This week, energy company Shell was forced to issue an unusual apology. Days after the invasion of Ukraine, the company took advantage of a huge discount in the price of Russian flagship crude to buy 725,000 barrels of oil. The company didn’t break the law and the deal was a profitable one, but it badly misjudged the zeitgeist.

“We are acutely aware that our decision last week to purchase a cargo of Russian crude oil…was not the right one and we are sorry.”

Less widely known is who Shell bought its oil from. The company didn’t buy it directly from Russia; rather, it came from an intermediary trading company, headquartered in Singapore, registered in Amsterdam, with roots in Geneva. That company is Trafigura and it ranks as one of the largest commodity trading firms in the world. 

It’s not the first time Trafigura has slipped under the radar. In 2015, BNP Paribas was fined $8.9 billion by US authorities for sanctions violations. I’ve highlighted this fine a few times over the past couple of weeks because it reflects a key mechanism by which authorities ensure sanctions are upheld – they go after the banks that facilitate breaches because as long as a bank wants to access the US dollar system, that’s where they have leverage.

But banks don’t act alone; they finance transactions for clients. According to the statement of facts provided by US lawmakers in the BNP Paribas case, one of the bank’s violations “involved US dollar loans to a Dutch company to finance the purchase of crude oil products destined to be refined in and sold to Cuba [a country under embargo].” The Dutch company? Trafigura.

Trafigura has released its own statement about the situation in Ukraine, announcing that “following news of the terrible violence being inflicted, we immediately froze our investments in Russia.” But it’s difficult to know whether the company really means it. In the past, commodity traders would often look on sanctions and embargoes as an opportunity. Sanctions create bottlenecks, and navigating bottlenecks is what they do.

Although it avoided being implicated in breaching sanctions on Cuba, Trafigura did plead guilty to subverting the United Nations oil-for-food programme in Iraq. And the industry overall has a history of violations. Marc Rich, whose eponymous firm Trafigura’s founders hailed from, was involved in funneling oil into apartheid-era South Africa, in contravention of a strict embargo. Challenged earlier over his dealings with Iran in the midst of the hostage crisis, he said: “In our business we’re not political. We never have been. That’s the philosophy of our company.”

Trafigura is a private company, owned by 1,000 of its employees. It doesn’t have a stock price, or even a credit rating, so it’s perhaps no surprise it flies under the radar compared with banks like BNP Paribas. I’ll be honest – it’s not a company I’ve looked at much before. But it shares many features of the trading operations that I am familiar with as a student of investment banking. Given Trafigura now sits at the heart of much of what’s going on in the world, it’s worth taking a closer look. 

Triangulating Trafigura

For many years, Marc Rich had been the leading commodity trader in the world. But by the early 1990s, he had run into problems. In a foreshadowing of events that unfolded this week on the London Metal Exchange (paid subscribers can read more about those in More Net Interest below), he began to accumulate a large position in zinc. For a while, the price went in his favour, but it didn’t hold up and he was forced to liquidate at a $172 million loss. The loss rocked his firm and fuelled resentment among its ranks. Together with a small team, Claude Dauphin, formerly head of oil trading, left to form a new firm, Trafigura. 

At first, the firm struggled. Dauphin and his team traded across both oil and metals, although oil trading contributed the bulk of the profit in the early years. In the firm’s first full year of operations, it made a profit of $3.6 million, rising to $20 million to $30 million a year through the rest of the decade.

In some respects, trading oil or metals is much like trading financial assets. Indeed, many traders don’t care what they trade: stocks, frozen orange juice, Treasury bills, barrels of crude – to many, they’re just flashing numbers. Yet the dynamics of these markets diverge and that has implications for how trading firms are structured. 

In financial markets, risk transformation occurs principally in the digital domain. Instruct your broker to buy or sell a stock and an entirely digital clearing and settlement function mobilises immediately. Any friction in the process derives from legacy systems and regulatory input. It’s technically possible to settle US stock trades in a day, but the system (for now) is set up for it to take a little longer. 

Commodities are different because they occupy physical space. Consequently, although commodity traders use financial markets to fund their operations and hedge or limit price risks, their logistical infrastructure has to be more physical than anything a bank has in place. Both commodity traders and financial brokers see themselves as being in the distribution business rather than the storage business, but how this creates profit opportunities differs. 

In commodity trading, there are three ways to make money:

• Geographic arbitrage. Oilfields and mineral deposits are rarely near urban centres of consumption, which means commodities need to be transported across what can be many miles. Unlike financial markets, where pricing relationships are normally stable across regions (Bitcoin being a relatively recent exception), proximity to a product in the physical trading world can have a big impact on pricing. This creates arbitrage opportunities. Commodity trading firms can leverage logistical capabilities to source product in one location and deliver in another, taking advantage of pricing differences between the two.

• Product arbitrage. Pricing differences exist between different blends, grades or types of the same commodity. There are over 160 tradable crude oil products with many different refined products and numerous end-users with highly specific requirements. By changing the form of the commodity, traders can lock in a profit. 

• Time arbitrage. Over the long term, supply and demand tend to find a balance but, on shorter term horizons, they can remain out of sync. Trading firms can take advantage by storing commodities when supply is unusually high and drawing down inventories when demand is unusually high. This means they may have to hold onto assets longer than a financial trader would but, through derivatives markets, they can hedge out their risk.

Time arbitrage contributed especially strong performance in 2020. Normally, a trading firm may hold assets on its balance sheet for an average period of 35 days; 10 days in the case of oil. In 2020, the collapse in oil prices at the outset of the pandemic persuaded traders to hold for longer. Trafigura competitor, Glencore, filled the largest oil tanker in the world, the Europe, and waited, selling futures to mitigate its risk. The firm ended up making $1.3 billion from energy trading in the first six months of 2020, a record performance. Its CFO said that the return on equity on some of its oil deals was as high as 100%.

While these sources of arbitrage provide plenty of opportunity to make money, sometimes commodity traders lapse into outright speculation. That’s particularly the case among agricultural commodity traders, who deal with thousands of small farmers and are able to collate a unique information advantage. In oil or metals, there are fewer suppliers and so, while winning large contracts with them is critical to success, it is not typically a source of informational advantage.

“We’re speculators,” one CEO tells the authors of The World for Sale, a book which charts the history of the industry. “We don’t apologise for the fact that we do speculatively trade. The worst things that have happened in this industry have happened when people pretended there wasn’t a speculative element to what they were doing.”

Just as in the financial services industry, the history of commodity trading is littered with sizable trading losses – and not all of them authorised. In 1999, commodity trading company Andre & Cie was brought down by a rogue trader who lost close to $100 million on soybean options. Glencore lost money speculating in the aluminium market in 2008 and, as we know, Marc Rich lost money on zinc. Less visible are the gains because they are typically rolled up into underlying arbitrage profits and not called out. Cargill, the world’s largest agricultural commodity trading firm, supposedly made more than $1 billion in 2008 by shorting oil and freight. 

The profits available from bringing together these strands can be striking. In 2021, Trafigura traded an average of seven million barrels of oil and petroleum products per day and earned $141 billion of gross revenue off the back of it. Add in revenues it earned trading metals, and total group revenues exceeded $230 billion in the year. The costs of deploying logistics around the world are high, and there are costs associated with hedging exposures, so the firm’s gross margin is quite low at 4%. But that still left over $1.2 billion compensation to be shared out among its lean workforce, and $6.9 billion of EBITDA to be shared out among its even leaner ownership base. 

With a return on equity of over 33%, investment banks might be envious. Goldman Sachs earned a return of 23% in 2021. Nor is the difference due to leverage. Assets cover equity 8.5 times over in the case of Trafigura, compared with 13.3 times at Goldman Sachs.

Rather, the business is more profitable, even within the perimeter of commodities trading. In commodities trading alone, Goldman Sachs earned $2 billion last year, according to press reports. Its financial disclosures reveal $25 million of “value-at-risk” in commodities, which is the trading loss it would statistically be expected to incur 5 days in 100 given its risk exposures. Trafigura’s “value-at-risk” was $48 million, which means it earned gross profit of around $190 per unit of risk; that compares with Goldman Sachs, which earned $80 per unit of risk in commodities. 

Out of the Shadows

Over time, the history of commodity trading firms and the history of banks have become intertwined. Lehman Brothers began life as a cotton trading firm, buying from local plantations in Alabama and shipping raw cotton to Northern mills, before collapsing under the weight of its financial exposures. Goldman Sachs acquired J. Aron & Company in 1981, from which many of the bank’s future executives emerged. And that same year Phibro, formerly Philipp Brothers, one of the largest metals traders in the world, acquired Salomon Brothers (now part of Citigroup).

As financial derivatives provided a bridge between the world of commodities and the world of financial markets, many more banks became involved. In addition, because of their access to wholesale funding markets, which provided them with cheaper funding than was available to other participants in commodity markets, large banks became increasingly important in a range of commodity-related activities. 

Given the physical demands of trading commodities, many banks even ventured into physical infrastructure. “Just being able to trade financial commodities is a serious limitation because financial commodities represent only a tiny fraction of the reality of the real commodity exposure picture,” said the head of JPMorgan’s commodities business after she acquired a storage and warehousing network in 2010. “We need to be active in the underlying physical commodity markets in order to understand and make prices.”

However, greater regulatory scrutiny around their overall operations forced banks to retrench. In 2020, global banks made only around $12 billion from commodities trading, representing around 8% of their combined revenues across fixed income, currency and commodities. This compares with $8.6 billion of gross profit that Trafigura alone generated.

Even their lending to commodity traders has receded. In the past, banking relationships had helped fuel the growth of commodity traders. Indeed, the modern business of commodity trade finance took off when Paribas – later acquired by BNP to become BNP Paribas – started financing Marc Rich from its Geneva office in the 1970s. By using the cargoes of the commodities being financed as security, traders were able to get financing at a cost only marginally more expensive than the banks’ own funds. ABN AMRO, also heavily involved, financed the management buyout of leading oil trader Vitol in 1990.

More recently, banks have been getting out of commodities financing. In mid 2020, ABN AMRO pulled back, disclosing that three-quarters of the impairments it had suffered in its Trade and Commodity Finance business over the prior ten years stem from fraud – an indication of some of the murky practices evident in the industry. And after its fine in 2015, BNP Paribas stepped well away from the market. 

For large commodity trading firms like Trafigura, this is not a bad outcome. It means less competition from Wall Street firms, and less financing available for smaller competitors. Its own financing is fairly secure. Indeed, it raised a new revolving credit facility for $1.2 billion just this week to allow it to handle higher commodity prices which inflate its working capital requirement. Even before the recent rise in commodity prices, Trafigura’s CEO remarked in his annual report that “raising sufficient liquidity to operate with commodity prices at elevated levels is clearly a challenge for the sector.”

At the same time, some of its traditional competitors have diversified into production to supplement their trading model, in particular, Glencore. “Trading is not a big part of the company any more,” says its CEO. “We treat the trading as a good way to understand markets and make sure we are also selling our products well into the markets.” Glencore reckons it can earn a steady $2.2 billion to $3.2 billion a year from its trading operations – a fraction of what it makes in its industrial businesses. 

As a diversified commodity trader, with less competitive pressure from banks and from producers, and with funding secured, Trafigura should be well placed. In normal times, commodity traders like Trafigura would do well in an environment of rising volumes and high (but not too high) volatility.

But these aren’t normal times. The commodity markets have had a shock, which Goldman Sachs describes as “the sharpest change to global commodities markets since the 1973 oil embargo.” And at the centre of it all sits Trafigura. How it navigates the crisis is important for everyone.

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Recommended reading. For more on commodity trading, I would recommend The World for Sale by Javier Blas and Jack Farchy. For agricultural commodities, The New Merchants of Grain by Jonathan Kingsman is helpful. Further bibliography available on this Twitter thread.