Lucy Carpinelli, Solution Architect at Evergen
Raw and tangible goods such as food, energy and metals, also known as commodities, play an important role in our everyday lives. The trading of commodities is an essential business that goes as far back as ancient civilisations, way before trading stocks and bonds came into place. In particular, energy commodities such as oil, gas and electricity are crucial to daily life – energy surrounds us at home, at work, getting from A to B – helping us to live a life the way we want. Energy sources are vital for our continued existence and energy trading is key to ensuring sufficient supply.
What is commodity trading?
Fundamentally, a trade is just a transaction, and trading is simply the action of buying and selling things. For example, if you were ordering a pizza, what basic information do you need provide?
- Quantity – number of pizzas;
- Location – address for pizza/s to be delivered;
- Date – when you want the pizza to be delivered;
- Price – e.g. 3 pizzas for $32.95.
The key points of data that make up a trade include:
- Counter parties;
- Commodity / quality;
- Transaction date;
- Delivery date;
- Delivery location; and
Who trades energy and why?
There are three main types of organisations that trade in energy:
- Producers / generators – energy producers such as Shell or Hydro Tasmania are sensitive to price decreases. If prices go down, their revenue will take a hit. Producers and generators trade to manage this risk and minimise impact on profits. A producer is said to be ‘long’ on energy – this terminology means that because you are producing the commodity, you need to offload it.
- Big consumers – energy consumers such as BHP or Qantas are sensitive to price increases. They have the opposite problem to energy producers – if prices go up, their costs will increase. Consumers trade to manage this risk. Big consumers are said to be ‘short’ on energy. As an example, BHP produces coal, so the company is ‘long’ on coal however it does not produce electricity, rather, it consumes electricity, so the company is ‘short’ on electricity.
- Trading houses and banks – the way trading houses and banks work is completely different. They trade on behalf of smaller players and earn fees for this service. For instance, a manufacturer exposed to the electricity market might not have the collateral, relationships or legal skills needed to trade electricity. They may engage a trading house or bank to take a trade that helps manage their risk, the bank will charge a fee for this service. Trading houses and banks also do speculative trading, as well as commodity arbitrage.
Trading is all about managing risk
How do you limit exposure to price fluctuations? Outlined are hypothetical cases for each type of trading organisation:
- Producers – An oil and gas company is producing a massive amount of gas in Queensland and Western Australia; accordingly, the company is ‘long’ on gas, meaning it is sensitive to the price of gas going down. To offset its position of being long, that is, to hedge this position, the company could sell the gas to a utility to be delivered in Q4 2020 at a price agreed in Q1 2020. This trade is a forward and locks in the profit or loss, minimising the company’s exposure to price fluctuations.
- Consumers – An airline has a considerable exposure to jet fuel and as the price of jet fuel goes up, its profits are at risk. The airline has a number of contracts in place with different suppliers to ensure it has jet fuel for the year 2020. That jet fuel will be supplied at the market rate, which is volatile, meaning prices rise and fall rapidly and unpredictably. To offset or hedge that risk, the airline executes a swap trade with an oil producer. In the swap, the airline will receive the difference between the 2021 fuel price and 2020 fuel price. If the price of jet fuel increases in 2021, the airline will (unfortunately) see an increase in fuel costs. However because they have this swap, the airline will receive revenue because of the price has increase – the airline’s increased cost from the fuel price increase has been offset by revenue from the swap. The flipside can also occur. If the price of jet fuel decreases, it is good for the airline as costs go down. However, the airline will have to pay out on that swap because it has effectively taken a bet about which way the price will go. The counterparty in this swap trade an oil producer because they are hedging too. Just as the airline is hedging against prices going up, the oil producer will be hedging against the prices going down.
- Trading house – A commodity trading company agreed to buy oil in Nigeria, then shifts the oil to Spain and sells the oil to a refiner who is going to turn it into petrol. This is an example of arbitrage – arbitrage is defined as buying in one market, to sell in another market with a better price. The important thing in arbitrage is that this is done simultaneously. Buy and sell trades are executed concurrently so the profit is locked in before any delivery takes place. Arbitrage is considered to be risk-free therefore it does not require hedging.
So what is the difference between hedging and arbitrage?
Imagine buying an apple from the grocery store for $1, then calling a friend and telling them, “I can sell you an apple for $2 tomorrow” and they say yes, then you have a risk-free deal – you are going to make a $1 out of that apple. This is arbitrage.
Hedging is all about identifying risk and then betting against your position. If you’re long, you sell. If you’re short, you buy. A hedge will offset your potential losses – but it will also offset your potential gains too.
These are the main reasons trading occurs – because there is some type of risk and the company wants to hedge it, or because the company is playing in that market and wants to make money by doing things like arbitrage trades.
What kind of organisation is needed to operate a trading business?
There is a whole organisation around a trading business. While it is easy to think of a room full of traders doing deals and making money, in reality, for every trader, there are a number of people who are making it all work. Generally, there are three departments in a trading organisation:
- Front office – this is where traders live and do what they do best, make deals and do trades. The front office also includes those who are forecasting or other pre-trade analysis such as managing weather data, as well as the scheduling and dispatch function which is all about minimising the cost of delivery.
- Middle office – this is the team that handles risk management and controls. The middle office calculates the risk inherent in the company’s portfolio and the exposure of the business on a day-to-day basis. This includes managing trader limits, credit and market risk, compliance and profit and loss reporting.
- Back office – this is the function that processes settlement and accounting and manages collateral, ensuring there are enough funds to clear deals. A trading business might have working capital, that is, money they have to leave in a bank account to demonstrate they can pay the bill on a certain trade. Additionally, the back office manages regulatory reporting and tax.
The responsibilities between the front, middle and back office are separated – this is commonly referred to as ‘segregation of duties’. It is imperative to have clearly defined barriers between the front, middle and back offices and what they can do. Why is this important? Segregation of duties is designed to prevent error and fraud.
Front office traders are money-making enthusiasts and have been known to push boundaries to close deals. Middle office are responsible for risk levels and impose controls on traders. There needs to be a separation between the people who control trader limits and the traders themselves.
The front office is also responsible for managing physical delivery, usually handled by the scheduling team. In oil or coal, this team would manage shipping. In gas and electricity, scheduling manages the use of pipelines and transmission lines. Traders are focused on realising value from the market and schedulers look at minimising cost of delivery.
As well as compliance elements, the middle office is also about tracking exposure to market and credit risk. Credit risk is the risk of default. Trading involves transacting significant amounts of money. For example, a shipment of liquefied natural gas (LNG) could be worth US$20 million. To prevent potential losses from a counterparty defaulting, suitable collateral must be supplied, which is managed through back office and treasury function.
Furthermore, a trading organisation can have multiple trading teams – there are traders that focus on different markets such as looking at only oil, or only gas, or only looking at long-term deals or short-term deals as there are different trading strategies that can be undertaken to generate revenue in each. Short-term trading explores matching supply and demand within days or even minutes, while forward trading is about taking a long-term view of demand for commodities and locking in prices to manage risk over a period of months or years.