Control Room of the Future
Commodity Trading & Risk Management
The future of commodity trading is poised for significant year-over-year growth, driven by population expansion, customer behaviour changes, evolving market dynamics, and increased global demand.
01 Background
To capitalize on these opportunities, companies must undergo a comprehensive evolution in their processes, systems, and operating models. This includes the adoption of advanced analytics and artificial intelligence to accurately anticipate market swings, ensuring they maintain a strong balance sheet to withstand liquidity challenges.
Furthermore, a robust risk management system and culture are imperative, allowing firms to strategically trade risks for incremental margins.
By integrating these elements, companies can unlock additional value in both future and spot trades, positioning themselves for sustained profitability and competitive advantage in the rapidly changing commodity trading landscape.
Point of View for Commodity Trading
Significant Trading Growth YoY: The industry has experienced significant growth, with an average year-over-year increase of 9% for the past 20 years. This trajectory has culminated in a cumulative gross margin of over 100 billion dollars in 2022 with potential to double by 2030.
E-Fuel and New Asset Classes: The energy transition has led to the creation of new asset classes in the trading market, including biofuels, hydrogen (H2), ammonia (NH3), SAF, and a variety of specialized blended products. These developments offer great potential for new and expanding trading desks.
Renewable Energy Investment Surge: In COP 28, 150+ Nations agreed the investment in renewable energies must grow 3x by 2030. This will trigger demand for some raw material unlocking substantial opportunities in the mining sector for essential elements like lithium, cobalt, and iron pivotal for sustainable technologies.
Promising Opportunity Ahead: By the year 2030, we anticipate a commodity market size ranging from 200 billion to 300 billion dollars, heralding a significant opportunity for emerging commodity trading companies to establish and refine and enhance their operating models.
Overview on Risk Management in Commodity Trading
Commodity Traders ensure products arrive at the right place, time, and price, acting as essential facilitators of international commerce, especially amid disruptions like the pandemic, geopolitical tensions, and energy transition.
Directors for Volatility:
- Disruptions from the 2020 pandemic affecting supply and demand.
- Geopolitical tensions, especially the conflict in Ukraine, impacting energy security and supply chains.
- Uncertainty and radical changes stemming from the energy transition towards net-zero emissions.
Market Impact:
- Supply-demand imbalances and the transition to renewable energy exacerbate volatility in energy markets.
- Traders play a crucial role by providing liquidity, encouraging investments in renewable technologies, and navigating market disruptions.
- The transition period involves higher capital requirements and increased credit risk, favoring larger, well-capitalized players.
The energy transition will fundamentally alter commodity trading, shifting focus from marginal gains to exploiting new market opportunities. Successful traders will adapt to new market conditions, embrace agility, and leverage their experience in nascent markets to dominate emerging niches. The transition period will be marked by increased customer-centricity and strategic partnerships.
Commodity trading, a multidimensional discipline
1. Availability of tankage
Tankage availability is key for oil and petroleum supply. It involves maintaining large inventory stocks in strategic oil tanks globally. Traders track tankage to manage storage capacity and identify supply sources.
2. Geopolitical developments
Conflicts in oil-rich areas and sanctions can impact oil supply and demand. For example, the U.S. Strategic Petroleum Reserve (SPR) is a significant emergency supply. The government can release stocks to manage supply.
3. Benchmarks
Oil prices are set using benchmarks like spot market prices, which reflect the larger market. Traders use these benchmarks to understand pricing, premiums, and market movements.
4. Bottlenecks, peaks, and troughs
Traders monitor natural cycles, economic trends, and disruptions to predict supply and demand changes. Knowing infrastructure limitations and seasonal variations helps manage these fluctuations.
5. Locations and logistics
Oil comes from multiple sources, making logistics complex. Traders optimize supply chains to ensure cost-effective delivery from extraction to end-users.
6. Product specifications
Commodity traders deal with various oil grades. They must match oil specifications with demand, considering differences in refining needs and market suitability.
7. Blending opportunities
Blending different oil types can meet specific demand. Traders take advantage of blending to create the desired product efficiently, considering the availability of ingredients.
8. Cost of financing
Trading firms use short-term secured finance to bridge buying and selling gaps. Higher interest rates increase financing costs, affecting transaction profitability.
9. Futures markets
Futures markets provide insights into expected supply and demand. They help producers, consumers, and traders act on market sentiment, offering a view of future price movements.
10. Contango and backwardation
Traders monitor if futures prices are higher (contango) or lower (backwardation) than spot prices. This helps in identifying inventory trends and arbitrage opportunities.
11. Risk management
Trading teams use futures, options, and risk management strategies to minimize market volatility exposure. They manage overall price risk to ensure stability.
12. Counterparty and political risk
Commodity trades involve large transactions. Traders limit credit risk through financial partnerships and manage sovereign risk by assessing counterparties and geopolitical conditions.
13. Cost/availability of substitute products
The availability and pricing of substitutes impact supply and demand. Substitutes can affect commodity economics and blending processes, influencing market dynamics.
14. Existing trade flows
Understanding trade flow fundamentals helps traders assess relative pricing levels. Changes in trade flow direction affect price differentials and trading strategies.
15. Cost/availability of freight
Freight costs vary with availability, affecting trade profitability. Physical commodity traders consider transportation costs and often work with freight traders to set prices for specific journeys.
02 Operating Model
Establishing a Trading function requires a clear positioning in terms of risk-return trade-off
Pure asset Backed Hybrid Proprietary Trading
Marketing & Financial Support Role
- Trading is secondary to the company's core operations.
- Trading supports the completion of product sales at optimal prices.
- Adopts a conservative approach, accepting risks linked with long equity positions.
Integrated Asset Management Arm
- Understanding client needs and optimizing product offerings (e.g., client segmentation, product bundling, logistics services).
- Creating systemic flexibilities in the geographical and temporal properties of goods, partly through asset management.
- Access to third-party volumes for overall optimization and establishing an operational commercial optimization function.
Pure-play Trading Desk as a Profit Center
- Utilize derivative instruments and take paper positions for hedging and risk management.
- Engage in active trading for profit and use derivatives to express market views.
- Accept selective proprietary activities, trading risk for additional returns while controlling risk.
Key Imperatives for Achieving Success in the Realm of Trading Operating Model
Risk & Governance
- Well-defined risk appetite by the Board of Directors
- Delegated authorities to enable very quick reaction times
- Strict governance model and reporting
- Decentralized, strict risk controls
People
- Specific skills and capabilities required
- Flat and lean organization
- Segregation of duties
- Trading specific HC requirements & compensation structure
System & Processes
- Requires own and specific trading/risk management IT systems
- Each molecule, product and dollar is documented, tracked, and accounted for automatically
- Bespoke finance and accounting processes
Stakeholder Management
- Multiple intercompany interfaces & shareholders
- Evolving relationship with current customers
- Expectations for domestic and international
- Bank relationship management
03 How we can help you
We can assist organizations in enhancing their operating models, gaining a comprehensive understanding of their risk framework, and implementing a robust risk management system.
This system should enable the company to effectively monitor and control its exposure, accurately assess value at risk, and maintain an appropriate risk appetite.
By achieving these goals, the organization will be better positioned to trade risk responsibly and strategically, ultimately driving incremental margins and ensuring long-term financial stability and competitiveness in the market.
