2. Trading modalities
As was outlined, the pattern of the global trade has fundamentally evolved in the last decades. On the one hand, the trading of minerals has moved from being a contract-focused specialist activity to now represent a more central role in global trade as a whole -- a trend that was facilitated by an increased financialisation of the market. On the other hand, increased market liberalisation and the growing presence of investment banks and hedge funds led to a greater interplay of the trading of physical raw materials and that of futures, over-the-counter and exchange trading, which significantly added to the scope and complexity of commodities trading.
In simple terms, however, mineral trading can be described along the lines of the dynamics between risk and reward, supply and demand, spot and derivatives trading. While balancing between these poles might also be key in other markets, there are a number of features, and the interplay between them, that distinguishes trading in minerals.
First, risks are generally considered to be higher when investing in commodities, as opposed to other trading opportunities. Because commodities almost entirely come in large quantities, storing them in particular is a major challenge and comes with significant costs, as well as auxiliary concerns such as over security.
Second, mineral trading requires costly transportation. Consumer markets are often thousands of kilometers away from where minerals are produced. Over half of China’s metal imports, for example, originate in Australia, Brazil and Chile. Just as with storage, transportation poses a range of risks that traders have to take into account. The load of a single oil tanker, for instance, might be worth well over $100 million, meaning that any issue with shipping the oil from one place to another, such as when leakages occur, can have disastrous financial effects on the trader, not to mention environmental consequences. As a consequence, insurances play a much greater role in mineral trading then they do in other markets.
Finally, commodities are much more prone to political risks. This relates to some degree to how the global economy is structured, where certain countries are responsible to above 20% in global production of a certain commodity, while other countries make up the gross of consumption. Policy changes on either side, producing or consuming countries, can therefore have significant impacts on their trading partners. If for instance China or India, two of the world’s biggest coal importers, were to shift to other energy sources, Indonesia’s coal industry would instantaneously crash, as there was no longer demand for 70 to 80 percent of the country’s coal production. Moreover, looking at this from the supply side, there have been a number of occasions where political instability in oil producing countries has taken large quantities of supply off the market.
In the following, some of the key aspects in trading will be outlined, as well as how the increased financialisation of the market has impacted how trade is conducted.
The spot market represents the segment of trading where commodities are available for instant sale and delivery. As opposed to futures trading, traders on the spot market would agree on the exchange of an actual cargo of any raw material at the market price of the date of the agreement, and usually for the delivery within one year.
A range of such spot markets exist, many of which are focussed on a particular mineral, such as natural gas. In its essence, however, spot markets can operate wherever the infrastructure to conduct the transactions exist, and with a growing number of transactions operated digitally.
A major driver for the evolvement of the commodity sector can be characterised by an increased financialisation, which represented a shift away from spot market trading. Through the various financial instruments that became more and more popular, trading commodities in form of derivatives, futures, swaps, options, etc gradually took over the majority of the total trade volume. While still close to non-existent in 1970, financial instruments already made up about 50 percent of trading in 1990 according to the Commodity Trading Futures Commission, and have since continued to play an ever-more important role in the commodity markets.
In contrast, investing in commodities had historically relied mostly on buying equity and/or debt of companies directly. The trade of the actual raw materials would be in the hands of a small circle of commodity producers and consumers, while few investors would themselves take on deals to buy or sell particular commodities.
As a consequence, for a long time commodity markets remained thinly traded and thus rather vulnerable to price volatility and even market manipulation.
Since the 1970s, however, companies like Marc Rich & Co. AG -- today known as Glencore -- started drawing business away from the larger established oil companies and more and more traders realised that raw materials could be traded with less capital, and fewer assets, than the big oil producers had been willing to do, if backed by bank financing.
The financial services sector, made up of banks and insurances, therefore became an integral component of minerals trading.
This trend further accelerated with the rise in commodity prices in the 1990s and 2000s. Interest in the market as a whole grew and led to an increase in complexity, with more and more financial products being available to traders, as well as an increase in the number of actors. A significant number of new commodity exchanges appeared and a wider range of offerings became available. Moreover, macroeconomic factors beyond the demand and supply dynamics, such as interest or exchange rates, increasingly started to drive market sentiment, which was now increasingly facilitated via digital transactions.
During this period, the use of commodity futures has evolved significantly. Yet future contracts are the oldest way of investing in commodities and the first exchange-traded futures go back to the 19th century when standardized agreements were first introduced to trade agricultural products, or so-called soft commodities, before later taking over significant proportions in the trading of natural resources as well.
In its simplest form, futures represent agreements between two parties on the exchange of an asset for an agreed price, with delivery and payment occurring at an agreed date in the future. The original reasoning to introduce futures contracts was to mitigate price risks, in the context of relatively high price volatility of commodities, which was achieved by fixing prices in advance for future transactions, and to thereby increase financial planability.
Since its first introduction, however, futures contracts have increasingly been used to speculate on price developments, placing bets on whether the price of a certain commodity will move in a particular direction. In recent years, more and more financial investors, who have no physical need of the raw materials, have therefore entered the futures markets. While this class of new traders is credited to have boosted market liquidity, it is an open question as to whether such speculation has in- or decreased price volatility.
The evolvement of futures contracts has furthermore created an opening for commodity traders, that could now act as middlemen and insure themselves against transportation risks, that come with carrying such large, valuable cargoes across the globe. A series of mega-mergers around 2000 consolidated global trade, so that major extractive companies such as ExxonMobil reduced their trading operations. By 2015, oil majors owned less than 10 percent of all tanker tonnage, with around a third of global crude trade going through intermediaries. Trading companies, on the other hand, increased their market share, with companies such as Trafigura holding up to five percent of market share.
Similar to futures trading, commodity swaps have increasingly been traded in over-the-counter markets since the late 1970s as another means for traders to hedge against price developments. Most commonly used for oil trading, swaps can be agreed on with any other mineral such as precious or industrial metals as the underlying commodity however.
In their essence, commodity swaps represent contracts through which two trading parties agree over a certain period of time to exchange a floating (or market) price of an underlying commodity with a fixed price. Although such agreements can take many different forms, the rationale behind such contracts is usually tailored to balance out sudden changes of value of a commodity. While one party might have an interest in securing a fixed price over a certain period of time, the other, and mostly more risk-taking party to the contract might prefer a trade with a floating price.
Another form of trading takes place via so called “options”. Such trade deals give one party the right to buy a certain mineral at a given time in the future from a particular seller, that is the other party to the agreement.
Options differ from futures, however, by the fact that they do not necessarily have to be implemented as the deal simply implies a possible sale or rather the option to choose whether or not the buyer wishes to purchase the commodity in the future. Typically, option contracts include a fixed price, as well as an ultimate date for the transaction. Depending on whether the purchase options are favourable to the buyer at that specific date in the future, the owner of the option is likely or not to exercise the purchase.