Who makes money trading in commodity markets? A brief look at the recent history of the Banks and Merchants in commodities

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The 1980s ushered in an era of free market reform, prosperity, and a financial revolution that affected all markets and asset classes, including commodities. The newly elected free market champions Ronald Reagan and Margaret Thatcher led this revolution, which was boosted by Paul Volker’s momentous changes in how the Fed managed interest rates in October 1979.

At the beginning of 1981, the US government ceded oil price control to market participants, marking the start of the physical West Texas Intermediate (WTI) crude oil spot market; the ensuing volatility led to the creation of the WTI Futures market in 1983. In the following years, multiple new hydrocarbon contracts appeared on both sides of the Atlantic, culminating in the NYMEX Henry Hub natural gas contract in 1990.

The repeal of the Glass Steagall Act in 1998 allowed most banks and financial companies to engage in commodity trading alongside well-established commodity merchants. The banks used their financial derivatives knowledge to provide hedges for corporations, create investment strategies for funds, and (before July 21st, 2010, and the implementation of the Dodd-Frank Wall Street Reform and Consumer Act) engage in proprietary trading activities. Morgan Stanley and Goldman Sachs also owned, leased, and operated commodity assets, allowing them to engage in the full suite of merchant trading activities, participating across the supply chain, and earning themselves the sobriquet of ‘The Wall St. Refiners’.

Commodity trading has occurred in one form or another since humankind began organising itself into communities.? The earliest derivative contracts can be traced back over 6500 years to Sumer (Iraq), where people agreed to future deliveries of agricultural goods on clay tablets. Between then and now, commodities and commodity prices affected the lives of every human being on the planet. Many wars have been fought over access to resources and trade routes (for resources), and all significant economies have developed due to the production, supply, and use of raw materials.? Where a commodity is produced, there is a trade to be done.?

The classic maxim for trading success, Buy Low and Sell High, applies to commodity markets but in a modified form. For a commodity trader, who most likely does not own a mine, a farm, an oil well, a ship, a manufacturing facility, a refinery, ?or a generation plant, the maxim modifies to Buy Low and Sell Higher than cost, insurance, freight, Letters of Credit, refining margins, processing costs, storage fees, tolling and congestion charges, distribution, futures positions margining, brokerage fees, bid-offer spreads, bonus pool allocations and wages.

Commodity merchants have been trading commodities for many years. Many companies are well-established, even historical, and some are recent entrants. However, all have industry connections and market presence, access to capital, and inherent talent for managing risks when moving a commodity along the supply chain.

Historically, a merchant trader might assume all the risks in buying from a producer and transporting the commodity to a consumer with whom they have a relationship. With the help of banks' financing, such actions and activities were the bedrock of the global commodities trade and a source of value to all participants in the supply chain.? Today, a Hedge Fund might buy and sell physical electricity for a fraction of a second and not necessarily buy from a producer or an end user. But they still serve a purpose: the creation of liquidity.

All market participants seek profits, but their roles often dictate their needs and trading activities.? Merchant activity can be defined as proprietary trading, trading profitably for their accounts. They serve an essential role in the global markets, but their raison d’etre is to make money. Similarly, producers of raw commodities must sell at a price above their marginal production cost (and all associated costs). The buyers and users of commodities have other economic factors to consider, but they follow a similar pattern. An industrial manufacturer may buy raw aluminium or copper but must fabricate and sell extrusions, wings, and widgets at a price that generates a profit for them.??

None of these enterprises last very long without profits. For the latter two participants, price hedging, developed through creating commodity bourses, has allowed them to survive and prosper. It has also permitted merchant traders to mitigate risks and banks to enter the commodity trading world by applying their risk management knowledge and offering corporate clients bespoke hedges on their price risks (and better credit terms than a Bourse is willing to offer).

Modern commodity price hedging practices are primarily acknowledged to have started in the mid-1800s with American farmers meeting at the newly formed Chicago Board of Trade, initially to deal in the cash markets for grains and then later agree with dealers and consumers to commit to buying fixed amounts of a specified grain at a specified price. These contracts became known as futures. Dealers or consumers thus knew their grain costs, and farmers could be assured of known future cashflows for a given crop. This certainty enabled all parties to plan their economic decision-making better: consumers knowing their input costs for food products or feedlots and farmers making better planting decisions based on the costs of various crops.?

As other commodities markets developed and other futures markets were created, companies associated with metals and mining, hydrocarbon production and electricity generation engaged in similar practices to remain profitable.

Profitable commodity trading can be broken down into several key practices

1)??????? Buy Low and Sell High

a.??????? The concept is simple and applies to all the other strategies, but it is not as easy for producers and consumers. What if no one wants to buy at the prices you need to be profitable? Or what if prices were higher when you started production, and you did not hedge them? Hedging production and consumption costs can lead to certainty of cash flows and profitability.

b.??????? Financial participants (including banks, merchants, funds, etc.) can always buy and sell futures and almost always have access to a market. However, whether they trade profitably depends on many factors, some related to markets, the rules within which they must operate, and some beyond their control. These might include geopolitical events, regulation, internal risk limits, and access to capital; there are many more.

2)??????? Geographical Arbitrage

a.??????? Merchant operators have historically bought and delivered commodities to different locations for profit. When sourcing the commodity from location A, they must consider the cost of the commodity, storage, transport, insurance, and other fees to deliver it to location B.

b.??????? With the proliferation of financial contracts and market information, financial players can use such information to inform their trading decisions, including replicating such trades. However, this is fraught with risk, as local markets operate on other factors, not just open arbs (arbitrages). Unless a trade is genuinely hedged, as a physical merchant might do with their physical cargo, the financial player can fall foul of another old financial maxim: markets can remain illogical longer than you can stay solvent.

3)??????? Storage Economics

a.??????? When a commodity needs to be held in inventory, or its use in a refining or production process takes a certain amount of time, the price in the future at which it will be sold or delivered must be hedged to guarantee profitability. Costs for storing a commodity include funding inventory, insurance and operational fees for the facility. If the cost of the commodity, insurance, and storage costs for a set time in the future are less than the equivalent futures price, then the storage economics work. You sell the future to lock in the economics.

b.??????? Traders often buy a commodity to eventually deliver it to a location where a futures contract will be settled. They will sell the associated future to hedge the storage (or transportation – similar issues, freight insurance, fees) arbitrage and then deliver the commodity into the future rather than close it before expiry.

c.??????? Suppose the economics of the situation change drastically before delivery. In that case, a trader may elect to unwind the trade by taking the commodity out of storage (to sell), unwinding the associated futures hedge, and locking in a profit—this is actual arbitrage trading.

d.??????? Financial players will also look at storage economics as an essential information signal for a market's direction. A heavily Contango market and all storage full suggest an oversupply; prices might fall. Backwardation is a strong indicator of the reverse, as a tight and strong spot market encourages inventory to be sold when spot prices are higher than the futures market, making storage plays uneconomical.

4)??????? Margin Economics

a.??????? Commodities are often converted (refined, stripped, generated, processed, smelted, even fed!) from one form to another. If a process with an input and output commodity is left unhedged, it will have profitable and non-profitable periods.

b.??????? For example, crude oil is used only to make refined products. This occurs at a refinery, where Gasoline, jet fuel, diesel, and fuel oil (and other products) are made and sold. The difference between the input cost of crude oil and the refined product slate is known as the refining margin, which must accommodate all costs associated with the process.

c.??????? The slate can be tweaked or optimised to improve the net margin. Still, the downstream oil business is complicated, and different factors affect different products, sometimes challenging profitable risk management.

d.??????? Financial players look at the individual spreads of products to the crude oil (known as a crack) to determine supply and demand, see if markets have become distorted, and whether a financial trade in those products might be profitable.

5)??????? Bid/Offer spreads and traditional Market Making

a.??????? In most financial textbooks, the role of a market maker is explained as someone who buys on the bid, sells on the offer, and makes a spread while minimising risks. In practice, buyers and sellers rarely transact simultaneously, so some level of risk must be warehoused. This is the skill and the role of the modern market maker.

b.??????? Before July 2010, banks transacted on a proprietary basis to accompany their market-making activities. ?Making markets available to all participants created liquidity for consumers and producers to hedge, creating cash flow certainty and building their businesses.

c.??????? The cashflow certainty that commodity price risk hedging gives has led to the development and proliferation of whole commodity-based and dependent industries. The legendary oil and gas entrepreneur and former CEO of Chesapeake Energy, Aubrey McClendon, almost singlehandedly developed the US natural gas drilling business (and later shale gas production) by perennially hedging his natural gas production. By selling his company’s future production into the contango curves that the natural gas futures market presented to all participants, he financed greater drilling programs and technological advancements that fed significant parts of the American economy, helped create a cleaner environment from electricity generation and reversed America’s dependence on LNG

6)??????? Investor strategies

a.??????? Commodity markets have continually attracted investors and speculators. The first major financial market bubble occurred in the Tulip market in Amsterdam in the 1630s. Famously, 1980 started with the first major speculative commodity (and economic) crisis of the decade, when the Hunt brothers attempted to (and nearly succeeded in) corner the global silver markets. Funds and investors have employed many (sane) methods to earn returns from these markets. Here is a brief overview of some of the more traditional strategies.

b.??????? Fundamental Focus

???????????????????????????????????????????????????????????????????????????????????????????? i.???????? Is the commodity’s price based on supply, demand, and stock levels fair? Traditionally, commodities have been mean-reverting, significantly influencing whether to buy or sell in each market. When the analysis is done, and every other factor a trader feels relevant is considered, a long or short position will be initiated.

c.??????? Relative Value

???????????????????????????????????????????????????????????????????????????????????????????? i.???????? Many traders are price agnostic. They do not wish to predict a commodity's price or the market's direction. Instead, they want to examine the relationship between two linked commodities and determine if they are mispriced. They will ask if Commodity A is historically, statistically, and fundamentally misvalued relative to Commodity B. If this is the case, they will buy or sell Commodity A and sell or buy Commodity B.

d.??????? Passive and Active Indices

???????????????????????????????????????????????????????????????????????????????????????????? i.???????? Since the creation of the GCSI in 1990, many funds, ETFs, and Total Return Swaps have been created based on the price and returns generated from a basket of commodities. Some parameter weights each to reflect its importance in economic use or the global economy.

????????????????????????????????????????????????????????????????????????????????????????? ii.???????? Commodities have a unique characteristic that is not found in most other markets. Their forward prices can differ significantly from their spot prices. They can be higher or lower, known as Contango or Backwardation. Being long in a Backwardated market (or short in a Contango one) allows the holder of a futures position to roll their position to a lower or more expensive price, generating an effective yield from holding such positions. This is one component of earning a return from a commodity market. The other components include the absolute price (and, in the case of Total Return Swaps, the interest accrued on the collateral from margining swaps positions)

e.??????? Quant Funds

???????????????????????????????????????????????????????????????????????????????????????????? i.???????? Like other asset classes, traders use moving averages, momentum, open Interest, technical analysis, and various signals to determine market direction.

????????????????????????????????????????????????????????????????????????????????????????? ii.???????? Many computer programs have been designed to predict price direction based on these and other inputs. A computer can quickly compute thousands of price signals to determine a course of action. The growing areas of machine learning and AI contribute to developing trading algorithms and the proliferation of high-frequency traders in permitted markets.?

The role of the Banks in commodity markets and the Ascension of the Commodity Merchants

During the 1980s and 1990s, Morgan Stanley and Goldman Sachs engaged in physical commodity activity, asset optimisation, and speculative trading. They also developed strong sales franchises that combined derivatives knowledge, investment banking know-how, and access to the capital markets. These sales units helped companies hedge their production and consumption of commodities, guaranteeing certainty of cash flows and earnings stability. Their success and the repeal of the Glass Steagall Act in 1999 led to many other banks trying to duplicate their modus operandi.

For a decade, the banks were the nexus of all commodity market activity. They could effectively match buyers and sellers while providing tailored risk solutions (as opposed to the less flexible and heavily margined futures contracts) and innovative finance solutions that allowed corporate clients to prosper through open credit lines.?

By 2008, many bank commodity businesses provided risk management and financing; some had acquired physical assets to become total participants in the commodity supply chain. While banks have long financed commodity cargoes, inventories, and purchases through lending facilities that commodity merchant traders exploited to such significant effect (after the withdrawal of those commodity banks in the aftermath of the GFC), they now were trading themselves. Moreover, they made good profits and diversified the revenue streams of these banks while serving the most significant parts of the global economy.

And then the 2008 financial crisis happened. Commodities became subjected to the harshest regulation on Wall Street since the 1930s, like fixed income, equities, and other securities. With the passing of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Aka Dodd-Frank), a United States federal law enacted on July 21, 2010, previously profitable and successful businesses buckled under regulatory, reporting, and capital charge burdens. While the associated compliance, reporting, and IT burdens were damaging, the new capital regime curtailed most of their commodity activity.

Helping clients with hedging, investing, project finance, and physical trade flows became much more expensive for many banks. American banks supervised by US prudential regulators suddenly had a severe commercial disadvantage compared to foreign-domiciled banks with representative offices in the US, which were regulated far more lightly or, in some cases, not at all. However, foreign banks also had their domestic regulators and rules and often lacked the capital to compete anyway. The retreat from non-core and off-exchange business began

Consistent pressure from the NY Fed on banks to conform with traditional banking businesses led to Regulators assessing Section 4(k) of the Bank Holding Company Act of 1956 (BHC Act) to explore if physical commodities trading is complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. The pressure came to a head on Nov 20th, 2014, when the main commodity heads of US banks were hauled before Congress for a hearing on 4(o) of the BHC Act, which covers the ability of banks to engage in merchant operations. Shortly after the hearings concluded and before the end of the year, Goldman sold LME storage company Metro to the Reuben brothers, and Morgan Stanley divested all physical oil assets to CCI.

Most banks tried to adapt, but soaring capital charges were passed on to clients, making businesses more challenging. A prolonged period of poor returns (fueled by lacklustre markets) made commodities unattractive as an asset class to the investment community, and repeated cycles of shale play scared banks and investors from lending to the sector for a while. The banks withdrew further, and another market participant emerged as the dominant force, taking the trading role that the banks had played but without taking on the responsibility of helping keep markets orderly that came from those bank sales franchises.

The ascension of the commodity merchants primarily occurred due to the withdrawal of the banks and the fact that they were not subjected to the same rules that governed the same (or very similar) activities.? Near-zero interest rates spurred their growth further as they could finance trade, inventory, and trading positions for minimal cost. Profits and reputations grew, but as we had seen when Russia invaded Ukraine, so did risk.

In 2008, the banks experienced a life-changing event that strengthened their grasp of all areas of risk management. In the spring of 2022, when the margining requirements for the hedges of their transactions exploded, commodity merchants experienced a similar reckoning. They scrambled to find additional capital while maintaining their existing trades.???

As James Clavell wrote in Noble House, “LEND A LITTLE, AND YOU HAVE A DEBTOR—LEND A LOT, AND YOU HAVE A PARTNER!” They overcame these challenges with the help of the banks (some who might have real issues if they pulled lines or withheld further credit) and made record profits in 2022 and 2023.

Historically, Exxon shunned oil trading when most of its contemporaries participated in the energy markets. Exxon’s profits from the physical business (primarily upstream) dwarfed what they thought a trading unit could make. Trading businesses have often had volatile earnings and attracted unwanted scrutiny from shareholders and regulators, and Exxon preferred to minimise risks to earnings and reputation.? In recent years, they have made several attempts to build a trading business, but they have a long way to go before competing with the best oil company trading business, BP.?

?BP has long engaged in commodity trading. It is consistently successful and has populated many other companies with well-trained oil traders. Alongside the merchant traders, BP has looked to fill the void left by the retreat of many banks, including in areas such as reserve-based lending, which has lucrative hedging transactions attached.

Many other energy companies (hydrocarbon producers, renewables, electricity generation, etc.) have trading units with remits that cover essential risk management and some levels of speculative activity.

The challenges ahead

The commodity markets will remain volatile for the next decade. Volatility brings opportunity to those who know when and where to invest and how to manage risks.

The transition to cleaner fuels and the electrification of the transport fleet will require considerable infrastructure investments. Base and specialist metals are needed (massive investment in mining, shipping, and smelting), and more reliable and continuous electricity generation and storage must be built to achieve the current decarbonisation targets.

Carbon Credit markets will continue to grow and become more legitimate as participants work towards developing trading markets for Verified/Voluntary Carbon Credits that serve all participants more equitably.?

Geopolitical divisions will exacerbate issues around commodity supply, demand and transportation– wars create distortions in commodity markets, as has been evidenced by the illegal Russian invasion of Ukraine in February 2022.

A rise in authoritarianism globally has affected the precious metals markets. Countries that do not adhere to Western values but have held substantial amounts of dollars for reserve purposes have contributed to record gold prices over the last few years. Historically, Gold has been a haven in turbulent times and appears to be filling this role, albeit for the bad guys. The trade is simple: Gold is being bought as US Treasuries are being dumped. And the price of gold has skyrocketed.

Lastly, climate change will also affect the markets through challenges with crop production (record high coffee and cocoa prices; olive oil is easing) and devastation from floods and hurricanes that will need more resources for rebuilding (Lumber futures) while causing short-term bottlenecks in energy supplies (such as oil and gas production in the Gulf).

Many more challenges remain, and the above highlights the significant, better-known issues. They will all add to market volatility in some way.?

As with every market, there will be winners and losers, and those with the right blend of talent, technology, and trading skills will prevail over those who lack experience, foresight and a well-defined risk management framework.

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Kevin O’Reilly

Berlin, January 2025