There is still confusion about what Commodity Traders do.

“Number of trading houses has dwindled and the institutional, pure-play commodity hedge funds that remain are a few”.  Bloomberg

1990

Phillip Brothers

The largest and most successful commodity trading house in its day caved, triggered by copper trading

1993

Metallgesellschaft AG

The New York branch of this large German conglomerate lost $1.5 billion in heating oil and gasoline derivatives

1995

Sumitomo Corp.

Yasuo Hamanaka blamed for $2.6 billion loss in copper scandal

2001-2002

Enron Corp.

Dissolves after misreporting natural gas trades, resulting in Arthur Andersen, a ‘Big 5’ accounting firm’s fall from grace

2005

Refco

Broker of commodities and futures contracts files for bankruptcy after accounting  fraud

2006

Amaranth Advisors

Energy hedge fund folds after losing over $6 billion on natural gas futures

2011

BlueGold Capital

One of the best-performing hedge funds in 2011, closed its doors in 2012, shrinking from $2 billion to $1.2 billion on crude oil bets

                                                               

2014

Brevan Howard Asset Management

One of the largest hedge funds globally. Closed its $630 million commodity fund after having run well over $1 billion of a $42 billion fund

2015

Vermillion Asset Management

Private-equity firm Carlyle Group LP split with the founders of its Vermillion commodity hedge fund, which shrank from $2 billion to less than $50 million.

Notable absentees: 

André et Compagnie S.A. (2001), the Switzerland based global grain company liquidated after writing-down russian invesments and wave of defaults in Argentina.

Cook Industries (1977), U.S Grain Trader who made losses in soybeans and played double.

Ferruzi (1993), Continental Grain ( heavy financial paper losses in the late 80s)

Armajaro Holdings (2012)

That we associate commodity traders to hedge funds is wrong-footed. One school focus is risk, (hedge flat price & operational risk), the latter on outright volatility (the opposite of that is desirable to operate in commodity trading and survive as a business) !

The risk management of a fund is nowhere comparable to banks who are risk-regulated or the insurance company who is purely a liabilitiesdriven investor.

Arguably anyone a limited quantitative background can incorporate a “hedge fund” or a “private equity” with an exposure to commodity, take risks and distribute these risks to investors.

99.5% of them, especially “commodity trading funds” run by ex-traders, claim to have well-thought risk management policies, but few actually can state trade-offs between risk and returns of a position and limits.

There is still confusion about what commodity traders do.

The role of a trader is to manage the time risk of when a buyer wants to buy and when a seller wants to sell. Because these two things rarely occur at the same time.

To better locate merchants and traders of physical commodities, they deal daily with risk. These firms hire the people in operations to facilitate the trade (surveyors, insurance, law, treasury & risk manager, credit, counterparty-risk, compliance, settlement, claims, scheduling , trade finance, accounting) only to make sure they don’t lose their shirt.

It is not to say that all can afford the depth of risk management and compliance with the overheads that commodity houses have self-imposed to monitor their trades.

The financial management of the firm can be an expansive discussion to have, egowise, when its management is comprised of ex-traders.

Armajaro has blown up a $3B sales merchant business of more than 500 employees on one mammoth bet.

In the Cocoa Market, the July and September contracts can be vulnerable to shortages of fresh cocoa supplies due to the crop season in the world’s largest cocoa-producing region, West Africa, with the main harvest due to start in September/October.

In July 2010, Armajaro took a one billion dollar long position in the July Liffe cocoa futures market.  At the time, Armajaro is a $120-150M net equity company, figure…

The trader hasn’t sought to unwind the position but on July 15th took physical delivery of $998M worth of the soft commodity in a miscalculated attempt to lift the prices at the expiration. However, the market has forced them out of the untenable position. 

Armajaro was forced to Liquidate all its Assets.

After the losses, after the redemptions, bruised egos (and after a bizarre, questionable and failed attempt to remake itself in 2011 during the social-political crisis Cote d’Ivoire ) the firm’s position was irreparably compromised.

As alluded by Jean Francois Lambert the ex-banker, the “Do business, do not invest”, old philosophy of Phibro has been totally forgotten.

Today the financial positions and risk profiles are very entrenched into assets that traders acquire and sell no on the margins on the commodity that they buy and sell.

Example: Glencore’s ebitda at one point last year was at more than 70% made of non-cash depreciation on assets.

We also forget that people are the most important assets of a trading firm.

Profiting from commodity trading demands a unique alloy of people with different skills, market knowing, intellect, financial and human capital, not luck.

Bad people, rank and file stupidity and sometimes corruption have jeopardized the Enron, Summitomo and Metallgesellshaft AG mentioned on the bloomberg list.

Markets aren’t more challenging these days that they were in the 70, 80s or 90s: it’s a world of traders and merchants that has always been and will always be in a constant crisis. 

The trade itself originates from supply & demand dislocations and crisis around the world. Isn’t it paradoxal to hear the same excuse over and over again : “its a difficult market” in conference calls, MD&As or in the official communication of a trader.

The second most frequent excuse (music played at an interval of 4 or 5 months) is : “times are difficult, since lending for commodity traders is restrained by regulatory changes“.

Do these traders only have an ability to trade with returns above their cost of capital ?

Accounting alone doesn’t reveal the true risk-profile of these traders. The balance-sheets are twisted.

A lot of these traders dance on losses, bet directionally on assets and financialize their losses. 

Referring to what I have said earlier, commodity trading is a transactional approach

It entails taking positions on an anomaly and execute a lot of sequencing in order to timely deliver.

However the practitioners thrive and survive only because they minimize delta and the gamma.

By buying assets, commodity traders are no longer functioning as arbitragists- they pay the delta, the theta and vega to get gamma and more vega on the asset. They synthetically replicate the positions of a fund trading volatility in the commodity markets but with physical assets. 

Yet no one can predicate future volatility. In other words, this is luck. They trade but in a way that carry concavity (no stoploss allowed).

There is a big gapping hole between the earnings and cash-flows generation of these firms as they sustain earnings by expanding in size / balance-sheet but these earnings are not supported by positive generation of cash-flows.

At the individual level, hordes of traders have a free-ride.

They rush into deals without going deeply into costs, the risks or the details and lose considerable money in large trades when the market is turning out of favor.

They get fired from the shop but pop-up 6-months later at another house or boutique, repeating the losses again and the process over many years.

It shows that the holes in risk & management oversight at these companies haven’t solely originated from the cycle.

You can never assume that in this market the good counterparty of yesterday cannot become rogue tomorrow. After you deal with …traders. The business is cyclical by nature and yes markets are challenging but at the end in the commodity trade, people are the real assets in good or bad markets. 

Don’t invest, do business and…..don’t risk or count on

 

Simon Jacques +1-226-348-5610

Advising Producers, processors and the end-users in North America

Commodity trading and finance

Manager of commercial relationships and mastering the art of commodity merchandising, Simon Jacques is advisor to leading energy marketers and producers on defining and imparting the knowledge and skill sets necessary for their professional staff to function effectively.

Physical Dimensions

Trade to Cash

Commodity Merchant Trading and Shipping Advisory Services


Navigating the commodities markets with Freight and Spreads © 2017

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