Arbitrage in Commodity Markets
Updated: Aug 4, 2019
Arbitrage is a word you often hear in the context of physical commodity trading. In theory, it involves simultaneously buying and selling the same or equivalent instruments at different prices, locking in a risk-free profit. In practice, modern markets throw up very few opportunities like this to anyone who isn't a bank or high-frequency trader. The word arbitrage has evolved to describe situations where merely similar products are traded against each other - the days of "pure" arbitrages are almost over. Finance academics frequently use assumptions of "no-arbitrage" in market models - if the model predicts a risk-free return it is probably incorrect.
As an example, the chart below shows the spread between the London Gold contract and the COMEX Gold Future outrights. Most of the time it trades within a 20c range, below transaction costs for the vast majority of market participants. The few spikes are very likely to be spurious data points given how rapid they return to normal, and would be very hard to capitalize upon reliably. While the technology to execute the trade at speed isn't as expensive as you might think (Trading Technologies' Autospreader costs around USD 1000/month), the barrier to entry here is a commercial one. Only traders with fee or rebate arrangements from the exchanges, and very low commissions from their clearers can execute this trade profitably. To achieve this you have to either be already trading huge volumes, or reasonably expect to from executing the trade.
The other thing that isn't clear from most explanations of arbitrage, is the actual mechanics. In the example above, what do you do if you are fortunate to book a trade at a decent spread between the two instruments? Imagine you buy COMEX at USD100/oz discount to London, do you:
1) Take delivery of your COMEX leg in New York, call a secure truck to pick up your gold bar, put it on a plane and fly it to London to be delivered into your short?
2) Wait for the spread to move in the opposite direction and trade out of the paper position?
Obviously 2) is the easier answer, that requires no knowledge of gold logistics, storage and transport. You also wouldn't have to pay in full for your metal, as futures are all traded on margin.
However, what if the spread doesn't normalize?
Below we'll go through the 3 main types of modern arbitrage approaches.
Physical Arbitrage
A physical arbitrage is in theory the best kind. If the prices of 2 fungible assets diverge sufficiently such that the price difference covers the logistic cost of delivering between the two markets, we can buy in the cheaper location, move the material and sell in the richer location. In practice how does this look? We'll go into this in more detail in a later post but you'll need to consider a few things to make this happen:
Freight: How are you going to transport your material? Is that mode of transport available where and when you need it? For example, railcars in the US are often very difficult to secure at short notice. How would a delay affect your trade?
Costs: Exchanges charge fees to remove material from their listed warehouses, and deliver in. These can be substantial in comparison to the margin of an arbitrage-type trade.
Warehousing: Chances are you are not the only person executing this trade - there will be lots of people trying to get material out of the exchange warehouses. Storage facilities often have a specific rate at which they can load out material, which can create a queue. Not only can this cause delays in the trade, but you will have to pay to rent during this period.
Financing: The margins on such trades are often thing - you don't want to come up with all the cash yourself. Making sure the banks understand the trade and are willing to come up with the cash on time is vital.
Insurance: If something goes wrong in transit or storage, you can't afford to lose your material.
As you can see, what sounds like a very simple trade can end up being quite complex and risky. Arbitrage traders really want to avoid executing the physical leg if they can (even if they are a physical firm), hence the popularity of the subsequent approaches to arbitrage.
Arbitrage as a Convergence/Divergence Trade
The best example here would be the Brent-WTI spread. The oils are different qualities and therefore barrels from one exchange cannot be delivered into the other. However, both futures represent similar underlying supply-demand dynamics - this is evident from the fact the prices move very closely together. However, on occasion they diverge significantly, creating an opportunity for an arbitrageur with a good understanding of the market.
The key to this type of arbitrage is risk management. You don't have the physical execution as a worst-case scenario way out, so convergence/divergence arbitrageurs need clear levels at which they will take profit and/or stop out.
Statistical Arbitrage
Statistical Arbitrage or stat-arb, is similar to the risk arbitrage described above, but is more often applied to a portfolio of assets. The classic example comes from equity markets, where there are distinct groups of stocks that tend to move in tandem. This allows stat-arb traders to trade against divergence in very similar stocks.
In commodities the relationship between different futures is not always as clear as in stocks While it is possible for an industry or sector to have similar responses to a macro event or sentiment change, different commodities may react very differently. However, firms do try and succeed in building models that describe the commodity markets well on certain timeframes.