the event, “Scanning the Horizon: Commodities Trading and Energy Markets,” a discussion that included a diverse set of government, industry, and NGO stakeholders. University of Houston Professor Craig Pirrong presented on the key findings of his March 2014 whitepaper, “The Economics of Commodity Trading Firms.” The Trafigura-funded report seeks to increase the understanding of the commodity trading world and illuminate how commodity trading firms (CTFs) operate.

20140421 Commodities2The paper overview aimed to provide an introduction to the basics of commodity trading.  CTFs perform physical commodities transformations at all levels of the value chain: in space through transportation, in time through storage, and in form through processing. In terms of space, CTFs may focus on the transportation of commodities from supply regions to consumption regions. Since commodity demand is dependent upon a number of variables, some CTFs specialize in storage–maintaining supply levels and withstanding market swings. Other CTFs may concentrate their efforts on transforming a commodity into its final, consumable form. Addressing constraints to transformations–bottlenecks–is of paramount concern to CTFs.

Another issue examined at the roundtable was the diversity of CTFs. Different firms focus on different transformations, different commodities traded, and varying levels of asset ownership. Privately-owned CTFs tend toward light asset ownership, while larger, publicly-owned CTFs are establishing a heavy asset trend. According to the whitepaper presentation, asset ownership can decrease transaction costs. In the case of storage facilities, efficient utilization of storage can ensure a rapid response to supply and demand shocks, and the ready accessibility of assets is necessary to execute arbitrage transactions. Diversity was also cited as a critical component of risk mitigation. In addition to diversity, CTFs seek to manage risk through insurance and hedging.

Further on the subject of risk, the whitepaper asserted that CTFs do not face the systemic risks confronting the banking industry because CTFs do not maintain fragile balance sheets, nor do they supply credit in the same manner as banks. The paper assets of CTFs are redeployable, and CTFs thus enjoy less vulnerability to economic crises. Even in serious catastrophes like the 2011 Japanese tsunami, large disruptions to logistics networks did not have systemic effects.

Among the main themes of the open discussion session was the effective management of existing industry hurdles. Part of the discussions focused on the means that CTFs use to identify and address bottlenecks. For some CTFs, success in resolving bottlenecks and related problems relies on early identification and localized communication with those directly involved with onsite operations. Major disruptions can be avoided by maintaining a solutions-oriented mindset across the supply chain.  The Keystone pipeline and its impact on the business of CTFs was discussed and as well as the associated increase volumes and the changes in basis differentials. On the issue of risk exposure to the Central CounterParty Clearing Houses (CCPs), it was discussed how companies manage such risk by working with multiple clearing houses—reiterating the importance of diversity within the industry. For a link to the whitepaper, The Economics of Commodity Trading Firms.