Chapter 5

Oil Trading
Matthew Ellis
Cargill, Incorporated, Minneapolis, MN 55440-5724

Introduction
Trading plays a key role in the fats and oils industry. It serves as the major method of price discovery; it facilitates price risk management and the transformation of oils and fats from places, times, and forms of plentiful supply to places, times, and forms of poor supply. Agricultural products such as oils and fats represent commodities that approximate most closely behavior consistent with pure competition as it is understood in economic theory. Especially when taken in the international context, there are a large number of participants who as individual companies do not produce or consume a quantity sufficient to affect the price of these commodities to any measurable extent. Therefore, the fundamental relationships of supply and demand are much more responsible for changes in price than in many other industries. What this means for anyone involved in the fats and oils industry is that price volatility is a major issue because the market value changes by the day, hour, or minute. As the marketplace perceives a change in the relationship of supply to demand on the basis of constantly changing information such as weather, prices of competing crops, economic conditions, government policy or exchange rates, so too does the price of the oil in the marketplace change. For anyone involved in the producer-processor-consumerchain of oils and fats, price volatility translates into a major risk factor in doing business because the magnitude of value added at each step can be appreciably less than the market price swings during the time in which a commodity is being held. A farmer who makes planting decisions in February that are based on a perceived market price obtainable in October may be very disappointed when October finally comes. The management of these price risks and the tools used in this management are generally the most confusing aspect of commodity trading to a newcomer to the field.

Purpose
Price Discovery

The trading of oils and fats provides the essential function of determining prices for various grades of vegetable oil and animal fat at any point in time. This allows the participants to make decisions on the type of fat to buy or sell, the shipment or delivery period in which to sell or buy, and the correct time to enter the marketplace to
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make transactions. The process of price discovery occurs through many participants making offers of quantities and qualities of oil that they would like to sell and others making bids for what they would like to buy. It is not unheard of for the same participant to have an offer and a bid in the market at the same time, the former higher than the latter, of course. It is important for participants to know the relative values of different fats and oils at various places around the world so that they can make both short-term and strategically efficient decisions for their companies. For example, if a producer of bottled vegetable oils for retail sale is selling a blended vegetable oil, he will be looking at the relative price of soy, sunflower, and canola oil to determine how to make the product at least cost without changing his retail price.

Risk Management.
With the increasing globalization of the fats and oils trade, the volatility of prices has increased immensely. Weather conditions in the corn belt of the United States during the growing season are no longer the prime variable in the marketplace; other factors such as palm oil production, Indian demand, Chinese crushing economics, and South American weather have been added to the equation. The role of managing risk has become much more important. Different players in the industry have different levels of risk, depending on the part of the chain in which they are involved. The producer carries an enormous amount of risk, given that the price of what he sells has very little correlation to the price of his inputs; therefore, how high he is able to sell will have a direct effect on his income. Processors generally have a high degree of correlation between the prices of what they buy and what they sell; however, they have risk between the time that they take delivery of their raw material and the time at which they sell their finished goods. Consumers, in general, experience a minimal relationship between the price of the ingredients they buy and the goods and services that they sell. For example, even though the prime ingredients of French fries are potatoes and vegetable oil, a restaurant chain will very rarely change the price of fries when the price of oil changes. Therefore, how low they are able to buy will have a large effect on the profitability of the restaurant business.
Transformation

The other important function of trading is the movement or transformation of oils and fats from places, times, and forms of surplus to places, times, and forms of shortage.
Place. There are many more soybeans crushed in Iowa that there are people to consume them. At the same time, there is much more oil consumed in New York State than there is oil produced. Thus, the price of oil is higher in New York than in Des Moines, and it is the function of the trader to move the oil from the lowerpriced market to the higher-priced market in the most efficient manner possible to make a profit.

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Time. Annual crops such as soybeans, sunflowers, and canola have only one harvest per year. The crops are most plentiful in the months after harvest and are scarce in the months leading up to harvest. Demand for those crops, however, is relatively constant throughout the year. It is the function of the trader to buy commodities when they are cheapest during harvest and store them until they are needed, in the most efficient manner possible to make a profit. Form. The palm plantations of Malaysia and Indonesia produce large amounts of crude palm oil. The margarine manufacturers and biscuit makers of Europe consume a large amount of palm oil-based shortenings, whereas consumers in India use a large amount of cooking oil. The palm oil refiners in both the Far East and Europe buy the crude from the plantations; through refining and fractionation, they turn it into cooking oil and shortening in the most efficient manner possible to make a margin. It is the trader, through the diligent purchase of crude oil and the sale of olein and stearin, who ensures that the refining business operates at a margin.

Participants
Producers
The farmer plays a large role in the commodity-trading picture because the decision to plant or not plant one commodity vs. another has a major effect on the perceived supply of a given commodity and, therefore, the price. In recent times, the plantations of the Far East, which have 20-year production cycles, have also played an increasingly important role in the behavior of prices. The producers willingness or reluctance to sell at any given time can have a major effect on either the basis or the futures price or both. The producer also carries a great deal of risk, which must be managed to remain competitive.

Processor
Processors include flour millers, corn millers, oil refiners, oilseed crushers, or others who are buying essentially raw agricultural products and producing value-added products sold as food ingredients. Processors generally buy from country elevators on the basis of the futures market and sell products in the same way.

Brokers
Brokers can insert themselves into any step of the chain and provide the service of putting together a buyer and a seller. They do not take positions in any goods, but are paid a fee, generally by the seller, for each unit of product for which they arrange a sale. Brokers provide the service of keeping small customers apprised of markets and act as industry clearing houses for information.

Dealers/Shippers
Unlike brokers, dealers actually take title to goods and also positions in the market. They are particularly active in flat-price traded commodities such as tallow, palm, or

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coconut oil. Dealers provide a measure of liquidity to markets that otherwise would require a small number of producers or processors getting together with a small number of consumers whose timing of trading may not coincide.
Consumers

At the end of the chain is a group who is buying a raw commodity or a processed commodity for use directly, or as an ingredient, in a food product. Consumers have the common characteristic of being very concerned with the flat price of the commodity with which they are dealing. A consumer can be a country, a food company, or an individual.
Others

Many other participants can enter into the process of commodity trading, including shipping lines, freight brokers, export brokers, commission houses, surveyors, tank terminal operators, banks, and expediters. A discussion of the roles played by these participants is far beyond the scope of this chapter, but they are mentioned in order to give some further insight into the complexity of many commodity trades and an appreciation of the skills required of an experienced trader.

Tools of Trading
Trading Rules

The first area for any aspiring trader to study is the relevant trading rules for the commodity in which they will be dealing. These not only outline the rules for weights, payment terms, invoicing, shipment periods, and so on, but they also stipulate the quality characteristics, which are of prime importance. Many organizations participate in the setting of trading rules for commodities. In the United States, the government sets the rules for corn, wheat, and soybeans, and the NIOP (National Istitute of Oilseed Products), NCPA (National Cottonseed Products Association), AFOA (American Fats and Oils Association), and NOPA (National Oilseed ProcessorsAssociation) for other oilseeds and oil- and meal-related products. International bodies such as FOSFA (Federation of Oilseed Seeds and Fats Association), PORAM (Palm Oil Refiners Association of Malaysia), AVOC (Asian Vegetable Oil Clubs), PCOPA (Philippine Coconut Oil Producers Association) and ANEC also have rules for the trading of fats and oils. Although these organizations have standard quality definitions and quality characteristics, these and other contract terms are subject to modification by the buyer and seller. Trading rules, as they relate to the quality aspects of products, become less and less important as agricultural products are more and more processed; they become differentiable on the basis of their particular attributes related to performance. Trading rules are not perfect, but they are necessary to ensure that some standards that will protect both buyer and seller are in place. They are also extremely important in expedit-

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ing contract negotiations because a number of terms can be agreed upon quickly by referencing a certain set of trading rules.
futures Markets

The futures market, as typified by the Chicago Board of Trade, is the single most important tool for managing the price risk involved in commodity trading. The concept of a futures market goes back many years and evolved from the necessity for farmers and interior elevators to be able to store crops through the winter (when frozen water ways prevented delivery) and sell them in the spring with some certainty of their selling price. In this transaction, the two sides of the futures market become apparent, i.e, one is the farmer who is minimizing price risk by selling his crops for a known price; the other is the merchant or processor who wishes to source raw materials to operate his facilities through the summer months before the next crop becomes available. This started with forward contracts in the 1850s and later evolved into what is now known as the futures market. However, the real facilitator of the modem day futures market are the speculators. They are participants who have no interest in either making or taking delivery of the physical commodity, but are betting that they are better at forecasting future prices than the rest of the market. It is important to recognize this principle of risk transference, which is a very important function of the futures market, whereby those involved in the physical handling of commodities (producers, transporters, processors, consumers) can transfer their price risk to speculative participants. These participants have no intention of actually being involved with physical commodities, but instead are gambling that the market will go either up or down from the price at which they have bought or sold. Another function that the futures market provides is liquidity. An active futures market used by many buyers and sellers means that buying and selling can always be accomplished. In a nonliquid market, it is sometimes difficult to find a buyer when someone wants to sell (or vice versa), if the buyers and sellers are scattered all over the world.
Hedging

Although the terms of a futures contract specify quantity, quality, and specific deliverable locations, it is seldom that any one in the producer-processor-consumer chain ever intends to deliver or take delivery under the terms of a futures contract. The futures market is used instead as a paper transaction to offset an actual physical commodity transaction or cash trade. For example, in March, a fanner wants to lock in a price for beans to be harvested in November. He does this by selling November bean futures at the market price of $6.00/bushel. When November comes and the beans are harvested, the beans are not delivered on the futures market according to the terms of the futures contract. They are sold instead to the local elevator at a price, which is based on the current futures market. The farmer receives a check from the elevator for his beans and immediately buys

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back the futures, which were sold in March. The money that was made or lost on the futures position is offset by an opposite gain or loss in the cash transaction. The analysis of this transaction in trading terms is as follows: In March, the farmer wants to sell his November beans, in other words he is long cash November beans. He sells November futures so that he is now short futures and long cash or a net even. In November, he sells cash beans to the elevator so that he is now even cash, but short futures and immediately buys the futures to become even in all positions. Two things must be remembered, i.e., (i) the farmer receives $6.OO/bushel no matter what the market does between March and November, and (ii) the rules of hedging are as follows: Buy the cash, sell the futures; sell the cash, buy the futures. Because the concept of hedging is so important in understanding commodity trading, another example is appropriate. In this case, assume that a soybean oil refiner is involved and that this refiner requires $0.04 over crude oil cost to cover refining and profit. In this case, also assume that crude oil has to be bought 2 mo in advance in order to be at the refinery when it is actually needed to produce finished oil. Crude oil is purchased on the basis of the futures market price, and refined oil is sold on the basis of the futures market price.
Step I . Assume that crude oil is required for July, and a deal is struck between a refiner and a crude producer for July oil with a futures price of $0.2200 Ib. At the time this price is agreed upon, the refiner immediately sells futures at the same level to offset the cash purchase. (Because the crude oil producer is also operating in a hedged fashion, he or she buys futures to offset the cash sale. This process can be short-circuited by a direct transfer of futures from the refiners account to the crushers account at an agreed upon futures price level.) At this point, the refiner is long July cash oil and short July futures or net even. Step 2. It is now July and the refiner sells refined oil to a customer at $0.04 plus the July futures price, which has dropped to $0.1700/lb. or $0.2100 for the refined oil. At the time of the sale of refined oil, July futures are bought at $0.1700 so that the position is even cash and even futures. In this case, oil was bought at $0.2200 and sold for $0.2100, yet the refiner still received the $0.04 required to run the refinery. The transaction works as follows:

In the cash transaction, the refiner bought crude oil at $0.22/lb. The refiner sold refined oil at $0.21/lb. The cash gain or loss = $O.OI/lb loss. In thefutures transaction, the refiner sold futures at $0.22/lb and bought futures at $0.17/lb. The futures gain or loss = $0.05/lb gain; the net transaction = $0.04/lb gain.

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The concept of hedging is so basic to commodity trading that it is simply automatically assumed to be functioning in trades between various links in the processing chain. Everything is done basis the futures market, which leads to the way trading is actually done or basis trading. Basis Trading In the examples shown above, the cash price and the futures price were assumed to be the same. This is virtually never the case; although the futures market determines the value of a commodity on a macrobasis, the actual value of a given commodity in a single location is determined by microeconomic factors in a given area. Freight considerations, supply factors, and alternatives to a given commodity in a given market all contribute to a cash market, which is different from the futures price. For example, soybean oil may have a cash value (in basis terms) of 200 over FOB Gulf, 440 under FOB South America, 40 under FOB Illinois, 80 under in Western Iowa, or 20 over in Georgia. The overs and unders refer to the Chicago Board of Trade futures price for the time period under discussion. Commodity handlers and processors practice basis trading to such an extent that values of commodities are virtually never discussed in terms of basis plus futures (flat price) but are discussed in the basis terms only. The basis is extremely important to processors because it is the basis that reflects any efficiencies or competitive advantages of one processor vs. another.

Flat Price. Flat price is largely irrelevant to the middlemen in the chain linking producer to consumer because it can be managed in large part by hedging (although basis risks need to be similarly managed); nevertheless, flat price is extremely important to producers (farmers) who ultimately receive a check for the flat price of their commodities, to consumers who ultimately have to factor in a flat price as an ingredient cost, and to traders who deal in commodities for which a futures market does not exist (e.g., palm oil, coconut oil, peanut oil, tallow, lard, and others). A flat price commodity trader has a much more difficult time from both a hedging and liquidity standpoint. It is the flat price that also determines the relative competitiveness of commodities on a worldwide perspective.
Supply and Demand Analysis In this chapter, we have mentioned many aspects of trading that rely on traders making the correct decisions concerning when and at what levels to buy and sell. Essential to making those decisions is a good understanding of current supply and demand trends and their effect on future prices. A number of companies invest significant amounts of time and money in this endeavor. The large trading houses have several economists who collect data, create models, and attempt to predict the future; they use this for their own profit. Futures commission houses also exert a similar amount of effort, sharing the results of their efforts with their clients. There are also

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independent research houses that sell their information and analysis for a fee. In addition to these, the government also expends large amounts of effort through the U.S. Department of Agriculture to forecast supply and demand trends; this is available to the public through monthly updates. No matter how a trader receives his information and analysis, it is important that he understand the implications of market-moving events on the level of supply that will be available to the market and the corresponding demand for those products. This chapter is not the place to list all of the variables that can affect supply and demand (hence prices); however, they include such factors as weather, planting intentions, yields, soybean meal demand, storage capacity, railroad performance, overseas demand, overseas crop production, and consumer preferences.
Government Policy

No discussion of commodity trading and pricing mechanisms can ignore the role of government in agriculture around the world. Government subsidies and the mechanisms whereby these subsidies are given play major roles in determining relative competitive advantage of one country vs. another in world markets. Because world prices of commodities are a function of complex subsidy interaction, any change in agricultural policy can have major implications for commodity prices. At times, U.S. government policy acts as a floor for commodity prices; at other times, it acts much like a ceiling. For a commodity trader, forecasting the actions of governments in agricultural policies can become as important as forecasting supply and demand factors in price prediction.
Suggested Readings
1. Commodity Trading Manual, The Chicago Board of Trade, Chicago, 1989. 2. Modern Commodity Futures Trading, Gold, Commodity Research Bureau, New York,

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3. The Professional Commodity Trader, Kroll, Harper and Row, New York, 1974. 4. Schwager, J., ed., A Complete Guide to the Futures Markets: Fundamental Analysis, Technical Analysis, Trading, Spreads and Options, Wiley, New York, 1984. 5. Hedging and Cross Hedging Selected Vegetable Oils, Fryar Oil Crops Situation and Outlook Report, February 1988. 6. How Flour Millers Employ Hedging, Grain Age, August 198 I . 7. Grains, Production, Processing, Marketing, The Chicago Board of Trade, Chicago, 1982. 8. Campbell and Fisher, Agricultural Marketing and Prices, Melbourne, 1986.