Diversifying risk and maximizing profitability in commodities

Global commodity markets are growing more transparent, with a higher amount of information available to different participants. This makes such information more “commoditized”. Consequently, information that once was a key asset for traders is now widespread, putting pressure on trading margins. For the traders, there are two possible methods to maintain or increase their profitability: increasing trading volumes or expanding the asset base. The first option requires additional funding, which is sometimes not available, and increases risk. The latter not only diversifies the risk but also allows traders to benefit from higher margins and more stable cashflows. 

Reducing risk through diversification 

When looking at the commodities value chain, traders have the option to expand into upstream or downstream activities. These investments are an efficient way of deploying excess capital while securing trade flows. As an example, in 2020 Vitol established Vencer Energy to exclusively look for upstream opportunities in the US. The venture has already successfully acquired Hunt Oil Company’s Midland Basin assets. Cargill invested into downstream/finished products with the acquisition of the Leman Decoration Group. The acquisition of a cake decoration producer by the largest agricultural trading company confirms the trend where traders are moving further downstream, resembling food companies. Therefore, they are reducing overall exposure to the trading business, securing higher margins and more stable cashflows. These two examples show how companies can successfully grow alongside the value chain, reducing risk. This ‘loophole’ of sorts will continue to prove popular in the wake of COVID-19, which exploited weaknesses in many businesses. Therefore, many companies are now looking to reduce risk should such a catastrophe strike again.  

The energy transition is also a hot topic for trading merchants, particularly those engaged in oil & gas and mining. There is a growing concern around emissions which has resulted in many of the larger merchants taking the necessary steps to alleviate these concerns. It is worth highlighting the Nala Renewables initiative. Trafigura have teamed up with IFM Investors (one of the largest infrastructure funds globally) to establish a joint venture focused on the energy transition. The joint venture has invested in a battery storage project in Belgium and, more recently US business Swift Current which has a portfolio of over 6 GW of solar and wind power, as well as energy storage projects. Initiatives like Nala Renewables are also a way to reduce risk through diversification. And in this case, they also address the energy transition agenda.  

Expanding information assets 

The pressure from investors and public opinion surrounding the energy majors is forcing them to rapidly address their de-carbonization plans, which in turn will play a key role in the establishment of a broader asset base for their traders. Privately held trading merchants do not face the same level of scrutiny from shareholders. Whilst the energy transition is here to stay, it is widely viewed that the need for oil & gas over the coming decade still makes investment into non-renewable assets an attractive option.  

It is thought that when supply cannot keep up with increasing demand, a commodities supercycle will occur. This might be further exacerbated as the world re-emerges from COVID-19. Talk of a supercycle is already rife throughout the industry. This trend, combined with strong liquidity in the market, will push for more M&A activity in the commodities sector. Companies are expected to increase in-house investments teams as sector knowledge becomes an important asset to deploy capital wisely. Creating a strong foundation of market knowledge will prove crucial to the success of a company’s investments.   

For more insights into the commodities sector, be sure to follow us on LinkedIn. For more information on this topic, please don’t hesitate to get in touch with Carolina Vernillo at Proco Commodities Singapore here.