What is Physical Trading?
A Physical Trader (firm or individual) buys and sells commodities delivering physically from producers, to consumer or processors. A trader may also engage in storing, blending or refining commodities to meet customer specifications and maximize their profit.
Physical Traders will use derivatives such as futures and options to hedge and from time to time speculate on commodity price movements. However their goal is really to make money from difference in price between locations or product quality. While in the past, traders would be jack-of-all-trades and dabble in many different products, taking advantage of whatever opportunity arose, nowadays most specialize in smaller subsets. The knowledge, logistics and networks required to trade profitable nowadays requires specialist teams. There are companies that do successfully trade different clusters of commodities, but the teams are often very separate - any edge usually comes from economies of scale and better banking relationships.
The world of commodities can be divided up many ways, and there are often crossovers between categories. Below is a summary of how most people see the different market segments.
1) Agricultural Commodities
This segment is perhaps the oldest as humans have been trading food, specifically grains for thousands of years. The first futures contracts in the US were for corn, and traditionally the space includes wheat, barley, soybeans and rice. Now most of the world's grain and oilseeds are traded by the "ABCD" of agricultural commodities: Archer Daniels Midland (ADM), Bunge, Cargill and the Louis Dreyfus Company. While they almost all started in the 19th century trading grains, these companies have recently diversified into a wide variety of businesses including specialty food ingredients, meats, energy and metals.
Energy is a huge market encompassing Oil and Refined Products, Coal, Natural Gas and Power. The pressure on petrol stations to be pumping and power always available in people's homes means that when supply gets tight markets can get very interesting. Similarly, most energy products are either expensive (oil), difficult (gas) or nearly impossible (power) to store, so this can create some bizarre price dynamics when there is too much supply - gas and power prices have been known to go negative!
There are a myriad of different companies active in this space, mainly due to the size and breadth of the market. Oil majors such as BP, Total, Shell and ExxonMobil all have trading desks that compete with the large trading houses such as Glencore, Trafigura, Mercuria and Gunvor to name a few. There are also many smaller companies that operate very profitable niches, either geographically or specialist product-focused.
Metals are sometimes lumped with energy but I feel it deserves its own section. Metals futures have been trading in London since the 16th century and the founding of the London Metal Exchange (LME).
Generally split into 3 sub-sections:
Base - Aluminium, Copper, Lead, Nickel, Tin and Zinc
Precious - Gold, Silver, Platinum and Palladium
Specialty - Tantalum, Cobalt, Molybdenum, Vanadium, Lithium, Tungsten, to name just a few.
Ferrous - Iron ore and Steel
Each sub-group has very different market structures and traders would certainly specialize in one or two metals within each.
As metals are some of the easiest commodities to store - they don't decay or catch fire like many others - warehousing is a key part of the physical metals business. The LME has a network of warehouses around the globe, and traders are constantly moving material in and out depending on market conditions. We will go into this in more detail at a later stage.
4) Soft Commodities
"Softs" include Sugar, Coffee, Cocoa, Cotton and even Orange juice. As a sector often flies under the radar when people think of commodities, but some of these markets are huge. With products often growing in tropical regions, supply can be disrupted by weather or unstable political regimes. Soft Commodity traders often talk about going "to origin", which means spending time where their product is produced, dealing with growers and suppliers.
In this blog series we will look to demystify an industry that undoubtedly affects all our lives, but has largely avoided public scrutiny. We will unpack the kind of trades that make money in the business so that you can either get a job in the business or trade commodities for your own account should you wish.