Everyone loves rooting for the underdog, so those with an eye on the refined products market across Europe and the Middle East should be looking forward to a 2016 that largely belongs to the tier two and three traders.
That’s not to say that the traditional big hitters aren’t still playing, or that they’re set for any particular shock, but the way the market has developed recently has made conditions much more amenable to their smaller, more nimble competition. Volatility is the new normal and the finance is finally flowing to bankroll oil trades again.
As the market changes, so too do the market participants. The leviathans are still there, but the smaller players are the ones to keep an eye on this year. Often these will be small trading outfits focused on crude and refined products – not necessarily new entrants to the market, but not the usual success stories either. Commonly, two or more such players will create a joint venture between them to pool their risk and resources whilst remaining small enough to be agile and take advantage of the environment 2016 has gifted them.
Out with stability, in with volatility
Oil and related commodities were some of the most stable asset classes around not so long ago. Demand was predictably and steadily high, and OPEC members cooperated to keep the price high. Equities or FX traders could only dream of such a set-up.
But then 2015 happened: oil crashed. American shale flooded the market, and OPEC refused to adjust production to maintain the pricing status quo, hoping to race the more cost-intensive shale to the bottom and reclaim market share. Suddenly, no one knew what was coming next, and volatility rocketed.
A little volatility of course, is a good thing. All traders need a little volatility to find opportunities. But the bigger the trader, the more they crave some stability too. Listed companies like Glencore have shareholders to think of and possibly dividends to pay (Glencore felt it had to suspend its own dividend payments in response to the crash).Privately owned tier-ones like Trafigura may not be beholden to a share price, but they still have nervous investors to placate.
Big traders are less able to take positions deemed high risk; they have to keep within a certain margin of safety. Their trading strategies are naturally more conservative in order to assuage a legion of risk and compliance managers.
A lot of smaller players aren’t constrained in the same way. The smallest may have invested their own capital in the company, answering to no one, and external investors in smaller trading outfits tend to be have a larger risk appetite to start with. They can be more flexible in terms of their trading strategies and approach to risk.
A certain portion of the market’s deal flow is therefore more suited to the smaller players, and the higher risk is often commensurate with higher rewards.
Some will fail of course, and may lack the reserves to fall back on that tier-ones enjoy. Plenty will make educated bets that pay off though, and they’re perfectly positioned to take 2016 by the horns.
Volatility rewards agility
It’s not just their capacity to take riskier bets that benefits the little guys in these uncertain times. Also key is their agility: their ability to respond quickly to the twists and turns of an erratic market.
Imagine a tier-one as one of the super-tankers its assets are shipped in: huge, impressive, but a two mile turning circle. By contrast, the smaller players are nimble: they can turn on a sixpence and respond quickly to changing events as they have much less complex portfolios and considerations to factor.
For example, when the US lifted oil export sanctions, Glencore was well-prepared and took many of the first cargoes. Good for them, but the others piling in just behind them were the tier twos and threes, stealing a march on their larger cousins.
Get it on credit
Before the financial crisis, a trader in the oil and refined products space would typically have a trade finance relationship with one bank.
When the crisis hit though, panicked banks didn’t want the exposure anymore, looking to split it where they could, or otherwise offload it. This meant less trade finance available to smaller, more highly leveraged players and more difficulty getting at what credit was available.
Now the banks are more stable as the recovery continues, but more importantly, oil has crashed to around $30-40bbl. At this price, the capital requirements to provide credit are lower, and so too are the banks’ exposure to the oil and refined products market relative to their total portfolios.
This means they can take on more risk, and extend more credit to finance trade deals in the sector – not really relevant to a tier-one, but of huge consequence to the smaller trading houses. They suddenly have access to a huge amount of capital to trade with, especially when sharing risk in joint ventures.
This means more is at stake for those who make losing trades, but greater returns and market share for the smartest players.
Whilst there is no reason to predict the demise of the tier-one energy commodity traders in 2016, there is reason to be optimistic for their smaller competitors, who should continue to see ideal conditions to take some market share. Those conditions won’t last forever, and traders should make hay while the sun shines: 2016 looks like a year that belongs to the little guys.
By Amrik Sembi
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