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Review: Report on Economics of Commodity Trading Firms

The recent release of Report on Economics of Commodity Trading Firms is a bold step from a well-respected Commodity Trading Firm (CTF) – Trafigura, in giving an insight and “demystifying” the secretive commodity trading industry. And it is indeed a very impressive read.

According to Reuters, “The firm approached Craig Pirrong, a well-known professor of finance and commodity markets commentator at the University of Houston, last July to commission an independent review of the commodity trading industry, with the goal of “demystifying” it. The resulting 63-page report, based on public filings and interviews with around 10 senior Trafigura traders and a number of C-level executives last September, reached a conclusion similar to several previous reports: relative to Wall Street banks, merchant trading companies’ size, function and balance sheets make them far less likely to be sources of systemic risk.”

The Report focusses on how Commodity Trading  Firms are exposed to various risks – Price, Basis, Spread, Liquidity, Credit, etc. and how they manage those risks. Risks are interspersed across the value chain of any commodity business, and the report emphasizes the need for commodity trading firms to have Risk Management practices in place. Notably, following points are very unique to this report:

  • There is very low, at times negative, correlation between quantities of various commodities (2001 – 2011). Given that Commodity Trading Firms are exposed to volumes more than prices, it shows that there are huge benefits from Diversification that firms can achieve – to reduce the variability of firm’s risk.
  • Integration across the value chain gives firms the ability to self-hedge and absorb the shocks to a certain extent.
  • Trafigura has invested USD 550 mn over the last 3 years in Risk Management and Measurement Systems. According to the report “The increasing data and analytical intensity of trading and risk measurement modeling is tending to increase the degree of these scale and scope economies.”
  • Trafigura measures Risk using Monte-Carlo method that combines 5000 risk factors, at 95% confidence level, for 1 day holding period and its VaR limit is less than 1% of Group equity.
  • Along with VaR, the firm uses Expected Shortfall (Conditional VaR) along with qualitative measures to broaden the scope of Risk Management.

These along with several such data points and perspectives make this a must read for all Commodity Trading Firms. You can read the original report here:

Report – The Economics of Commodity Trading Firms – Trafigura