How Commodity Trading Works: The Complete Guide To International Trade
The commodity trading market is a vast industry that has existed throughout history, as nations have always had a constant need to exchange goods and services in order to keep their economies growing. Commodities like oil & gas products, solid minerals & metals, and agricultural products are the basic commodities that drive the market. They’re traded all around the world with businesses in two countries acting as the key catalyst for the trades, while their governments provide the infrastructure needed to make it happen.
In recent years, the commodity trading market has become more open for far smaller players. In the past, only large conglomerates controlled the industry, making it difficult for small companies to survive. But today, a person with no office can start a commodity trading business with as little as $5,000 dollars depending on what volume of a particular commodity the prospective buyer wants, the cost of acquiring and shipping the commodity from their country to the international buyer, and subsequently grow from there with trade finance.
What Are Physical Commodities?
Physical commodities are soft (agricultural products) and hard (minerals & metals) commodities such as minerals & metals like oil, copper, gold, silver, etc. and agricultural products like sesame seeds, ginger, soybeans, and much more. These commodities are usually shipped by sea to many countries around the world in large volumes & low prices under well-preserved conditions.
Physical commodities are grouped into two types:
1). Primary Commodities:
Primary commodities are natural goods that are produced/extracted directly from the natural resource point. Their quality varies greatly and they are solid minerals, metals, and agricultural products that are gotten directly from the mines, oil wells, and farms.
2). Secondary Commodities:
Secondary commodities are goods which are manufactured from primary commodities to cater to the needs of markets that need them. For instance, maize is used to produce animal feed, fruits are used to produce juice, crude oil is refined to produce diesel and other products, and much more scenarios. Just like primary commodities, the quality of the product can also vary depending on price, skill, and the production process.
Who Is A Commodity Trader?
A commodity trader is an individual or organisation that trades in any type of physical commodity between two different markets either as a broker or the direct seller or buyer. It’s the job of the commodity trader to make the trade happen, as countries mostly do not handle the trades themselves, but rely on local organisations to carry out the trade with businesses in international markets.
What Is The Commodity Trading Supply Chain?
Successfully trading and ensuring the buyer and seller remain in business has a lot to do with the terms of the contract and the supply chain process.
Essentially, the supply chain process for every type of commodity varies, but on a general scale, they could be similar depending on the types of commodities.
For Agricultural products, it usually goes through the process below:
The Farm → Store/Blend → The Mill → The Consumer
For Metals, it usually goes through the process below:
The Mine → Store/Blend → The Smelter → The Consumer
For Oil, it usually goes through the process below:
The Well → Store/Blend → The Refinery → The Consumer
In all, the consumer is always the end client, but depending on what capacity you have, you could be operating in the first, second, third, or fourth supply chain level.
But despite the end consumer being the real last client, a couple of factors go into ensuring that commodities meet the specification the mill, smelter, or refinery wants; and that’s “blending in storage”. Blending is done to adjust the product to meet the buyer’s specifications, and this can be done by mixing/processing variants of the products from different locations to ensure the minimum quality averages out to whatever the buyer wants.
For instance, a mine could produce 10% Zinc ore, which is then processed to concentrates of 15 to 20% Zinc. This can then be mixed with concentrates from other sources to ensure the lot size meets the minimum quantity and quality of maybe 15% Zinc requested by the international buyer.
The same happens with crude oil and agricultural products where the commodities are blent to either meet the minimum specification or to even attain a richer quality before delivery is made.
How Are Commodities Priced?
The price of a commodity is highly dependent on four different factors:
- The type of commodity requested.
- The quality of the commodity requested to determine how much would go into processing.
- Where the commodity is to be shipped to in order to determine freight costs, insurance, and route risk.
- And when delivery is expected, so as to determine the cost of the commodity at the time based on scarcity or abundance.
Key Factors That Affect Successful Commodity Trading
Many factors can affect the success or failure of any commodity trading operation. Some of them are:
- Product Source Location & Logistics: Since commodities are sourced from a wide range of locations, it is key for the commodity trader to weigh the best options of where to source products in relation to logistics challenges and eventually profitability. Sometimes it could be better to pay higher for a commodity in a place where logistic costs are far lower, then lower for the commodity in a place where logistics is a big challenge.
- Storage Availability: Commodity traders always need to know where they can store commodities acquired for the lowest possible price. Some factors to consider are proximity to the ports, security, ability to blend the commodities in the location, and the price of storage.
- Product Specifications: Commodity traders must always ensure that the price the commodity is being purchased at from whichever source must enable them to meet the minimum product specification agreed to in the contract.
- Political Instability: Political instability can be a major threat to commodity traders as they may purchase a commodity and just before export, the trade of that commodity is banned in the country or some other political risk could cause great financial losses. In this light, it is then key that commodity traders must structure safe trade processes that reduce their exposure to risks.
- Trade Finance: Since the commodity trading business is a large-volume/large-expense business, commodity traders must always seek trade finance to enable them to continue their trade at every point in time.
- Contango & Backwardation: A contango is when the spot or cash price of a commodity is lower than the forward price and backwardation is when the spot or cash price of a commodity is higher than the forward price. The forward price here is the “futures” price. when you understand how to handle contango and backwardation, profitability is easier to attain.
- Futures Market: The futures markets gives data about what the supply and demand of a commodity will be in the future and how commodity traders and even consumers can act today. It mostly gives an accurate prospective price of a commodity at a later point in time.
- Cost & Availability Of Alternative Products: When the availability of a substitute product rises and the price drops, the demand for the commodity being traded drops and the price equally falls. Hedging risks in relation to this are key to success.
- Freight Costs: Freight costs are another key metric in determining the profitability of any commodity trading transaction. Depending on the volume of what is being exported, you could either choose to lease the vessel at a fair cost or find a shipper that charges low freight costs for your target destination.
- Arbitrage: Arbitrage is one of the most important things commodity traders must know in order to maximize their profits. It is the simultaneous buying and selling of commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset. For instance, if a commodity trader knows that in 6 months, the price of a certain commodity could triple because of scarcity, they could purchase the commodities are low prices now and make a huge profit in the near future.
Since arbitrage is so important…
What Are The Types Of Arbitrage Every Commodity Trader Must Know?
1). Location Arbitrage:
Location arbitrage occurs if a commodity trader is required to supply a certain commodity and the trader then decides to ship the commodity from a closer location to the buyer than from the usual location. Now, the usual location may be cheaper to source products from, but when freight costs, logistics risks, and more are considered, the closest location to the buyer to source the commodity from becomes more lucrative for the commodity trader.
In simple terms, the delivery journeys are shorter, the freight costs are lower, and the overall profits are higher when location or geography arbitrage is taken advantage of.
2). Time Arbitrage:
In time arbitrage, future or forward prices are of utmost importance. If the price of a commodity in about 6 months is going to be at a higher premium than it is today, commodity traders who purchase the commodities today but choose to delay on delivery but sign contracts for deliveries to commence in 6 months will tend to make more money than those who deliver today.
3). Form Arbitrage:
In form arbitrage, blending and processing of commodities are taken advantage of. Here, it could be far cost effective to source commodities from different locations at varying prices, then blend them to achieve the specification the buyer wants at a totally lower price to the commodity trader than to source the exact specification for a higher price.
A smart commodity trader would take advantage of all types of arbitrage to maximize their profits. When one or all of the location, time, and form arbitrages are combined to facilitate a trade, the margins generated from the trade are usually far higher than the average commodity trader would have earned.
Remember, when you source at the right place, store in the right location, blend with the right mixes, and deliver in the most efficient manner possible, commodity trading becomes a lucrative venture, even if it is supposed to be a large-volume low-margin business.
Commodity Trade Finance
Trade finance is how commodity traders get to always have enough funds or capital resources to ship commodities whenever an international buyer makes a request. This makes financial institutions key players in the commodity trading business, as without them, commodity traders cannot truly attain accelerated growth and success.
Since financiers play a key role in facilitating commodity trading, how do they do this?
They facilitate trade by funding commodity traders in means of a Letter of Credit. Here, they issue a bank payment guarantee on behalf of the buyer to the seller, with the intent to pay if delivery is successful and the terms of the contract are met. When financial institutions do this, they use the commodity as a collateral because if the commodity is delivered and paid for to the seller but the buyer fails to pay the bank, they can sell the commodity to regain their money. Now, the buyer would mostly no longer be in complete control of the commodity once it has been paid for because the bank would ensure that the market that needed the commodity gets to purchase it under their supervision, so they can regain their money and pay the buyer the rest.
For the sellers, they could go through the same route locally by their banks issuing a payment guarantee to the local mines, farms, or processing facilities. But these companies usually want an exporter who’s willing to pick it up at their locations, and so, may fail to work with a payment guarantee. Here, the exporter may then need to get their bank to open an overdraft to enable them to purchase from the local supplier under bank supervision. But in this case, you may be required to present an asset-based collateral.
While these trade finance processes for commodity trading may seem simple and that no financial institution should have a problem funding any business since they will only basically give a payment guarantee and not pay until the product has been delivered, it is key to know that past performances must be presented and proven before the financial institution would be willing to take a risk on your business.
How Does A Commodity Trader Guarantee Payment From A Buyer
The safest way to guarantee payment from an international buyer is to request an irrevocable confirmed Letter of Credit. In some instances, pre-payment is always agreed upon, but this presents a great risk to the buyer. But when a letter of credit is issued to a seller from a top rated world bank, the buyer’s bank would be obliged to pay as long as the shipment meets the terms of the L/C.
To Sum It Up
There’s so much more to learn about the commodity trading business which mostly only comes from active engagement in the industry. But with an understanding of the basics and a study of other commodity trading articles that we’ve previously published, anyone with a keen interest in the industry can have a good understanding of the trade process involved and have a good chance at success.
About The Author
This is an article written by Stan Edom, the Editor In Chief of Startuptipsdaily.com and the founder of Globexia Limited, a global commodity trading firm that exports solid minerals & agricultural products from Nigeria, and facilitates the global trade of oil & gas commodities.
This article along with others are written to help exporters and importers around the world to have a better understanding of the commodity trading business and to improve their chances of becoming successful in the industry.
If you’ll like to contact Stan Edom for questions or inquiries, you can reach him on +2348080888162 or via email at firstname.lastname@example.org.
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What are your thoughts on this complete guide on how commodity trading works? Let me know by leaving a comment below.