How oil traders make money?
Because cocaine and hookers are an expensive habit
We reached the last part on this little hedging and trading physical oil set of articles, in which we are going to explore how oil traders make money, and since oil traders are constantly hedged that leaves no much room to wiggle, but a trader’s job is to create and manage risk. They trade “Basis risk”, which is, if you remember, the risk of changes in the difference between the price of a physical commodity and the price of the hedging instrument used to manage price exposure.
Let’s view it from the lenses of an oil trading house (Vitol, Trafigura, Glencore, etc.) and try to understand how do they make money.
History time: These traders all started as a proper merchant, buying wholesale and selling retail. They would buy a batch from a refinery or a full vessel of diesel or gasoline, and then break it down in smaller chunks. This was before the explosion in futures and derivatives, so suffice to say hedging wasn’t a common practice. This line of business is still widespread in Asia where the market is more fragmented.
Then, in the 70s and 80s when we had the wave of nationalizations and independent crude oil producers, is when the oil trader made the big money and earned their reputation. Basically, the business was to bribe officials in 3rd world countries and get a supply deal below market price. Billions were made like this, but with time this thing of paying bribes became kind of frown upon… not to say it doesn’t happen nowadays, but after a few high visibility cases they resorted to other ways.
Arbitrages: There is still a big part of trading physical barrels, but as the markets evolved in price discovery the opportunities are becoming scarce, since everyone knows where to source and how much a barrel is worth at any given time.
For example, a trader buys a North Sea cargo, and has a customer in Lavera, France. The proper way to hedge would be like this, even before you have a price for your cargo, you should have sold your cargo at a floating price plus a mark-up the Dated + $1.50.
In this trade, what he is doing is try to lock in your profit (P&L) using the available instruments, in this case he is long Dated Brent at a fixed price and to offset that position first selling Brent futures, and for hedging that “Brent component”, he is using the DFL (dated to frontline) instrument. Is that a perfect hedge? No, because the DFL is a monthly swap and you are delivering your cargo before the contract expiration, so there is the basis. The P&L is pretty much fixed, but there is a small risk.
This is pretty close to a real-life example, see how you put almost $50 million on the line to make $150k. Not a good business, so in order to afford these fancy dinners and exotic holidays you have to up the ante.
Welcome to the world of “proxy hedging”. Basis risk could be achieved by the lack of instruments, or by design. What if instead of hedging with brent futures, you hedge with gasoil? Or what about instead of hedging the 700k barrels, you just hedge 600k..or 800k. That is what traders call “hedging optimization”. I call that gambling, but that’s just me.
Traders have a view on their market, and the way to express that is to push the risk a little, using different instruments, time frames, and locations. So, hedging a Brent physical cargo using Dubai swaps, or hedging a Gasoil cargo in Asia using the Jet crack, or ICE Gasoil.
Trader positions are grouped by desk or regional office, a trading book would look more like this
Where the total barrels position is flat (0) and there is a floating P&L.
There are times when the book is unbalanced where paper and physical positions are not matched, and they adjust by trimming the paper positions, or adding physicals. One recent example of this are the WTI cargoes that are sent directly to Asia but sold in the North Sea window, they are just swapping a physical cargo with a paper position in Brent
Very often a cargo is bought and sold many times during its voyage, those are traders getting in and out of positions.
The best way to think about Oil Traders is to think like if they were Hedge Funds (in many ways they are), but instead of taking money from LPs, they take credit lines with financial institutions, and they use the physical cargoes as collateral to borrow against to, at some point the physical cargoes become an excuse. A trading book for an oil trader follows the same principles of modern Portfolio theories, adjusting positions by volatility, co-variance and what have you, all disciplined by VaR (value at risk) with all its limitations.
In essence, traders hedge the tail risks and play in between the different markets or spreads. Oil plummeted $15/bbl in two or three days, and yet nobody went bust. But this doesn’t mean they don’t lose much money, on the contrary... spreads like inter-month or Brent/Dubai are much more volatile than flat prices, and maintenance margin requirements from exchanges are much smaller that buying outright Future contracts, so the temptation to overleverage is there, and that’s when things usually go wrong.
Even this space is becoming a bit crowded, so in the last ten years oil traders pivoted to pursue different strategies as the information asymmetry on what they once thrived, is also no longer there. They have begun using the Oil Majors playbook, integrating vertically and horizontally. Today these traders own terminals, tank farms, refineries and optimize through infrastructure. Asset light traders are an endangered species, and the few that remain are basically arbitraging credit more than cargoes, they buy in cash to and oil major and sell to 30/90 days to an independent refiner or 3rd world fuel distributor.
Also in the last years there has been a tectonic shift, this industry once dominated by the Europeans now is pretty much an Asian game, this isn’t worst or better is just different when you have an Unipec or PetroChina with unlimited funding, with Middle East producers switching to spot pricing, is way more competitive now, so is natural that the biggest risk seekers moved to he sanctioned/black markets where real money is being made.
Should you be interested in learning more about this fascinating world, I leave you some books that are easy and fun to read.
Trafigura paper on Risk Management (Free)
Understanding Risk Management and Hedging in Oil Trading: A Practitioner's Guide to Managing Risk
Trading and Price Discovery for Crude Oils: Growth and Development of International Oil Markets
The World for Sale: Money, Power, and the Traders Who Barter the Earth's Resources
impressive!!
Great insight ! Thanks for the write up.