Notes on Commodities Demystified
Reading Trafigura, Commodities Demystified
What are Commodities?
The "complex, intensely practical business of getting resources out of the ground, moving them across the globe and turning them into the raw materials we use every day."
Transformations in space (transportation), time (storage) and form (processing)
Primary and Secondary Commodities
Primary commodities - Extracted or captured directly from natural resources; Farms, mines and wells; Non-standard, quality and characteristics vary widely
Secondary commodities - Produced from primary commodities; Crude oil refined to make gasoline, fuels; Concentrates smelted to produce metals; Minor variations in quality depending on production process
Commodity Futures
Rudimentary futures markets existed in Mesopotamia and Japan several thousand years ago. Farmers needed to protect themselves from the vagaries of the weather. They managed that by fixing a future price for their crops. This gave them the confidence to start sowing the next year’s crop before they received any money from the current year’s crop.
What is a commodity future? - Contract, traded on an exchange, to delivery a commodity (of which there is a wide variety, particularly for primary commodities); Specified quantity, quality, delivery location, delivery date; Seller is obliged to deliver at delivery location on delivery date
Commodity futures prices converge with physical commodities
Possibility of physical delivery impose price discipline, but physical delivery against futures contracts almost never happens in practice. Sellers close positions by buying contracts on or before the delivery date (with the same quantity, quality, delivery location, and delivery date)
1940s - Oil Majors, "Seven Sisters" (often described as "the Seven Sisters"), total control of oil industry; Vertical integration, prospected for oil, extracted, transported and priced it, controlled refineries and sold oil products to end-users
(Funnily enough, Sherman Anti-Trust Act passed in 1890, break-up of Standard Oil in 1911 for same concerns, but Standard Oil's subsidiaries ended up dominating the oil market anyway, lol)
1970s - Erosion of monopolistic position; Oil-producing nations, especially in the Middle East, assert national sovereignty over natural resources (OPEC founded in 1960)
Independent operators became increasingly influential; Before OPEC, majors owned or chartered 2/3rds of tankers, by 2015, just 10%
Metals
Iron
Shift in trade since 2000s; Destination countries, China from 10% in early 2000s to 50% in 2014; Source countries, North to South, half of metal exports to China came from Australia, Brazil and Chile
Before China, Japan, last big economy, industrialise, fast growth; 1970s and 1980s Japanese steel makers preferred stability over price; Set prices annually with the iron ore producers rather than market price; Annual contract prices set the price benchmark for the sector
(In general, stability preferred due to costs of stopping and starting production, cheaper to sell at a loss)
China, shortage of iron ore under the annual contract system, spot market and India (did not supply Japanese) for extra tonnage; Before GFC, 2008-9, spot price twice contract price, backwardation (producers favoured stability as well, or they would have sold on spot market); During crisis, contango. Post-crisis, reversed again
Copper
China used to import vastly more refined copper than copper concentrate, but shift to more concentrate; By 2015, proportion about equal, proportion of concentrate continuing to increase; China's increased smelting capability (which I think is part of China's general increase in manufacturing capability)
Strain on world mining resources; More quantity, lower quality; In 2000s copper content in raw ore 2-3 percent; now 1.5 percent; more energy to crush and mill into concentrate, more impurities; Variable quality, more trading opportunities; Smaller scale mines, opportunities to provide technical knowledge, capital, purchase agreements, distribution
(Random side note - This video
has an interesting comparison between finding alpha (performance exceeding benchmark) and finding gold; In 16th and 17th century, gold easy to find, surface, Spanish treasure fleet quadrupled amount of gold in circulation in Europe; nowadays we need industrial methods to extract microscopic particles of gold; but today we extra 2,500 metric tons of gold per year, vs 1.5 tons in 16th century)
Characteristics of Commodities Markets
Physical supply chain
Connected markets - Many types of crude, but pricing differentials limited, otherwise blend and transport cheap crudes to expensive markets; US shale, reduced US net oil imports, pushed US coal out of domestic power market, negative impact on international oil suppliers and international coal markets
Storage - Inelasticity in the supply and demand for commodities (due to production start and stop costs), medium term, lower demand, persistent, excess supply; Storage acts as a shock absorber, reduces price volatility; Supply > Demand, store; Demand > Supply, draw
Arbitrage, transient by definition; High cost of short delays; Without owning storage facilities, exploited, artificial delays, premium rates for "express" service (Less risk for "floating" storage since bulk ships and tankers are mobile)
Volatility - Markets function most effectively when there is deep and consistent liquidity (??? This is a deep statement thrown out as a one-liner, lol. Requires more thought); Traders increase liquidity, lower transaction costs, especially active in volatile markets; Traders do not cause volatility, e.g. oil is volatile because of geopolitical forces, sanctions, seasonality, fiscal policy, management of strategic oil stockpiles
Challenges
Profit margins for trading firms are thin, scale business, require heavy investment in systems, processes and technology; Thus dependent on banking sector with appetite to finance trade and deep and liquid derivative markets to manage price risks; Regulators concerned with systemic financial risk may unintentionally negatively impact trading