Streetwise Professor

March 25, 2019

Oliver Wyman Misdiagnoses the Causes of the Commodity Traders’ Malaise, and Prescribes Nostrums to Treat It

Filed under: Blockchain,Commodities,Derivatives,Economics,Energy — cpirrong @ 6:15 pm

There are many silly things written about commodity traders, and alas many of the purveyors of this silliness get paid large amounts of money for it. Case in point, this just-released Oliver Wyman study, “Commodity Trading Goes Back to the Future.”

The piece begins with a well-recognized fact (that I’ve written about frequently in the past): commodity trading firm margins are down, relative to 2014-15, and especially 2008-9. It goes off the rails in totally misdiagnosing the cause:

Signs of the coming dramatic shakeout that will result from the commodity trading margin squeeze are already at hand. Trading margins have fallen by more than 20 percent from their recent peak in 2015.

This trading margin meltdown will continue as commodity markets become more mature, stable, and liquid. Over the past decade, the volume of commodity contracts traded nearly tripled and the value of contracts traded on standard electronic platforms doubled. Commodity market data is also increasingly readily available and widely socialized, as a greater number of players sell information and provide services to commodity traders. These new sources of data allow commodity traders to estimate much more precisely events that impact their trading strategies, such as when commodities will arrive at a specific destination and when local stockpiles will be high or low.

The combination of increased transparency and gluts in almost every commodity should keep volatility in the relatively tight band it has been confined to since 2012.

Where to begin? For starters, the electronic trading volumes of futures and futures option contracts has jack-you-know-what to do with the margins on physical commodity trading. Ditto the market data from these transactions. To throw these topics into a discussion of physical commodity trading profitability is to shoot your credibility in the head on page 2.

Further, as I’ve written extensively, particularly with regards to the ABCDs, “gluts in almost every commodity” do not necessarily imply compressed physical trading margins–in fact, they usually do the reverse. What has happened is that commodity transformation capacity has outstripped commodity transformation demand.

So that’s a self-inflicted double tap. Quite a trick!

Relatedly, low flat price volatility is a complete red herring. What matters to physical traders–who transform commodities in space, time, and form–is the volatility of relative prices, specifically the spreads between transformed and untransformed commodity prices.

Triple tap. Even more impressive!

Indeed, the irrelevance of gluts is readily evident from Exhibit 1, a graph of margins by year. When were the biggest margins in oil and oil products? Glut years–2009, and 2014-2015. The traders made easy money on simple storage plays. As Trafigura illustrated in its half-year report last September, it is the disappearance of the contango (i.e., the disappearance of the oil glut) that crushed margins.

Amazingly, the word “contango” does not appear in the OW report. That just screams credibility, I tells ya.

The report also discusses increased price transparency as a source of pressure on margins, but I am unpersuaded that there has been any meaningful increase in cash market transparency, at least not enough to make a difference. Take the grain markets. Yes, you can go online and see what local elevators are bidding in the US. But bids and transactions are very different things, and in these markets there can be huge differences between offers and bids. Having studied the US grain markets for almost 30 years, I don’t see a material increase in cash price transparency in that time. And I can say pretty much the same about cotton and oil.

This is moderately intelligent, at least as a forecast rather than as a diagnosis:

Major commodity producers and consumers like national oil companies and miners will charge higher premiums and claim more margin as they expand their global reach and become more sophisticated market participants. Simultaneously, physical infrastructure service providers and new online platforms will impinge on traders’ traditional roles. These players are making traders less essential by removing bottlenecks in order to correct supply imbalances and connecting more commodity producers and consumers directly

But that has everything to do with increased transformation capacity chasing a limited supply of transformation opportunities, and nothing to do with gluts or increased price transparency.

But every moderately sensible statement is undone by silly ones, like this:

As commodity markets become more liquid and accessible, commodity traders are relying more and more on algorithmic trading, coupling predictive analytics with robotic trade execution. Traders are improving their ability to hedge and speculate by developing codes that more nimbly identify trades and execute them across a broader set of
tradable instruments

Yeah. Robotic execution of physical trades. Right. These statements have some applicability to paper spec/prop trading. Virtually none to trading of physical barrels and bushels.

After completely misdiagnosing the disease, Dr. Wyman has a cure–BIG DATA!

Well, I guess that’s something: they could have prescribed blockchain.

Yes, improved data analytics may permit those who employ them to pick up a few more pennies in front of the steamrollers, but its beyond a stretch to claim that this will affect industry profitability overall.

The report in fact hedges its bets, acknowledging that there is no proof that BD is not just more BS:

It is often unclear if anticipated relationships between data feeds and commodity prices actually exist, and even if they do it is not certain the volume of data is sufficient to make meaningful predictions. For example, it is incredibly difficult to analyze global satellite imagery
to identify precisely the daily flow of commodities given the frequency at which images are being taken. Depending on the specific market, these signals are often also relatively limited compared to just market sentiment when forecasting in the horizon of interest

Who knew?

Nonetheless, OW boldy recommends that traders “completely revamp” their operating models, and closes with:

Traders need to make maximizing the potential of information
advantages their top priority. Previously unthinkable digital
capabilities will determine who will be the industry’s leaders
in the long term.

And no doubt, big fat consulting contracts with Oliver Wyman are ESSENTIAL!!!! to make this leap.

Yes, data analytics will no doubt prove of use, and they will become a necessary tool in traders’ kits. But they are unlikely to be transformative–because the big determinants of trader margins are the demand for transformations in space, time, and form, and the capacity available to perform them. Further, the industry is a very competitive one, with relatively free entry and exit, meaning that any persistent increases in margins will be eroded by new entry, and persistent decreases by exit.

The pool of entrants has plausibly increased, as the one sensible part of the OW piece says. That will tend to lead the traditional players to contract (or at least lose share). Some of the entrants are not mentioned by Wyman, such as the farmers in North and South American who are integrating into traditional merchant niches.

These are the first order drivers of past, current and future commodity trading profitability. Big data is an attention grabbing subject, but at the end of the day, it will be a second order (if that) driver of physical commodity trading profits.

But I guess consultants gotta eat too, right? But that’s no excuse for anyone to pay them, especially for drivel like this report.

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  1. I am waiting for the follow up report when they throw in “pipeline”, “mass effect” and the all too familiar, “ALT DATA”. Like a good magician that earns millions on stage in Vegas, it’s all about distraction from the action.

    Great review of something far from great. Keep it up.

    Comment by Carl Larry — March 26, 2019 @ 6:39 am

  2. “physical traders–who transform commodities in space, time, and form”

    It’s amazing how many people who pontificate about commodities do not grasp this very simple principle. The money is made by moving stuff from a cheap place to an expensive one (space), into and out of storage (time) and from one spec to another (form).

    Another bellwether of ignorance is the view that the futures price is the expected future price. It is of course nothing of the kind, it’s actually the price now for delivery in the future, but that doesn’t stop, for example.

    Comment by Green as Grass — March 26, 2019 @ 9:48 am

  3. @Carl–Thanks!

    Comment by cpirrong — March 26, 2019 @ 1:46 pm

  4. @Green–You’ve identified two of my pet peeves. Of course, I have to build an ark to hold all of them 😉 but those have pride of place.

    Comment by cpirrong — March 26, 2019 @ 1:47 pm

  5. Wonderful analysis that made the issues clear even to someone !like me who has never really with non financial commodities and who is very unsophisticated.

    One thing that I do know a little about and that really is annoying is the use of the buzzword s big data, particularly as some kind of anodyne to all the issues anyone seems to face. The fact of the matter is that in areas such as biomedical research where big data solutions have been swallowed whole, there are tremendous problems with replicability. Some studies have these problems running as high as 80%+. If there is any truth to this one should be very leary of any big data based models of solutions.

    Comment by Sotos — March 26, 2019 @ 3:44 pm

  6. Surry the first sentence should read dealt with, not just with! Dang fat fingers and a tiny tablet.

    Comment by Sotos — March 26, 2019 @ 3:59 pm

  7. @Sotos–Thanks. I am not surprised by the non-replicability problems. A lot of BDBS is data snooping/mining. You are always going to find correlations in data just by chance. Given another independent data set, those chance correlations won’t be there. You need to impose some structure, some discipline, in the form of a theory, rather than just crunching a lot of data looking for “patterns”.

    Comment by cpirrong — March 26, 2019 @ 5:21 pm

  8. AIUI the current thinking about pyramid construction is that they were built outside the farming season by otherwise unemployed farm workers, and that the labour was paid with stored food.

    This would mean that the PDPW (Pharaonic Department of Public Works) would have to go to local grain traders and ask, What’s your price for 5,000 bushels of grain in five months’ time? The answer, of course, would be, Today’s price plus the cost of five months’ storage.

    That is a futures price: the price now for delivery in the future.

    If the trader chalked those prices up on the wall, right there, you would have had the very first contango forward curve.

    FWIW, and hence, I reckon the first futures trader in history was Joseph in the book of Genesis. Several pieces of evidence support this.

    1/ Based on an astute piece of technical analysis and forecasting insight (= a dream), he bought up grain, stored the warrants in Egypt, and accumulated an inventory overhang large to force the contango for seven years.

    2/ He thus controlled the marginal supply – or the ancient Egyptian grain SPR if you like – at next to no cost. When exogenous events created backwardation, he was able to liquidate into the screen.

    3/ He was so ruthless he even fucked over his own brothers.

    4/ He was also described as wearing a coat of many colours

    5/ He started his trading career in a pit.

    I rest my case. Joseph was a floor local made good.

    Comment by Green as Grass — March 27, 2019 @ 4:55 am

  9. I’d argue that cash pricing transparency has increased, at least in oil. PRAs are assessing more markets than they were, so you can more easily compare the niche west African stream with competing crudes in Asia, say, than you could 10 years ago. That’s one advantage that trading companies used to have over refiners that they don’t have as much of anymore.

    I agree that the new entrants thing is probably a bigger factor, though. Aramco Trading is big and expanding and starting to do some interesting things on fuel oil. And Exxon, of all people, is hiring futures traders.

    Comment by Down With This Sort Of Thing — March 29, 2019 @ 7:11 am

  10. Good Luck capturing quantitative data in the Physical Commodity World! As for Algo Liquidity, its there until they shut off their machines! Laissez les bon temps rouler!

    Comment by atfinola — April 4, 2019 @ 3:38 pm

  11. […] absence of any talk of contango (or backwardation either) from the Oliver Wyman paper is odd, and has encouraged the charge that […]

    Pingback by Backwards To The Future – Seeking Alpha – Short Term Wealth — April 18, 2019 @ 5:05 am

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