Turbulent markets, such as those triggered by the Covid-19 crisis, inevitably raise worries about risks to the financial and trading system. Given the scale of recent price movements, particularly the oil price, attention has naturally turned to the commodities trade. This attention was further sharpened by the difficulties experienced in April by some smaller trading firms in Singapore. Some are asking whether such difficulties could balloon into a systemic problem in the market, a threat to financial stability, or even a danger to the continued supply of necessary commodities.
These questions, which have been raised before and are often accompanied by calls for tighter regulation of commodities trading firms, are understandable given the long shadow cast by the global financial crisis of 2008-2009 and the cracks in the banking system which that exposed. They are, nevertheless, off-target when it comes to the business of commodities trading.
Far from posing a systemic threat, the large commodities trading firms (CTFs), of which Trafigura is one, in many ways do the opposite, by playing a central but largely unseen role in managing the inherent financial and other risks that arise in volatile markets.
They have also made a vital contribution to smoothing over the disruptions resulting from the supply and demand shocks we have experienced in recent weeks.
Commodity trading firms are an important link in the supply chain connecting producers of such commodities as oil, agricultural produce, iron ore and non-ferrous metals with processors and consumers. Through the substantial credit facilities on which they rely, and through their extensive use of liquid commodity derivatives markets such as futures to hedge their trading positions, they are also intimately connected to the global financial system.
But it is important in assessing risks posed by these firms to understand the difference between physical traders and financial institutions. Unlike banks, for example, CTFs do not transform short-term liabilities, such as deposits, into longer-term assets, such as loans. While they do use leverage, their current assets normally exceed current liabilities by a comfortable margin. This means that if a trading firm runs into trouble, its business and assets can be taken over and maintained by others.
How CTFs Reduce Volatility
A critical distinction also exists between CTFs and hedge funds or commodity funds. The funds are financial sector players whose primary role is to take speculative positions on the direction of price movements, often expressed through derivatives but almost never through the physical commodity itself.
The large CTFs, by contrast, take direct ownership of the physical commodity, and use derivatives markets principally to minimise any price risks; any more speculative trading positions are of a much lower order of importance and in no way core to the business.
Arguably, the difficulties experienced by two Singapore traders this year resulted from weak hedging policies and speculative trading positions, not from physical trade. The authorities are right to have adopted a calm and measured approach to these firms' failure, emphasising the importance, resilience and diversity of Singapore as a physical trading hub.
The model of the large global CTFs is quite different from that of localised operators. Physical trading is their business, and their core competence lies in understanding the global supply chain in great detail and in managing infrastructure such as oil storage facilities, pipelines and freight capacity.
Far from creating risk at times of crisis, these assets are central to the CTFs' ability to navigate turbulent markets - and to the service that they provide to producers, processors and consumers.
To understand this, consider the recent oil market disruption, which saw the price of US oil fall into negative territory for the first time on record. These were extreme and unusual conditions, resulting from the hit to demand from the Covid-19 pandemic on the one hand and a jump in supply caused by a price war among producers on the other.
But the most obvious physical manifestation of this crisis was a shortage of oil storage capacity. At moments like this, the role of the CTFs with their access to physical infrastructure becomes more important than ever, as they can alleviate - via their supply chain - some of the industry's natural bottlenecks.
CTFs are also, by definition, extremely agile in adjusting their storage portfolio to cope with sudden changes in markets. As the largest exporter of US crude, for example, Trafigura had ample pipeline, tankage and freight capacity to play its part in channelling the supply glut that caused negative prices domestically to foreign markets, where prices were higher.
Differences between spot and forward prices and between different locations provided a financial incentive to move the barrels. That is how the market works matching supply and demand, and CTFs play an essential role in enabling such flows.
Similarly, in Asia, we have been playing a key role in helping the market adjust to a glut resulting from a sudden fall in Chinese oil refinery run rates and other changes. We leased significant extra tank capacity in countries such as South Korea, for example, and boosted our already strong storage position for liquefied natural gas (LNG) in Singapore.
By adding storage in over-supplied markets, we provide a vital buffer to reduce volatility and ensure security of supply over time.
So it is time to stop worrying about systemic risks in commodities trading, and instead to appreciate that without trading firms and effcient physical trading and storage hubs such as Singapore, the impact of recent volatility on consumers and producers would have been much more painful.