Blending and its role in Commodity Trading
Updated: Aug 4, 2019
Blending is a key component of many trading operations - grains, oils and metal concentrates. It allows the trader to purchase material of varying quality and still deliver a product to the consumer that meets specification. It also offers an opportunity to profit. Contracts will have discounts or penalties for material that doesn't meet requirements, so if they can buy this material cheaply, then blend in a smaller amount of higher quality product, they can then sell this at the prevailing market price, pocketing the difference. Furthermore, different consumers might require slightly different specifications. Blending allows the trader to deliver these products in the most cos-effective and profitable manner.
A clear example of this comes from the grain markets. Although there are many specifics to a wheat contract, arguably the most important grading factor for a shipment is its protein content. Imagine we are operating a grain elevator - a facility for storing and blending grains, to which farmers will bring their harvest to be sold. Our customer, a flour mill requires 4,000 bushels of wheat, at a minimum of 12% protein content. Below we have the protein content and premium/discount per bushel to market we paid for 4 different silos from which we can draw:
1) 11% Protein, -15c
2) 12.5% Protein +5c
3) 10.5% Protein, -30c
4)11.5 % Protein, -7c
It is our job to find a combination of the above that meets our 12% target, with as low price paid possible. Given that our total protein content and price paid is a weighted average of the constituent parcels, we could do the following:
3000 bushels from silo 2, blended with 1000 bushels from silo 3. This gives us:
(3000 x 12.5 + 1000 x 10.5)/4000 = 12% Protein
(3000 x 5c - 1000 x -30c)/4000 = -15c Discount
So on this blend, assuming we sell the parcel at flat to the market, we will pocket 15c per bushel. This is in a nutshell the economics of operating a grain elevator. However, it is not a strategy limited to agricultural commodities - oils, base metals (concentrates) and all the soft commodities play this game.
An important note to job seekers, you might see a case study as part of your interview process with a scenario like this.