Trends in Supply and Trading
Growth of Electronic Trading
Over the course of the last decade, the energy futures markets have evolved from open-outcry dominated exchanges – where live people executed orders, to electronic markets where the Supply and trading take place on the screen of a computer.
Most new trading and hedging platforms are computer-driven on a real time, 24/7 basis. Participating companies can post and execute transactions directly onto the electronic system. Counterparties can review the transactions and select those that they are willing to accept and automatically execute.
The change in the traditional exchange institutions has been evolutionary:
- When ICE (Inter Continental Exchange) acquired the IPE (International Petroleum Exchange, London), in 2001, it was under the condition that the IPE would go fully electronic in a certain time period. In 2005, after a period of running open-outcry and electronic trading in parallel, the IPE closed its trading floor.
- The CME’s dominance of theier commodity trades was enhanced by its commitment to electronic trading, as it moved from the floor – open outcry – system. For example in 2000, 85% of CME trades were on the floor, by 2008, only 17% of its contracts traded on the floor.
- The NYMEX with a strong commitment from its members to maintain open-outcry trading, still runs concurrent floor and electronic trading.
- In Aug 2006, the NYMEX switched its electronic trading products from the proprietary NYMEX ACCESS system to the CME Globex system due to technical superiority and the need to compete with the growing popularity of the global ICE electronic trading platform
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Asset Position Affects Trading Strategy
As the chart indicates, Supply & Trading functions operate differently when they exist in either an asset-based or non-asset-based (or knowledge based) environment. The trend today is for:
- Traditional asset traders (oil companies) to move to more knowledge based strategies, and
- Non asset traders (banks and trading houses) to acquire assets to leverage their knowledge strategies.
With asset-backed, or proprietary trading, the trading entity has an investment in the underlying physical assets. Most oil company S&T functions are asset-backed with decisions concentrated on effective coverage for the supply system – with some consideration of optimization of the assets.
For example, a refiner is short of crude oil needed to run the refinery; but is as long with petroleum products – i.e., has products on hand that need to be sold in the market. Supply & Trading is responsible for making sure that the crude oil is available when it is needed and sufficient quantities of product are available to meet sales obligations. Hedging strategies are often put in place to ensure stability on supply and price as inevitable fluctuations and timing differences occur.
Non-asset backed participants need not necessarily have a portfolio of physical assets to sell and buy crude oil and products. Most financial institutions and speculators are non-asset backed and trade energy derivatives – i.e., financial instruments (paper) which derive their value from another asset – with no intention of delivering or accepting the physical commodities. The key asset of these institutions is their market and trading knowledge and (often) sophisticated, quantitative models used to set trading strategies.
The lines are getting blurred. Some non-energy companies have acquired energy assets – e.g., crude reserves, product storage capacity, transportation assets – simply to improve their strategic position in the trading markets. At the same time, some energy companies are increasing their level of paper trading to capitalize on the inherent knowledge of how to leverage their physical assets Energy Traders
Banks
As the energy markets have evolved over time, the distinction between market participants has blurred.
- Commercial players are those who participate in the physical energy markets, and whose main goal in the financial markets is to hedge the exposure of their physical positions.
- Non-commercial players include speculators and funds that primarily use the futures and OTC markets to make bets on the movement of energy prices.
As the participants became more sophisticated, many traditional financial institutions realized the value in having more exposure to the physical markets.
One of the first examples of this occurred in the 1990s when Morgan Stanley trader Olav Refvik leased storage terminals in the New York harbor where the NYMEX heating oil contract is delivered. This storage capacity allowed the trader greater flexibility to take advantage of the volatility that occurs as contract expiration nears, since there was now the option of taking delivery of the actual commodity that the futures contract represented.
This position earned him the nickname “King of the Harbor”.
Independent Traders
Until the mid 1970’s, integrated oil companies followed the classic Standard Oil model and controlled all the key aspects of the supply chain including production, refining, shipping and ownership of terminals and branded service stations.
Today, most oil companies have a tendency to supplement their own hydrocarbon supplies with third party supplies. Sourcing patterns continually reflect traders moves to eliminate arbitrages across markets.
Crude and refined product flows are now driven by growth in the world oil markets in Rotterdam, Singapore, the Middle East, New York, and the US Gulf Coast.
Privately held trading companies with expertise in these markets, such as Vitol and Glencore and others listed in the chart, have grown into massive participants using their trading expertise. The most recent entrant, Gunvor Group, only came into existence in 2001, and is now one of the top traders in Russian oil.
Most of these traders have expanded their operations to include physical investments in exploration, shipping, refining, and storage in order to leverage their trading market knowledge. These organizations, and others like them, often operate very privately due to their partnership status and are not required to publish financial data.
Centers of Oil and Gas Trading
Both London and Geneva have an advantageous time zones to deal in global markets, versus New York. For example, a London-Geneva typical trading day goes like this, with all times based in London:
Traders get to the office at 7am:
First step is to check with the (still open) Singapore markets. Singapore is the primary hub for export fuel oil supplies that go to Japan-Hong Kong. It can also come into Europe and (rarely) to the US. There is a fuel oil arbitrage between Singapore and Rotterdam similar to the Brent WTI crude oil arbitrage discussed previously.
Until 2pm:
Monitor the European markets. Trade ICE and other electronic contracts that are actively traded in London
2pm London: NYMEX floor opens in New York (9:00 – 2:30 EST)
Trade the crude and refined products contracts – watching crude and (especially) product arbitrage opportunities between Europe and the New York Harbor and US Gulf Coast.
Traders leave London/Geneva 7:30 pm, after the NYMEX closes.
Global energy trading operations are moving to Geneva from both London and New York. There are tax and secrecy laws in Geneva which are advantageous to a private company.
Strategic Petroleum Reserves (SPR)
The other part of the crude supply system in most countries with growing future importance is the Strategic Petroleum Reserve (SPR).
After the crude crisis of the mid-70’s, the US and other key consuming governments, like Japan, recommended that 90-120 days of crude requirements should be held in reserve. In the event of another supply shock, industries could be kept running while adjustments are made to reestablish a stable supply pattern.
In March 2001, all 26 members of the International Energy Agency (IEA) agreed to build strategic petroleum reserve (over time) until they equal 90 days of oil imports for their respective countries. China has recently put a similar policy in place.
Currently in the US, the SPR only holds about 30 days crude supply because of the large volumes of crude oil needed to meet US demand.
The US SPR was tapped after Hurricane Rita in September 2005. The crude oil pipeline infrastructure in the Gulf of Mexico was so damaged that the Gulf Coast refineries could not produce enough crude oil from the Gulf. Crude was released from the SPR into certain refineries and then paid back over time.
Care is taken by all countries in filling their strategic reserves so that the pricing in crude oil markets is not disrupted.
Freight Forward Agreements
A key component of crude and product movement around the globe is the cost of shipping. The high degree of volatility in freight rates requires this component also be effectively hedged.
The Baltic Exchange, operated in London, provides daily freight market rates as well as maintaining various shipping cost indexes. The Baltic Exchange also operates a market for freight futures, known as Freight Forward Agreements (FFAs).
This pricing information is the main source of indexing and settlement for physical and derivative contracts in the freight market. These contracts are traded in the OTC market and can be cleared through participating clearinghouses.
Participating clearing houses include
- London Clearing House (LCH)
- NOS Clearing ASA (Imarex)
- Singapore Exchange Limited (SGX)
- NYMEX Clearport
Some indexes posted by the Baltic Exchange include:
- Baltic Dry (Bulk) Index
- Baltic Capesize Index (BCI)
- Baltic Panamax Index (BPI)
- Baltic Tanker Clean Index
- Baltic Tanker Dirty Index
In June 2008, Imarex, who owns NOS Clearing ASA, launched an electronically traded and cleared futures contract of the Baltic Dry (Bulk) Index. The high volatility (sometimes 70%) and growing liquidity in the freight market has drawn interest from financial players including hedge funds.
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