Date of Source: 2016
Commodities trading – supply of the basic staples that are converted into the food we eat, the industrial goods we use, and the energy that fuels our transport and heats and lights our lives – is one of the oldest forms of economic activity, yet it is also one of the most widely misunderstood. At no time has this been truer than in the last 20 years, with the emergence of a group of specialist commodities trading and logistics firms operating in a wide range of complex markets […]
It is unfortunate that the general public’s perception of commodities trading has been most heavily influenced by the Enron fiasco of 2001. Perhaps more importantly, many who are peripherally involved with finance view commodities trading through the lens of wild speculation. This perception is understandable given the marketing machine that is sell-side research which purports that making money in commodities is a function of charts, patterns, Elliot waves, COT reports, support and resistance, pivot points, seasonalities, moon phases, planetary alignments, doomsday scenarios, ad nauseam. That the overwhelming majority of commodities trading advisers (CTAs) propagate these extraordinary, fantastical claims does not help to dispel this belief either (even though according to Equinox’s curated CTA list the average annualized return for “best of breed” CTAs has been about 0.75%… YUCK). What’s even worse is that many decent people are led to embracing the insidious and convincing do it yourself with “charts” mantra. Personally, my early views on commodities trading were molded most by boozy, bombastic dinosaurs who were then known as floor traders, many of whom outwardly projected themselves as though they were the knights of the last bastion of capitalism, and some others (as I was to learn) lived lavishly at someone else’s expense.
Anyhow, the kinds of expected returns from commodities speculation are absolutely the pits, especially when you consider the risks involved. If you’re selling me diversification, I’m buying canned food. A more honest account of “proper” commodities speculation is demonstrated within the Eddie Murphy classic, Trading Places. If you have an inkling of interest in financial market, but haven’t seen this movie yet, my advice is to go watch it… right now.
Although most volume on futures exchanges consists of speculation (i.e., trading without taking delivery), the total open interest on oil futures contracts on the NYMEX and ICE represent only 5% of the physical market for oil. It stands to reason then that some commodities trading actually is not speculation, but is rather value-added to the world economy by connecting supply with demand.
Sic the main purpose of Tranfigura’s guide to trading and the global supply chain, Commodities Demystified: to properly differentiate between speculation and trading.
The guide intends to dispel many misgivings about the business. Chief among these is the notion that making money in commodities is easy. In fact, page 2 of Trafigura’s 2016 annual report suggests that it is anything but. With $98.1 Bn in revenues, the firm pulled in a mere 2.3% gross margin and just under a 1% net margin (according to its CEO, 2016 was a year of “robust” performance). These are the profit margins of neighborhood grocery stores, not those expected of “fat cat traders”; yet, these results are indicative of the firm’s target profit-per-trade of 3%. Additionally, these results are likely representative of “the best” and most well-informed traders on the market. As the guide elaborates, expected trading profits are not some free lunch; rather, they are made possible only through an articulation between well-informed market participants and high barriers to entry provided by a capitally-intensive and integrated asset base.
Another primary intent is explain the history of how commodities articulated within the global supply chain. The first several chapters frame much of the foundational minutiae. Later chapters delve into current topics such as how institutional approaches to the trading business have adopted to changing market conditions. For example, one change has been the insurmountable problem of increasing efficiency. Relative efficiency over other market participants is a trader’s primary weapon. Therefore, broad market efficiency is his/her enemy. Although the first impulse might be to resist this change, efficiency is correlated to the increasing dispersion of information technology and its growing role as part of man’s embodied cognition. Generally, the discovery of both strong and weak forms is expected to become increasingly difficult as market participants become increasingly wary and capable of detecting mis-pricings and implementing more efficient pricing mechanisms. Trafigura’s incisive response to shrinking inefficiency is encapsulated in bold text within Chapter 5:
As markets become more efficient, commodity trading is evolving into a low-margin service business. Increasingly, traders make their living by providing a solidly reliable logistics service between producer and consumer.
The paper conveyed the sense that there two ways to make money in commodities trading. The first way is to create value — this is the core of Trafigura’s stated business model. The razor-thin margins for providing liquidity to buyers and sellers are augmented only through value-added and/or exclusive rights to blending, storage, and shipping activities. The second way is through arbitrage. In Trading Places Eddie Murphy and Dan Akroyd orchestrate an illegal arbitrage by front-running proprietary data before it is made public. Not all arbitrages are illegal, however. In fact, arbitrage is value added to the general consumer because the act of arbitrage eliminates arbitrage. Or, in the more eloquent words of the document’s author(s):
Traders are not speculators – their job is to match buyers with sellers. They do that through arbitrage. Far from making markets more volatile, arbitrage actually helps to re-establish balance and improve efficiency and transparency in physical markets.
All in all, I agree that market efficiency is good for the general consumer but bad for traders. But to the extent that human error (speculation?) exacerbates market inefficiencies, I suspect that there will continue to be a robust niche for arbitrageur-traders to take the other side.
Report Source: Trafigura. Commodities Demystified: A Guide to Trading and the Global Supply Chain. Date of publication: 08 Jul 1905. Original content accessible: http://www.commoditiesdemystified.info/en/#Fundamentals-of-commodities/diaporama
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