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Business Management Review | Wednesday, September 27, 2023
The next normal in commodity trading promises to be a dynamic and transformative phase, presenting various opportunities for players to adapt and thrive in the evolving landscape.
FREMONT, CA: The commodity trading industry has experienced a positive trajectory, and its future prospects appear promising. The industry is now at the cusp of a new phase, referred to as the next normal. This transformation is driven by the ongoing energy transition, which encompasses economic and physical changes that integrate global food, energy, and materials systems. From a commodity trading perspective, this transition will lead to increased structural volatility, disrupt trade flows, redefine the concept of commodities, and fundamentally alter commercial relationships. These developments present both unique opportunities and challenges for both existing and new players in the industry.
The liquidity in commodity markets has significantly increased over the past five to ten years. Although certain events, such as the drop in liquidity in power and gas trading, have occurred in recent times, they are unlikely to impact the overall positive trend. One significant contributing factor to the rise in liquidity has been the shift of large producers from direct-to-consumer (D2C) sales to trading, as it allows them to capture more value from their global logistics, systems, and inventories. Similarly, some major customers have moved away from long-term contracts (LTCs) to take advantage of benefits from the spot market.
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Market developments in recent times have facilitated this increased liquidity. New exchanges and platforms are surfacing, as are changes to regulations and standardization of contracts. A number of improvements have also been made in the area of price transparency, access to structured and unstructured data, such as satellite images and infrared imaging. As barriers have lowered, market participation, transaction volumes, costs, and speed have all experienced positive growth. While market volatility may have led some customers to reconsider LTCs, the overall increase in volumes will likely ensure that short-term volumes also see growth. This overall trend indicates that the addressable market for all commodity flows continues to expand.
The current market environment has heightened the perception of risk among customers, prompting many to pursue LTCs. Although these contracts may not significantly reduce risk, they offer customers the ability to lock in a price mechanism and secure a stable supply. On the other hand, producers may gravitate towards short-term markets to avoid the negative impact of reduced flexibility, neglecting arbitrage opportunities arising from short-term volatility, and facing high hedging costs for illiquid long-term positions. Short-term markets may be slowed by regional or commodity-specific nuances, and producers may still use LTCs to make projects bankable and finalize investment decisions (FIDs). Consequently, a potential outcome could be a world where short-term volumes remain robust, and price indexes are recalibrated to more liquid and stable benchmarks.
In the context of new commodities, producers will likely need to maintain the ability to adjust production levels rapidly, which could be challenging if they are bound by offtake agreements. Emphasizing the ability to switch between producing and selling power and hydrogen based on short-term market conditions would encourage commodity players to return to short-term markets over time.
To avoid hindering the energy transition, producers of new commodities may move faster towards short-term markets compared to those dealing with commodities like LNG and power. Established global players are well-positioned to benefit from this trend due to their diversified portfolios and strong balance sheets, enabling them to handle long-term merchant risk associated with asset investments while actively participating in short-term markets.
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