How To Understand The Impact Of Price Risk On Commodity Trading
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1 Global Commodities Forum Palais des Nations, Geneva January 2012 Price risks & Volatility: Impact on Commodity Trading Companies By Mr. Samir Zreikat, Director, Dealigents Sàrl, Geneva "The views expressed are those of the author and do not necessarily reflect the views of UNCTAD"
2 Price risks & Volatility: Impact on Commodity Trading Companies Samir Zreikat dealigents Sàrl, Geneva t.: m.: e.: samir.zreikat@dealigents.com Topics covered in this presentation: Focus on small and medium commodity trading actors Consequences of the higher volatility in commodity prices since 2008: Credit crunch in the trade financing sector Consequences on market share distribution between commodity traders Focus on small and medium commodity trading actors Introduction to hedging techniques and consequences for commodity traders: Hedging principles Where are the profits for commodity traders What prevents them from playing their optimisation role New trade financing patterns? Commodity traders and trade financing banks Possible shift towards more creative solutions 1 2 The Lecturer Samir Zreikat, owner of Dealigents Sàrl, a service and consulting company specialized in commodity trading. Career started in 1986 (Cargill, Vitol) Expert in commodity trading Lecturer at the Master and Diploma programs in Commodity Trading from the University of Geneva. Expert for the Bachelor major option in commodity trading at the «Haute Ecole de Gestion» (HEG Geneva a Business & Administration state owned school) Various consulting and internal audit & support mandates Tailor-made training for trading companies, trade finance banks, audit firms Currently holding an acting management position in a medium size oil trading company (Caspian, Mediterrannean and Black Sea markets) Software provider for small and medium trading companies The Context 3 4
3 «Commodity trading» is a portion of Producers Receivers Retail store Consumer Commodity Traders: Risk takers (reduced possibilities to transfer price risk to third parties) Typology of companies Not clear typology but: Vertically integrated companies: reduced exposure towards price changes Segmented actors (producers or refiners or traders): limited ability to transfer non favorable price changes to counterparties National companies, Multinational trading firms, Refineries or niche players: Market segmentation where higher risks are often for small players Non equal or similar access to (trade) financing Different exposure towards price volatility And since a few years: External actors (hedge funds, financial traders) entering the commodity exchange (but not physical) markets But fundamentally: Producers must pay their costs and retail consumers must be able to buy the finished goods 5 6 Risks factors: Price is not the only one Visible risks: Mainly EXTERNAL: markets, price, counterparty, etc. Invisible risks: Mainly INTERNAL: Expertise (lack of ) Processes Systems Overload Miscommunication etc. Risk approach: a «hot potatoe» game 7 8
4 The 2008 Crisis July 2008: historical drop in oil prices (similar changes in other Immediate consequences of higher volatility in commodity prices since 2008 commodities) Price volatility reached levels that were rarely seen before (still persits) Typology of market players changed: the biggers became bigger, the smaller disappeared or where pushed to niche markets Financial constraints increased 9 10 The Context Derivative instruments: created by commodity traders Various political and economical instability leading to price volatility Fundamental correlation between volumes of derivatives and physical volumes of commodity cargoes traded in the world New influencial actors: Breach in above fundamental rule: volatility increase obviously connected to financial markets and trading strategies from non commodity traders Trade finance banks new challenges: Basel III ratios / Capital requirements Credit lines granted to commodity trading companies cannot be automatically adjusted to price fluctuations Market price level Credit Line (trade financing) Corresponding tonnage $ 500.-/ton $ tons Introduction to hedging techniques and consequences for commodity traders / actors $ /ton $ tons 11 12
5 Commodity Trading is fundamentally simple: Identify imbalances that can generate profits («arbitrage») Secure a net positive cash position thanks to import/export flows Goods A major trading burden: Doing a trade is by essence a trade off: You want: To buy At low price With max. guaranteed specs And lowest possible financial commitments They want: To sell At high price With limited guarantees But with maximum financial security $$$ Opposite objectives! (except that goods are needed) What if prices change dramatically AFTER the deal was done? A hedging issue: hedging doubles these flows! Other Financial Issues Producers: Sales income cashed (much) later than investments and production costs or expenses (soft commodities especially) Costs in local currencies - Sales in hard currencies Financing of costs depends on access to banking support, trade financing solutions and/or local partners Exporters: If different than producers: exposure to currency exchange and securization of sales income Exposure to possible pricing risks (buying fixed price, selling based on international price benchmarks) Traders: Price risk exposure and mandatory hedging imposed by banks. High financing costs. Logistical, market, counterparties and hedging risks Receivers: Similar risk typology as Exporters (for refiners: see next slide) Hedging main objective: Remove price risks and make purchase or sale prices irrelevant to margin calculation Assumption: The perfect hedge exists! Issue: The perfect hedge rarely exists Main question: «What happens to my profits if the market changes?» So let s review first some hedging principles 15 16
6 A simplified view of price risk (no hedging) Price: -$1 000/ton (expenses) $200/ton price loss (other costs excluded) Price: +$800/ton (revenues) And hedging means: Opposing to unforeseen price moves a reverse «trade» which should generate opposite margins! «Derivatives» are like «clones» of the physical trades but without physical delivery or logistic involved: Futures, options, swaps, etc Pure financial trades where money is exchanged (not physical tons) Derivatives move like physical prices (but not exactly): Prices Goods Loading Goods Discharge «Physicals» versus «Derivatives» Definition of «derivatives»: A financial instrument whose characteristics and value depend upon the characteristics and value of an underlying physical commodity. Physicals Derivatives Goods are delivered No delivery required (exceptions) Transport may be required Purely financial Buyers and Sellers know each other The trader of a derivative uses an «Exchange Market» or an «OTC» (over the counter) exchange market Payments & security depend on contract terms / counterparty The «Exchange» limits and controls the counterparty risks 19 Same example but with hedging: Physical price: -$1 000/ton BUY Derivative price: +$1 050/ton SELL Goods Loading $0.00/ton price loss Physical price: +$800/ton SELL Derivate price: -$850/ton BUY Goods $200/ton loss on physical Discharge $200/ton profits on derivatives $ 0/ton price risk! 20
7 So why using derivatives/hedging? To remove the «absolute» price risk: Buy PHY Buy FUT Crude Oil prices collapse (July Dec 2008) Prices Sell FUT Sell PHY Time Regardless of price moves: Regardless opposite of price P&L impact moves: And opposite ABSOLUTE P&L impact PRICES DO And NO ABSOLUTE LONGER MATTER PRICES DO to NO Traders LONGER who MATTER use hedging! to Traders who use hedging! Bullish Bearish $/bbl drop!!! Brent spreads (Dated vs 1st Month) 2H08 Refiners Price Risks How it works Raw commodities to be transformed before being marketable Using derivate price benchmarks (futures) for raw materials and refined products give indication of the revenues that should be expected from the purchase of 1 ton of crude or raw commodities. Example: Type Commodity Qty Price Value Buy Raw / Crude material 3 $100 - $300 Sell Refined product 1 2 $120 + $240 Sell Refined product 2 1 $ 80 + $ 80 Net difference (crack spread) 0 + $ 20 Costs Refining costs 3 $ 30 -$ $/bbl max increase!!! 23 Negative margin since crack spread < refining costs Hedging tolling, refining, processing requires skills, tools and strong financials No perfect hedging (futures physical prices) i.e. indirect hedging risks! 24
8 So where is the trader s profit? Careful with signs: - (negative) ie money going out (costs) + (positive) ie money coming in (revenues) Description Physical transaction Hedging (futures) Net results Purchase of goods (benchmark only) - $ $ $ 50.- Sale of goods (benchmark only) + $ $ $ 50.- Net preliminary results: - $ $ $ 0.- Purchase discount +$ 50.- Note: Freight and other costs - $ Discount means lower costs. Premium means higher Sale premium +$ revenues. Final trading margin - $ $ $ 50.- Absolute prices become irrelevant! Minimum requirements to generate margins Strong expertise in a specific market: Identify imbalances between markets, producers/refiners or receivers Be able to secure and manage the different risks efficiently Well organized team of experts Information: Have access to information that others do not have yet Manage this information efficiently Logistics: Without control of logistics: open door to competitors Secured access to terminals, storage, transportation facilities Financing: Free equity used as leverage and independency Network: Representative offices or agents to secure the above Loyal partners Example 1: the Airlines hedging issues Airlines need Jet Fuel stocks for a set period In rising markets (July 2007 to July 2008), Airline companies may «lock in» the value of their future needs of kerosene through «forward contract» (where they will know today the price of their future deliveries to take place next year for example). The «Cathay Pacific» case: July 2008: Jet Fuel peak price of $ 182.-/bbl Cathay contracted forward contracts until 2011(buying forward at such high levels) Prices dropped down to $77.-/bbl International Accounting Standards (IAS) require to show stocks or unrealised positions at «mark to market» levels or cost prices, whichever is.. higher (ie worse) December 2008 closing: $980mio unrealised losses! Example 2: the Counterparty risk Remember: your counterparty has opposite objectives! When prices are dropping, a buyer may find any mean to escape from his obligation - even if the price is already fixed and the ship is waiting to discharge her cargo - in order to buy it back at market prices (lower) If you hedged your sale (by buying futures) and your physical sale has «gone» then you are left with expensive futures that you need to sell back (high losses) Your cargo becomes a «distressed cargo» which will be hard to sell Hedging although made in strict confirmity with the «rules» - has led to doubled losses! 27 28
9 In other words Managing hedging (and associated risks) can t be achieved by all commodity trading companies Financing becomes more complex: Physical goods financing Access to an exchange market and ability to cover margin calls (cash coverage required to protect the exchange market from your possible losses) Do you have a perfect hedge and reliable/secure counterparty? New Trade and Trade Financing Patterns for small and medium commodity traders? But commodity traders who would not hedge are exposed to price changes! Traders vs Trade Finance banks Large and solid players (the «Majors») are pushing small to medium trading companies to the edge of standard commodity markets: Niche markets with higher political, market and logistical risks left to the small players who bring the goods to an easy accessible point for the large trading companies Unstable situation: Forces the smaller to become stronger and protect their niche and local market control More and more «mercenary» profiles in Majors versus managing shareholders and loyal employees in small companies Trade Finance banks new challenges: Trade financing = small share of the large banks activities Image and political issues when financing involves politically exposed countries or people Requires complex team structures and expertise Basel III and Financial crisis forces them to avoid cash intensive trade financing schemes Consequences and solutions Key to survive: Creativity and higher risk taking Find alternative to Trade finance banks Stronger presence in local markets Alternative trade financing: Appearance of cash-rich actors searching for alternative to financial markets or hedge funds New Funds proposing similar solutions as Trade Financing banks for commodity traders and exporters Such Funds often backed by Hedge Funds raising equity New partnership models between trading firms to split price and financing risks Above models mainly target small and medium trading companies, producers and exporters 31 32
10 Conclusions Consequences of a Global Economy combined with a Financial crisis: Access to cash has become a major burden Liquidities exist and holders of such assets are looking for safer investment solutions based on more fundamental market behaviours Commodity exchange markets are «polluted» by external actors Commodities are in essence based on clear fundamentals: How to return to volatilities that market fundamentals can explain? Should commodity exchange markets be accessible only to «authorized dealers» that can prove their active role in commodity trading? Exchange markets to identify trades made by commodity traders (for hedging) and pure speculators? Should authorities or governing bodies endorse a higher role in granting access to trade financing lines to non Major companies (producers, exporters, importers, etc.)? Thanks for your attention! Samir Zreikat dealigents Sàrl, Geneva t.: m.: e.: samir.zreikat@dealigents.com The solution may be in this audience 33 34
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