Commodities Trading 101: Market Participants

commodity 101

From a trader’s perspective commodities market comprises of:

a) producers

b) consumers

c) other trading entities

d) auxiliary service providers

Producers obviously are involved in production of commodities and include as diverse examples as:

farm cooperatives, mines, oil fields.

When we look at producers, we need to discern the level of processing involved, for the same commodity.

To show what I mean by a level of processing, let’s take metals as an example.

In metal’s case we start with mines that output ores which are then processed by concentrates producers to concentrates – and then again processed by smelters to refined metal.

Usually, for metals, the same metal is traded in all those different forms of refinement. Depending on the specific metal in question, market for a specific level of refinement varies in size and importance.

For instance there is a very large (especially in terms of sheer volumes) and economically important market for iron ore (with highly active trade in between Australia and China), while a market for antimony ore is of secondary importance even if we only compare it with antimony refined metal market, on basis of proportions.

As it often happens in metals, the same company which is engaged in mining also engages in concentrate production, as the process of ore transportation is not very economical.

After all what you really pay for is a metal contained.

Percentage of metal contained in an unprocessed ore will be much lower than in concentrate, and again percentage of metal in concentrate will be much lower than in refined metal.

So, what else is there in ores or in concentrates, beside the metal that we pay for?

All sorts of geological waste, simply speaking, but also other metal elements which may or may not be of interest to our customers.

For example production of technologically important minor metals, which are so key for cell phones, battery or defense industry comes very often as a byproduct of other more important (in terms of market size) metals.

With regard to oil & gas industry, it is important to clarify what up-stream, mid-stream, and downstream mean in terms of market segments.

Up-stream – refers to oil/gas field production
Mid-stream – to its processing (think refineries)
Downstream – to its wholesale and retail distribution

Correctly or not up-stream, mid-stream and downstream categorization is being used in other commodities markets, not only O&G (Oil&Gas) from which it originally derives.

In a mind of many newcomers to physical commodities trading industry, the best deals entails buying directly from producers and selling directly to final consumers. Such strategy however, even if sometimes may help to maximise the margin in the spot market is not as straightforward as it seems.

Try to look at this issue from the perspective of producers.

Producers aim to secure the sales for their yearly output. Hence one, even large spot deal, that would make some traders salivating would be not so much attractive for a producer.

Producers aim for long term agreements, where traders contractually declare to off-take batches of commodities every month for a several months periods, so typical long term contract may entail following provisions:

Quantity: 50 000 MT
Shipment: EX Warehouse Rotterdam
Delivery time: 10 000 MT in January, 2018
10 000 MT in February, 2018
10 000 MT in March, 2018
20 000 MT in April, 2018

Final consumers are rarely interested in the quantities in which producers are interested to deal, hence it is more difficult to structure a back to back deal deal in between producers and final consumers.

Producers very often also have their marketing departments, which tend to structure market share according to their strategy, either handling some big final users directly or going for exclusive distribution agreements in certain jurisdictions with specific traders.

Therefore if you approach them, they want to know specifically if not a company name, then a concrete destination where you will ship the commodity and its final application. This practice is particularly prevalent among some of the biggest Japanese metals producers. Personal relations tend to also play as big if not bigger role than the business terms.

Hence more often than not, especially for spot business, traders buy from the other traders, which sometimes can offer better price than producers and certainly more flexible terms.

Why a trader may offer a better price than a producer of a commodity?

a) trader may have bought the commodity at the lower price in the past and after factoring in, storage and financing costs he is still well off selling the commodity at this point in time.

b) trader may have hedged the commodity using a derivative instrument hence the physical price is not relevant for him anymore. At this point he is simply trading a basis (more on basis trading in separate article).

Just for the heads up – if you bought a commodity 20 dollars cheaper per MT than the price of derivative that you sold at the same time you have effectively established a basis of USD – 20. Let’s assume that the price of commodity you bought was USD 600/MT. A week passed by, market price changed to USD 560/MT, and you decide to sell the same commodity. It appears you are selling at loss.. nothing further from truth!

Since the derivative contract trades now at USD 550/MT you are selling a physical at the basis of USD + 10. At the same time you are buying the derivative back and you effectively make USD 30/MT of profit!

c) trader wants to cut his losses and exit the position, believing that the market will fall further.

In case of consumer-end the same logic holds true. Opposite to what many people outside of industry think you can make higher margin, selling to other traders than selling to final-end buyers as industrial plants. Same logic applies:

a) trader may buy at higher level than a plant, because he may have long term contract in place, secured in the past at the higher level than the current market spot price, but he happens to be short of commodity to cover this contract, so he is ready to buy from you, at what you will perceive as a high price.

b) he is trading a basis

c) he has an opposing view of the market, he thinks market is in contango and price is expected to increase, so he amasses the commodity paying what you consider to be a high price.

The biggest problem with selling to industrial plants is that:

a) they usually have established suppliers in place who they trust. So they are not always keen to switch only because you offer a little better price

b) since they are large, continuous buyers for given commodity, they enjoy high bargaining power, meaning they expect from you advantageous payment terms (as payment 2 months after delivery) Рwhat makes sense from their perspective (think of production life-cycle, they tend also to be paid with delay). Nevertheless it is risky and inconvenient for you. Anything can happen in 2 months time Рthey  can even go insolvent..

Besides think how it will affect your cash flow. So it is a value proposition better for large commodities companies which have their credit risk insured and who have enough money to trade with, so cashflow is rarely a problem.

I think we already discussed to some extent other trading entities. At this point it is perhaps worthwhile to mention an importance of brokers in an overall scheme of things. Brokers play sometimes larger sometimes smaller role depending on the market. In dynamic, large volume markets as grains they are prevalent and they role is important also from the perspective of the information that they provide.

There is no better way than to call a broker to find out what are the prices in the ports of certain regions of the country, or to deduce from information provided what competition is doing..

In other markets as minor metals they play a marginal role.

Good broker is a beginner’s traders best friend. Keeping him well informed about the physical market. More experienced traders adopt with time the ability to gauge the physical prices/premiums from fewer points of reference, taking into account regional peculiarities. For new traders it is a difficult task to accomplish. More importantly brokers also help to put more deals together. In many trading houses swim or drown culture prevails. Young, promising people are being given a chance, but no matter your charm and intelligence, your key characteristic shall be an ability of prolific deal making.

It is crucial to remember that brokers do not care about the price per se. They charge fixed commission for unit of commodity sold. Usually they also only charge a commission on the seller side.

Hence for them it does not matter if the market is up or in a doll drums. What matters for them is a volume of deals struck. Therefore they have an incentive to convince/cajole the buyers and sellers to establish the price that will lead to the conclusion of the deal, when there is a difference as to the price idea.

To develop successful relations with a broker mutual exchange of information is a key. Even if it is a relation in which trader keeps an upper hand. Sometimes lot’s of back and forth is required to close a deal. In the meantime, one can keep a conversation going by exchanging prices heard and sharing opinions on the market.

Brokers fulfill also another important role, providing a neutral contract to both sides.

Commodities contracts as issued by different companies tend to be fairly similar but they differ sometimes in details.

Each company has its own crafty lawyers trying to formulate general terms and conditions of trade/purchase as advantageous to the company in all foreseeable situations as possible.

Hence if two trading houses with equally sophisticated general terms & conditions decide to do a deal, they prefer the standardized broker contract. What constitutes an ideal situation for a broker since he does not need to work to put a deal together while the charged commission stays the same. Such trading houses go for a broker that they both know and respect.

How to find reliable counterparties to trade with?

Usually a good idea is to find conferences organized by key commodities information providers as: Metal Bulletin, Platts, Argus. They are more often than not commodity and region specific. Ideally, one should attend the conference to meet the players, face to face, but even the participants list (often publicly available free of charge) is valuable. Companies ready to splash a few thousand dollars to attend a conference, tend to be serious about doing business.

Another good source are the associations, which usually gather producers, traders and services providers for given commodity class. Check GAFTA for grains and MMTA for minor metals to see what I mean. Perhaps such association membership directories are even the better source, since their members tend to be vetted in some way.

Auxiliary service providers might be divided into following categories:

a)transport companies
-shipping companies
-trucking companies
-air freight forwarders (for precious metals as gold/silver)

b) warehouse/storage companies

c) surveyors

d) financial market counterparties
– trade finance departments of banks
– derivatives brokers

e) information providers/journalists

The cost of freight is one of the key determinants, that renders the trade possible from the economic perspective.

Some markets which are unreachable for traders at the time of high freight prices, all of the sudden becomes available when the prices sink.

Shipping markets are not less volatile than commodities. Since the largest operating expense for ship owners is the cost of fuel, freight is correlated to the price of oil.

Shipping operators can be crudely divided into tramp shipping operators and container lines operators.

Tramp operators can be compared to taxi services. They happen to have their favourite areas of operation but if the fare is right they can pick up the cargo where they want in the world, elastically reacting to the forces of supply and demand.

While shipping lines operate largely as bus operators, within set routes, with planned stops on the way which are not easily altered.

Hence when booking your cargo on the container line, one needs to make sure to not miss the next bus (ekhm) vessel. Since intervals between the service can sometimes interfere with your business plans.

Trucking services are less susceptible to
freight cost changes but they are also to certain degree volatile.

Warehouse/storage facilities – 3rd party warehouses play a key role in trading of some commodities. They help to make trading more secure, with mechanisms as payment against release in place.

In payment against release seller instructs the independent 3rd party warehouse to issue a provisional release to the buyer. Buyer pays against provisional release and after presenting bank payment confirmation, goods are unconditionally released to the buyer.

Such method is cheaper and faster than dealing with banks for both sides, while provides usually enough insulation from risk.

Established warehousing companies, also operate futures exchanges approved warehouses, bonded warehouses which allows to store goods in the ports for further re-shipment without the need to pay customs duties and also act as VAT agents or general logistics services providers (you book your vessels or trucks through them).

Recognized warehousing companies often possess a network of warehouses around the globe in key commodities trading centres and key ports. What helps traders structure their trades with one point of contact.

Surveyors (inspectors) are companies, providing testing/measuring services. Similarly to warehouse providers they posses a network of offices in commodity industry sensitive places around the world.
They are also happy to travel on assignments to more obscure places for an appropriate fee. They are usually present during loading/unloading of the cargo, to supervise it. They also have a network of laboratories where they can test the taken samples for specification. Assays play crucial role in this business. A few percent difference in key element or impurity in the commodity can have huge impact on its price!

Traders or their financing departments are in constant contact with the banks which facilitate secure transactions (Letters of Credits, Bank Collections) or finance them (factoring, secured credit lines, financing against underlying commodity).

Derivatives brokers help to manage price risk and hedge the transactions for commodities which can be hedged that way.

Finally we have information providers, who cover the commodity markets, publishing the analysis and market reports. Yet very often their key source of revenues come in form of price assessments.

Price assessments for traders are important since:

a) they tend to be incorporated to the contracts as a basis for a price – if benchmark is widely recognized and established

b) give a point of reference in negotiations – especially critical for commodities which price is not established on futures exchange trading markets.

Naturally this overview of the key market players is based on simplification and generalization of different phenomena.

Yet it is necessarily so, to sketch those key characteristics and provide you with a representative taster, that would helpfully encourage you to pursue the course, and learn more about physical commodities trading.

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