Adam Smith’s Visible Hand: How Commodity Traders Operate

Tldr: Commodity traders are the visible manifestation of Adam Smith's Invisible Hand because they direct resources to their highest value by arbitraging mispricings using logistical operations and financial markets.

A recent Oliver Wyman report stated that the commodity trading industry has accumulated $120 billion in cash reserves after record profits over the past few years.

Trafigura reported record net profits of $7.4 billion in its most recent financial year; it also tripled its dividend to the company’s 1,200 employee-shareholders to $5.9 billion – approximately $4.9 million per employee. The median NBA contract for the 2023-24 season is $4.6 million.

Vitol, the world’s biggest independent energy trader, recorded net profits of $15.1 billion in 2022 and paid an average of $785,000 in salaries and bonuses to its 3,311 employees.

To put their scale into context, the 5 largest oil trading companies handle 24 million barrels a day of crude and refined products, almost a quarter of the world’s oil demand. The 7 leading agricultural traders handle just under half of the world’s grains and oilseeds.

Vitol's revenue in 2022 was $505 billion, which made it the fifth-largest company in the world by revenue that year — behind only Walmart, Amazon, Saudi Aramco, and the State Grid Corporation of China.

Glencore, the largest metals trader, accounts for a third of the world’s supply of cobalt, a crucial raw material for electric vehicles.

How Do They Make Their Money??

Buy Low, Sell High. Obviously.

Not so obviously, the business model is based on identifying and acting on opportunities which present themselves as mispricings between ‘untransformed’ and ‘transformed’ commodities. Traders act on these pricing signals to direct commodities to where they are most valued, eliminating the market mispricing i.e. they arbitrage away the mispricings.

Commodity traders are essentially logistics companies that use financial markets to fund their operations and hedge different risks involved. They earn their profits by arbitraging global commodity mispricings using logistics operations and transformations.

Commodity traders spot gaps in the market: they monitor relative prices for different grades of a commodity (the quality spread), for the same commodity with different delivery locations (the geographic spread) and for different delivery dates (the forward spread). When a mismatch is identified, they can lock in profit by buying in the cheaper market and selling in the more expensive market.?

The 3 types of transformations are as follows, and most arbitrage will consist of some combination of the following:

1. Geographical Arbitrage/Spatial Transformation: Transporting commodities from where they are produced to where they are consumed is the most visible aspect of the commodity trading business. Oilfields and mineral deposits are rarely near urban centers of consumption. Shipping therefore plays a vital part in commodity trading.
2. Time Arbitrage/Temporal Transformation: The demand for commodities is seasonal. Supply can be disrupted in the short term by industrial action, geopolitical conditions, or extreme weather. Oversupply or excess demand can persist over the medium term, because of the time it takes for productive capacity to adjust to changing demand conditions. Traders deal with mismatches in supply and demand through temporal arbitrage i.e. they store commodities while supply is unusually high and draw down inventories when demand is unusually high and this smoothes fluctuations in the prices and eases availability of commodities.
3. Technical Arbitrage/Form Transformation: Commodities are processed before they can be consumed: crude oil and metal ores have to be refined, grains need to be threshed, etc. While commodity traders do not usually involve themselves in industrial processes, they often blend different grades of refined oil or metal products based on customer specifications.

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Commodity Traders use financial instruments including forward contracts, futures, swaps, weather & shipping derivatives, and other derivatives to hedge their risks because transformation operations can take several months. This “hedging” can and frequently is itself a profit center: traders use information gleaned from their opaque, physical operations to speculate on the future direction of price changes in commodities. Also see Risk Management below for more on this.

Commodity traders must have excellence in and deep understanding of all 3 legs of their business: effective operations, market dynamics, and capital markets – and how changes in one leg affects the other two legs.

The Economic Impact Of Commodity Traders

1. Arbitrage Eliminates Market Anomalies

Over time, the effect of the arbitrage on supply and demand moves the two markets into balance and the anomalies disappear. Thus, commodity traders create increasingly efficient and competitive markets by pursuing physical arbitrage opportunities. Both producers and end-users are the beneficiaries.

2. More Transparency and Increased Competition

The price anomalies that lead to arbitrage often stem from poor information or limited competition. As markets get more efficient, pricing differentials are getting smaller, more transient, and get harder to identify. Commodity traders can still generate sustained profitable opportunities wherever they can develop a competitive advantage. Many firms are building

alliances and developing efficient logistics to execute transformations more cost effectively than their competitors. Increased transparency encourages commodity traders to exert control across the whole logistics chain. As markets have become more competitive and information has improved, the traders’ emphasis has shifted towards cost reduction.

3. Reducing Costs With Improved Logistics

The larger commodity traders acquire interests in industrial assets where it identifies opportunities to strengthen their supply chains. These may include terminals, storage, and transportation facilities. For instance, Trafigura acquired an oil terminal complex in Corpus Christi, Texas in 2014 just as shale production was gathering momentum. Trafigura developed the the Corpus Christi complex and it became a major hub for oil products. It sold 80% of its interest to Buckeye Partners, professional terminal operator, for $860 million in 2015 while retaining its minority stake and exclusive commercial rights to use of the terminal.

The other ways commodity traders add value are by financing their counterparties (vendor financing and supply chain financing), and capital investments in infrastructure such as owning and operating ports (backward integration) and gas stations (forward integration).

Risk Management

Risk management is a core competence for commodity trading firms. They store and transport physical assets across the globe and earn slim margins on high-value, high-volume transactions.

Financial Risk

Major traders have annual turnover that is many times their own equity capital and puts them firmly in the ranks of the Fortune 100. They rely on large amounts of trade finance and other credit to buy the commodities they need to trade. This credit would not be available to them if they cannot demonstrate the sustainability of their business model and trades to banks.

Managing financial risk effectively is, therefore, critical for trading firms. They use derivative markets to hedge against absolute price risk (flat price risk). They also take out commercial credit risk and political risk policies in the insurance market.

Credit Risk and Political Risk

Trading firms take many steps to protect themselves from credit risk (non-payment by companies), and political or country risk (governments blocking payment or seizing assets). Insurance is a critical business enabler because not every risk can be managed directly.

[In 2011] After some discussion, Vitol accepted the deal. Things went awry within days. Despite promising to keep it secret, the rebels announced they’d made an arrangement to sell oil.

In response, Qaddafi’s forces immediately blew up a key pipeline. Without oil, Vitol couldn’t be paid. Still, the company upheld its end of the bargain. Over the coming months, its tankers shipped cargo after cargo of gasoline, diesel, and fuel oil into eastern Libya. “The fuel from Vitol was very important for the military,” Abdeljalil Mayuf, an official at rebel-controlled Arabian Gulf Oil in Benghazi, later said.

Still, the company upheld its end of the bargain. Over the coming months, its tankers shipped cargo after cargo of gasoline, diesel, and fuel oil into eastern Libya. “The fuel from Vitol was very important for the military,” Abdeljalil Mayuf, an official at rebel-controlled Arabian Gulf Oil in Benghazi, later said.

In the end, the rebels brought down Qaddafi, and once the fighting subsided, Vitol got its oil. At one point, as everyone waited for production to restart, the amount owed by the rebel government ballooned to more than $1 billion.

Source: Inside Vitol: How the World's Largest Oil Trader Makes Billions

Traders cannot afford uninsured operations. The loss of a single cargo could cost tens or hundreds of millions of dollars. Insurance against credit risk and political risk can be taken out on the Lloyd's Market in London. CEND policies provide cover against Confiscation, Expropriation, Nationalization and Deprivation.

Operational Risk

Global trading firms encounter many risks in many jurisdictions. Their counterparties include governments, state agencies, banks, private and public limited companies, and even rebel groups. Many environmental risks loom large for any company transporting, loading and unloading large volumes of oil and petroleum products, especially the danger of an oil spill.

There is also the potential for injuries, fatalities, extensive environmental damage, massive financial penalties and huge reputational damage. Trading firms use best practices in their own operations and must ensure that their commercial partners comply with similarly high standards. For instance, when chartering ships, most insist on double-hulled, certified tankers. Many also impose an age limit on the ships they charter.

Reputational Risk

Traders store toxic, flammable and hazardous materials and transport them across continents by land and sea. Should anything go wrong, the reputational fallout would be very damaging. They are active in remote parts of the world with widely varying levels of governance. For example, Vitol paid $135 million to resolve a foreign bribery case in 2020 related to payments made to public officials in Ecuador, Mexico, and Brazil.

Diversification and Integration Reduce Risk?

Global trading firms have diversified operations across a variety of commodities which gives them a certain level of natural protection from commodity price changes.?

Additionally, the integrated nature of their operations provides another natural hedge within the overall business. For instance, in the copper market, a decline in demand for the refined metal may or may not lead to reduced smelter production and lower demand for concentrate. Either way, the demand for storage (either of concentrates or refined copper) is likely to increase. In an integrated trading operation, increased demand for storage offsets lower demand for shipping.

However, diversification and integration provide little protection in the event of a systemic change in market sentiment. The Global Financial Crisis, Covid-related shocks, and the economic slowdown in China would have been catastrophic for any trading company that took no additional steps to hedge their market exposure.

Conclusion

Commodity trading firms thrive by surfing the waves of economic change and market volatility. Change created the modern trading industry and being alive to it ensures its prosperity.

P.S. If you want to read the history and learn more about the commodity trading industry, I’d recommend World For Sale and The Prize.