Alan Kovski © 2013  |  All Rights Reserved

Commodity markets, especially oil

Most of what you have read in newspapers about commodity markets probably was dead wrong. The daily market reports, in particular, tend to be nonsense. The market players and analysts who participate in or follow the markets do not give away their knowledge for free. Their best information is too valuable. It is used to provide the trader with an advantage in buying or selling. Or the knowledge is sold, or traded, or selectively shared for favors. It is not given away to reporters.

Here is how it works when a reporter calls an oil trader to ask, let’s say, why the price of oil in Houston dropped $2 a barrel that day. The trader may know why the price drop occurred. Let’s say it was because a big company chartered several tankers to take additional West African crude to the Texas Gulf Coast. That action means a temporary surplus of oil will appear on the Texas Gulf Coast, when the tankers arrive to help glut the market. So traders decided to bargain the price of crude down in Houston in anticipation of a temporary glut.

When the reporter calls up to ask about the price drop, the trader does not want to give away behind-the-scenes information. Again, to stress: knowledge is valuable. So what does the trader say? He looks at his computer screen, sees there is news of fresh worries about policy disputes over government debt in Europe, and he tells the reporter, “The price went down because of worries about European debt. That could depress economies, which could depress oil demand. So the price went down.”

Sheer nonsense. The trader fed the reporter that nonsense because it was free information, not valuable behind-the-scenes knowledge. It was information that anyone could get by turning on their computer and looking at the economic news. It was worthless to the trader. It was crap. But it pacified the reporter, so the trader has pleased a person who might—who knows?—someday be useful to the trader, if only because of the publicity for the trader’s employer. And that is what gets reported in the newspapers and in the wire services on the internet: crap used to pacify a reporter.

Some reporters understand what is going on and play the game because their employers pay them to do so. The employers and editors may not understand how the game is played. The reporter does not want to write crap, but he has a mortgage to pay, so he writes something to pacify his editors and keep himself gainfully employed. His report goes out on the internet via some wire service, and other traders and reporters see it and use it as a justification for saying and writing similar nonsense. Another day of market reporting is wound up. Some editors also understand exactly what game is being played, but they go along with it for the same reason the reporter does, because it is expected or mandated from above.

Commodity markets have some appealing characteristics. There is a basic logic of supply and demand, with price fluctuations reflecting the shifting imbalances. It is not like an industry where the fashion-following tastes of the public might dictate a market outcome, or a wave of advertising might suddenly tilt the market, or a tight web of contracts among entrenched players might dictate things, or a basic superiority of product might overwhelm the competition. No, at its best, a commodity market is the logic of supply and demand, and there is something satisfying about that, about logic and fundamental realities.

Notice I qualified the preceding phrase with “at its best.” Markets are not perfect. They come in differing degrees of imperfection, and are rarely at their best. But in the big markets there is enough of that supply-and-demand logic to be satisfying to those of us looking for some basic realities.

The logic of supply and demand also has a peculiar pitfall. Competitors can see the same imbalances, and they may try to take advantage of those imbalances at the same time and in the same way. In doing so, they may undercut each other by moving en masse to buy the same crudes, therefore driving the price up and losing the bargain advantage. They may shift en masse away from some crude because it is overpriced … and their shift away causes the price of that crude to drop with falling demand, creating a bargain as a consequence of being abandoned. And because all of the market players understand all of this logic—this risk of simultaneous movement by players—they engage in a lot of feinting, shadow boxing, maybe issuing statements full of bravado about what they will do in the hope of deterring a competitor from doing the same. The deterrent is the idea that you are a step ahead of the competitor, so the competitor should not bother following your lead.

And there is more than just a simple logic of supply and demand. Another appealing characteristic of commodity markets is that all sorts of complications can be found when you get beneath the surface. Complications of commodity quality, location, buyer need, seller need, overlapping markets. The complications are many, and they keep it interesting. More than that, they keep consultants and oil company staff analysts employed in studying the markets and making recommendations to the oil companies on what equipment to install, what crudes to buy, what markets to cultivate—in effect, what the overall strategy should be. If it were easy, everyone would do it, and everyone would do it in the same way, following the same logic. That would leave no bargains, no surprises, maybe no need for analysts or even traders. Just automate it and be done with it.

Hedging is the term for signing contracts that will counterbalance adverse market movements. If you want to sell a commodity—oil, wheat, hogs, copper, whatever—you may want to hedge in the futures or derivatives markets so that a drop in the price of the commodity, hurting your sale price, is counterbalanced by a profit from the futures or derivatives. Hedging can take the risk out of the market. It also can squeeze profit out of the market for the hedger, so you have to know what you’re doing. Reduced risk comes with reduced profit.

Contracts also can take risk out of the market. A contract can provide that for every increase in the crude oil price by $1, the refiner will receive an equivalent price boost from his refined products made from that crude. So the price increase is passed on automatically to protect the refiner from market risk. The risk is transferred to someone else, who is willing to take that risk because of his own estimation of the counterbalancing rewards.

A trader always wants a certain amount of risk. The risk justifies his existence. The trader wants some price volatility because he feels confident about his ability to understand and profit from that volatility. Too little turmoil—a flat market—leaves no opportunity for noteworthy profits. (If it stays flat, there is no need for traders.) Too much turmoil can ruin the participants. The trader needs a middle range of volatility, potentially profitable but not likely to be ruinous.

Gossip is useful. Temporary trading alliances are useful. Financial backers are useful. Diplomacy is useful. (You haven’t angered a member of the Saudi royal family, have you?) Above all else, foresight is useful. Did you install the right kind of equipment in your refinery at the right price and the right time? Did you invest in the right oil fields or prospective fields? Did you lock up a set of buyers in contracts at the right price and the right volumes to weather the troubles to come? Did you sell that refinery before the government slapped another set of expensive regulations or taxes on it? Foresight—analytical acumen—is the great gift of some market players. But luck can be even better.

November 2012