The Fuse

Oil Merchants Contend With New Market Reality, Possible OPEC Deal

by Matt Piotrowski | October 19, 2016

While the drop in oil prices in 2014 put intense financial stress on the international oil majors, independent U.S. shale producers, petro-states such as those in OPEC, and services companies, there was one group that thrived: The major trading houses. They took advantage of the sharp increase in volatility, the widening of the futures curve, the decline in overall costs, and the jump in arbitrage opportunities to boost their profits. In addition, they also snapped up assets to hedge against risk and diversify their portfolios. In fact, 2015 was a bumper year for the likes of Vitol, Trafigura, Glencore, Mercuria, and Gunvor. Their earnings are never dependent on the flat price of oil. As Gunvor’s David Fyfe told The Fuse earlier this year, “It must be said that the flat price is immaterial to us. It’s all about spreads and arbitrage. In some ways, we benefit from lower absolute price because capital requirements are lower.”

The merchants have typically resorted to operating in the shadows of the oil markets, exploiting opportunities under the radar, as they moved cargoes from a point of surplus to a point of deficit. But recently, they have become more open and transparent about their financial status, their outlooks on oil prices, and their operations across commodity markets. All signs now point toward tougher times ahead.

But the situation has changed. Volatility has dampened for the time being, while the contango—when prompt prices are lower than deferred contracts—has shrunk. Meanwhile, refining margins have taken a hit and the entire trading landscape continues to be hyper-competitive. As a result, the big oil traders are experiencing a tough year, and the outlook for the foreseeable future is uncertain. The merchants have typically resorted to operating in the shadows of the oil markets, exploiting opportunities under the radar, as they moved cargoes from a point of surplus to a point of deficit. Recently, though, they have become more open and transparent about their financial status, their outlooks on oil prices, and their operations across commodity markets. All signs now point toward tougher times ahead.

Speaking at the Oil & Money Conference in London this week hosted by Energy Intelligence and the International New York Times, CEOs of several of some of the big trading houses highlighted the stress on their margins from current market conditions. Ian Taylor, head of the world’s top trading house Vitol, said that this year will not be as strong as 2015 when the company posted record earnings and trading volumes. According to Bloomberg, profits for the first six months of the year totaled $546 million, down by almost $400 million versus the same time in 2015.

Gunvor’s CEO Torbjorn Tornqvist explained why profits are taking a hit. In order to thrive, traders have to spot arbitrages quickly since competition is “intense.” He added that companies have to be better and faster in order to survive as a result of the small-margin environment. “Margins are very small and margins for error are even smaller.”

“Margins are very small and margins for error are even smaller.”

Margins are overall very thin in the trading world, creating a barrier to entry for smaller players. Traders must be nimble in order to take advantage of arbitrages between geographic areas and the spreads between crude and products. Commodity trading typically generates high revenues, but that fronts a very competitive environment and mostly low-margin business. Taylor said that the severely competitive environment has kept out many small firms, noting that the number of players is far less than seen in the 1970s through the 1990s.

Against the backdrop of a tougher environment, traders are looking to diversify their asset base and trading volumes. Dutch company Trafigura, for instance, is now trading around 3 million barrels per day, as it has deepened its ties with Rosneft and is reselling Russian Urals. Glencore, the only big merchant that is publicly traded, is now trying to muscle its way deeper into unstable producers such as Libya, Iraq, and Iran. After a robust 2015, the trading house reported a 47 percent drop in earnings for the energy trading division in the first half of 2016, another reflection of the difficulties facing the merchants. The ventures into these petro-states also highlight how big traders are willing to take risks in volatile areas when they see opportunities that others, such as oil majors, avoid because of danger. One major example occurred in 2011, when Vitol supplied fuel to the Libyan rebels that ousted the Qaddafi regime.

OPEC cut to have limited impact

Given that the traders deal with many of the OPEC producers, the cartel’s decision will likely have a meaningful impact on their market outlooks and arbitrage opportunities throughout different regions.

Just like the rest of the oil market, the merchants are closely watching OPEC’s upcoming meeting in late November. Given that the traders deal with many of the OPEC producers, the cartel’s decision will likely have a meaningful impact on their market outlooks and arbitrage opportunities throughout different regions. Based on comments from the CEOs at Oil & Money, the big traders see OPEC striking a deal, but its effect will likely be relatively small. They predict that oil prices will be in the mid-to-high $50s a year from now, not much higher than current levels.

Taylor said: “There is obviously a definite willingness and desire on behalf of most OPEC countries to see the price a bit higher. But to do that, they will have to cut back. They have done it before, they can do it again. I am not quite sure who is going to do what.”

He added: “My expectation is that we get [some sort of OPEC deal] but whether it’s quite enough to really cause a substantial rebalancing in the short term, I don’t know.”

Gunvor’s Tonrqvst argued that the futures market has already priced in an OPEC deal, but he also pointed out how costs have fallen sharper than expected, keeping a ceiling on any price rally. Mercuria’s Daniel Jaeggi agreed with the two that a deal would occur, saying there is now “political will” to follow through on an agreement, in contrast to previous meetings.

High risk, high reward

Oil traders, like the rest of the industry, have had to adjust to new market realities since shale boomed earlier this decade, OPEC has shifted its strategy, increased outages have occurred, and oil prices collapsed spectacularly. While merchants have benefited from a number of trends, they also have to navigate through unfavorable conditions similar to what is occurring now. The trading business has always been volatile, and it will likely remain that way. The big merchants are nimble, and will pounce on opportunities whenever they arise despite the risks involved.

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