A guide to trading and the global supply chain. Commodities trading is one of the oldest forms of economic activity, yet it is also one of the most widely misunderstood. This guide explains the functions and modus operandi of commodities trading firms and their role in organising the global flows of vital materials that underpin economic growth.
A guide to trading and the global supply chain
Section A - Fundamentals of commodities
Section B – How commodity trading works
Section C – Commodity trading & financial markets
Glossary of terms
This Glossary is a non-exhaustive list of the key terms used in commodities trading.
Primary commodities are either extracted or captured directly from natural resources. They come from farms, mines or wells (e.g. crude oil).
Secondary commodities are produced from primary commodities to satisfy specific market needs (e.g. crude oil is refined to make gasoline).
Agricultural commodities include grains and oilseeds (corn, soybean, oats, rice, wheat), livestock (cattle, hogs, poultry), dairy (milk, butter, whey), lumber, textiles (cotton, wool) and softs (cocoa, coffee, sugar).
Primary energy commodities such as crude oil, natural gas, natural gas liquids, coal and renewables are refined and processed into many different petroleum products and fuels, from bitumen to gasoline, biodiesel and LNG (liquefied natural gas).
The major base metals mined are iron ore, copper, aluminium, nickel, zinc and lead. Iron ore is left untreated, but mined copper, lead, nickel and zinc ores are turned into concentrates, while bauxite is turned into alumina. Iron ore, concentrates and alumina are traded as primary commodities. Smelters process these into refined metals and useful alloys such as steel.
The physical supply chain is the beating heart of the commodity trading business. Global trading firms manage transportation and complex logistics to source, store, blend and deliver commodities for their customers around the globe.
Commodity traders need excellent peripheral vision to understand the interconnected nature of the global economy. Conditions in commodity markets can change rapidly and traders have to remain alert to many micro and macro factors. Economic cycles, geopolitical developments and technical factors all have an impact.
Commodity traders are essentially logistics companies that use financial markets to fund their operations and hedge or limit the price risk involved. They transport, and in several ways, transform, commodities across the world. This notion of transformation is key.Watch animation
Getting product from one part of the world to another brings many different modes of transport into play. Below are the main inland modes of transportation.
Just as commodity trading firms need onshore facilities to load, offload, store and blend cargoes, so they need ships to carry their cargoes across the oceans. Shipping therefore plays a vital part in commodity trading.
A trader can buy a commodity for delivery on a date in the future in one of two ways. He could either borrow money now to buy the commodity today, and store it until the desired delivery date or he could buy a commodity futures contract. When futures price drift higher than spot prices, markets move into contango. The opposite situation, when futures fall below the current spot price, is known as backwardation.
Chinese copper consumption has grown markedly since 2000 making the country the world's largest consumer. The quality of concentrate available has suffered with the growth in demand. As existing mines get depleted, smelters are more reliant on new, sometimes arsenic-rich, sites for their concentrate. This poses health and safety issues. Processing techniques such as oxidisation can reduce arsenic content, but these are costly and they also affect copper levels. Another solution is to blend the concentrate. Mines producing arsenic-rich concentrate sell at a discount to trading firms. Traders blend the material with cleaner concentrates before selling on to smelters.
Structuring and maintaining an efficient operating model is at the heart of profitable commodity trading. The operations team has an important role in helping to define and refine protocols that help the trading firm minimise risk and reduce costs.Watch animation
The practice of hedging is fundamental to commodity trading. Trading firms systematically eliminate their flat price exposure by taking out futures contracts against both components of a transaction.
Banks facilitate a trade by providing a letter of credit (LC) to the seller on the buyer's behalf. This document is a bank-backed guarantee that the seller will receive payment in full so long as certain delivery conditions are met. The seller has the assurance that should the buyer be unable to make payment on the purchase, the bank will cover the outstanding amount.