In Times Of Turbulence, The World Needs Physical Commodities Trading
Turbulent markets such as the one triggered by the Covid-19 crisis raise concerns about the financial and trading system.
Turbulent markets such as the one triggered by the Covid-19 crisis raise concerns about the financial and trading system. Due to recent price movements, especially about oil, the public's attention has naturally turned towards commodities trade. The difficulties faced by smaller trading companies in Singapore in April only added to this attention. Many wonder if these difficulties could become a systemic problem on the market, a threat or danger to financial stability, and even the supply of essential commodities trading.
These questions have been asked before and often come with calls for tighter regulation. However, they are not on target when it comes to commodities trading. This is understandable, given the long shadow cast of the 2008-2009 global financial crisis and the cracks in banks that it exposed.
The large commodities trading firms (CTFs), including Trafigura, are not a threat to the system. They do the exact opposite. They play a crucial but often overlooked role in managing volatile market risks.
They also contributed to smoothing the disruptions caused by the supply-demand shocks that we experienced in the past weeks.
Commodity trading companies are an essential link in a supply chain that connects producers of commodities such as oil, agricultural products, iron ore, and other non-ferrous metals to processors and consumers. They are connected to the global financial market through the large credit facilities and the extensive use of liquid commodity derivatives markets like futures to hedge trading positions.
It is crucial to distinguish between financial institutions and physical traders when assessing the risks presented by these firms. CTFs, unlike banks, do not convert short-term liabilities like deposits into long-term assets such as loans. Although they use leverage, current assets are usually greater than current liabilities by a comfortable margin. If a trading company runs into difficulties, other people can take over its assets and business.
How CTFs reduce volatility
CTFs, hedge funds, and commodity funds are also important distinctions. Funds are financial sector players who take speculative positions on price movements. They often use derivatives but rarely the actual commodity.
CTFs with large amounts of assets have direct ownership of the commodity and use derivatives markets primarily to minimize any price risk. However, any additional speculative trading positions are of much lower importance and not essential to the business e mini futures.
This year, two Singapore traders' difficulties could be attributed to weak hedging policies, speculative trading positions, and not physical trade. These authorities have acted calm and measured in their handling of the failures of these traders. This emphasizes the vitality, resilience, and diversity that Singapore is as a physical trading center.
The model of large, global CTFs is very different from that of localized ones. Their core competency lies in physical trading. They are skilled in understanding and managing the infrastructure, such as oil storage facilities and pipelines, to ensure that they can make a profit.
These assets do not create risk in times of crisis. They are crucial to CTFs' ability to navigate turbulent markets and provide to consumers, processors, and producers.
This is why the recent disruption in the oil market saw oil prices fall to negative territory for the first-ever time ever. These unusual and extreme conditions resulted from the Covid-19 pandemic's impact on demand and an increase in supply due to a price war between producers.
The most visible manifestation of the crisis was the shortage in oil storage capacity. CTFs' access to infrastructure is crucial in such situations. They can help alleviate some of the natural bottlenecks in the industry through their supply chain.
CTFs can also adjust their storage portfolio quickly to adapt to sudden market changes. Trafigura, the largest US crude exporter, had significant pipeline, tankage, and freight capacity to channel the supply glut that led to hostile domestic prices to foreign markets.
The financial incentives to move barrels were provided by differences between spot and forward prices and between locations. This is how markets work, matching supply and need. CTFs are essential in enabling these flows.
In Asia, we played a crucial role in helping to adjust to the glut caused by a sudden drop in Chinese oil refinery runs rates and other changes. For example, we leased substantial additional tank capacity in South Korea and increased our liquefied natural gases (LNG) storage.
We provide an essential buffer by adding storage to over-supplied markets. This helps reduce volatility and assure supply security over time.
It is time to forget about worrying about systemic commodities trading risks and to appreciate instead that, without efficient physical trading and storage hubs like Singapore, the recent volatility would have been even more devastating for consumers and producers.