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How commodities trade: The physical traders: transformation, finance and power

Understanding Commodities / Module 6: How commodities trade Part 5 of 5

The physical traders: transformation, finance and power

Behind the exchanges sit the firms that actually move the goods: Cargill and the grain houses, Vitol, Glencore, Trafigura and their peers. They make money on price differences rather than price levels, finance producers and buyers, and increasingly own ports, tanks and mines. Their size and secrecy have made them indispensable and controversial at once.

5.1 Traders transform commodities in space, time and form

Pirrong's framework is that every commodity must be transformed between mine or farm and user. In space, because production and consumption are far apart. In time, because crops are harvested once a year but eaten all year, and shocks must be buffered by stocks. In form, because soybeans must be crushed, crude refined and concentrates blended to a smelter's needs. A trading firm earns money when the price gap between the untransformed and transformed commodity exceeds the cost of the transformation.

His example: buy corn in Iowa at $5.00 a bushel and sell to Taiwan at $6.25. Elevation onto barge and ship, barge and ocean freight, finance in transit and insurance cost $1.15, leaving $0.10. The trader hedges the flat price with futures and lives on the spread. Profits depend on margins and volumes, which rise together, and peak in turbulent times such as the Iranian revolution or the Soviet collapse, when shocks open gaps between places, dates and grades.

Price transparency has been eroding the edge of pure trading. The response has been to buy assets. Trafigura's fixed assets rose from 6% of total assets in 2007 to 13% in 2012, while Glencore's reached 49% and Vitol's stayed near 5%.

Pirrong explains which ones with transaction-cost economics. Ships are mobile and charter markets are competitive, so traders rent them. Terminals and storage are fixed and few, and their owners could hold up a trader whose arbitrage depends on fast access. So traders own them, such as Trafigura's Burnside coal terminal on the Mississippi, or the ABCD firms' Amazon grain ports.

  • Pirrong (2014), The Economics of Commodity Trading Firms · pdf pp. 6-9, 14-15, 40-47

5.2 Two dynasties: the grain merchants and the Philipp Brothers line

Morgan reports a 1975 USDA finding that five family firms, Cargill, Continental, Louis Dreyfus, Bunge and André, handled about 85% of US grain exports; in 1974 Cargill alone shipped 42% of US barley exports and 29% of wheat. Their power came from controlling the pipeline: elevators, barges, rail cars, a quarter of New Orleans loading capacity in Cargill's case, and crushing plants in the United States, Brazil and Europe. Today Blas and Farchy report that the seven leading agricultural traders, led by the ABCD group of ADM, Bunge, Cargill and Louis Dreyfus, handle just under half of world grain and oilseed trade.

The oil and metals houses descend from Philipp Brothers, the metals trader built up by Ludwig Jesselson. Marc Rich, a trainee there from 1954, made his name moving Iranian crude through Israel's Eilat-Ashkelon pipeline. In 1973 he and Pincus Green bought Iranian crude at $5 a barrel against an official $3.29; ordered to sell, they watched the price reach $11.58 after the October embargo. In April 1974 they founded Marc Rich + Co in Zug. In 1979 it earned more than $1 billion, according to former executives. Rich was indicted in the United States in 1983 for tax evasion and trading with Iran, stayed in Switzerland and was pardoned in 2001.

In 1993-94 his traders forced him out and renamed the firm Glencore. Claude Dauphin and five colleagues left to found Trafigura with about $12 million. Vitol, started in 1966 with 10,000 guilders to trade fuel barges on the Rhine, became the largest oil trader in the 1990s. Marc Rich handled about 1.3 million barrels a day in the mid-1980s, Vitol 8 million in 2019.

  • Morgan (1979), Merchants of Grain · pdf pp. 31-33, 325-327
  • Blas & Farchy (2021), The World for Sale · pdf pp. 14, 26-44, 47-62, 69, 94-96, 114-128, 158, 281

5.3 Traders finance trade, producers and sometimes whole countries

Pirrong explains that a cargo is typically financed at up to 100% of its value through transactional bank lines, marked to market weekly and repaid when the buyer pays, hence called self-liquidating. Blas and Farchy credit Marc Rich and Paribas with popularising letters of credit, which let traders handle huge volumes on little capital. Defaults on trade credit in general averaged 0.02% in 2005-2009. In 2012 most traders had assets of 2.4 to 8 times equity, against a median of 10 for systemic US banks, and they fund short-term assets with short-term debt.

Traders also lend. An offtake agreement commits the trader to buy a set share of a mine's or refinery's output at a floating price. A prepayment adds money up front, repaid in deliveries; Pirrong notes that the discount on the price is in effect the interest. In tolling, the trader supplies alumina or crude, pays a fee and takes the output.

In mining, offtakes help projects raise finance. Humphreys reports that Japanese and later Chinese buyers preferred minority stakes plus offtake rights to owning mines. Scheyder describes Ford's binding offtake for lithium from ioneer's Nevada project in 2022, enough for 175,000 vehicles a year and worth about $800 million over five years. In a streaming deal a financier pays a miner up front for the right to buy a share of future output, often by-product silver or gold, then pays a preset price per unit on delivery, generally below spot; a royalty instead takes a share of the value of production, with no further payments.

At the extreme, traders finance states: Glencore arranged over $17 billion of oil prepayments in the six years to 2016, and with Vitol advanced Rosneft $10 billion.

5.4 Market power and controversy follow the traders

The traders insist they are apolitical and profit only from efficient transformation. Pirrong, writing with Trafigura's support, argues they are not too big to fail: smaller than systemic banks, modestly leveraged and free of the maturity mismatch that causes runs.

Four controversies recur. First, information and market power. Morgan quotes a North Dakota official describing a pyramid: thousands of farmers selling to a few hundred elevators feeding a handful of exporters, with information concentrating at the top. Blas and Farchy report that the five largest oil traders handle 24 million barrels a day, almost a quarter of world demand, and Glencore a third of the world's cobalt. Their trades for the marginal barrel or bushel often set the price.

Second, conduct. In 2010, while Glencore was long wheat and corn futures, the heads of its Russian grain business publicly urged an export ban. Two days later Moscow imposed one and wheat jumped 15%; Glencore's agriculture unit earned a record $659 million that year. ADM's ethanol lobbying helped divert one in six of the world's corn bushels into fuel by 2011.

Third, corruption, sanctions and harm. Rich told his biographer that bribes for Iranian oil contracts were the cost of doing business. Pirrong lists Trafigura's Probo Koala waste case and ADM's $54 million bribery settlement among the trade's legal risks.

Fourth, politics through finance. Vitol supplied $1 billion of fuel to Libyan rebels in 2011; traders advanced Kurdistan up to $3.5 billion, about 17.5% of its economy, before its 2017 independence vote; Chad's oil-backed debt to Glencore and partners reached about 15% of GDP. And over two decades Vitol paid 13% tax on more than $25 billion of profits.

  • Pirrong (2014), The Economics of Commodity Trading Firms · pdf pp. 5, 9, 17
  • Morgan (1979), Merchants of Grain · pdf pp. 324-325
  • Blas & Farchy (2021), The World for Sale · pdf pp. 10-14, 25, 69, 236-245, 276, 284
  • Blas & Farchy (2021), The World for Sale · pdf pp. 6-12, 248-249, 258

See it in the table

Cu CopperAl AluminiumAu GoldAg SilverLi LithiumCo CobaltWh WheatBly BarleySoy Soybeans

Check your understanding

In Pirrong's corn example, what is the trader's margin per bushel?

The $1.25 price gap less $1.15 of elevation, freight, finance and insurance leaves $0.10, earned on the spread with the flat price hedged.

Why do trading firms tend to own terminals and storage but charter ships?

Pirrong's transaction-cost argument: temporal and site specificity make ownership of fixed midstream assets efficient, while mobile ships can be rented without hold-up risk.

In a commodity prepayment, where is the interest on the advance usually found?

Pirrong notes that the seller gets cash up front in exchange for lower payments later; the price discount is in effect the interest.
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