The commodity industry is used to turbulence and knows how to navigate it, for good reasons, since agricultural, energy, or hard-commodity trading and especially the logistics of such products is the backbone of our economy and ultimately of our daily life. But still, the measures governments imposed on society in order to break the exponential spread of the new Coronavirus were extraordinary and for many of us unimageable.
Times of uncertainty
From a fundamental commodity trading point of view - matching supply and demand of goods – some of the more efficient commodity markets reacted very early. Quite some time before Covid-19 was declared a pandemic, main agricultural and energy price indices came under pressure, anticipating decreasing demand.
As Covid-19 spread, commodity prices quickly eroded to levels beyond imagination. Market values for goods with immediate or short-term delivery lost significantly. Refinery margins and crush spreads were affected as well, sometimes to negative gross margins, directly impacting profitability if production was unhedged and exposed to market risk.
To what extent were such losses expected in the price risk models? Covid-19 also questioned the validity of the toolbox provided by commodity trading and risk management (CTRM) systems to simulate worst case price movements and estimate loss scenarios. How should a risk manager deal with the fact that zero is no longer the lower price limit and how do they cope with hyper-volatility?
Of course, negative prices are not new to the market, but the drop of WTI crude oil, one of the most liquid and important commodities, was spectacular and unexpected. The impact of such volatility also became visible from a liquidity and cash flow management perspective; not being able to adequately incorporate negative prices and hyper-volatility in risk and valuation models can lead to a shortfall to cover margin calls and potentially impact the central counterparty clearing concept. As a reaction, CME changed its option pricing model for oil products from Black Scholes to Bachelier Options Pricing Model with immediate effect and consequently, this change may also be required in CTRM tools supporting recalibration of risk and option pricing.
Remote collaboration
The cornerstone social-distancing rule has many far-reaching implications. Social distancing had direct operational consequences within commodity companies; with little lead time, employees had no access to their physical workplace and documents anymore. Suddenly, teams were forced to function remotely. Most commodity trading companies were well prepared and able to quickly transition to a work-from-home mode. Many companies were already using internal collaboration tools and business critical information had been digitized before, both facilitating this new working model.
Digital transformation
Digitization is the process of converting information into a digital format. When this process is leveraged to improve business processes, it is called digitalization. The results of this process are called digital transformation.
While 85% of commodity companies (see graph below) could quickly create a stable remote working model, collaboration with 3rd parties, especially securing the logistics processes, was more challenging. Managing the supply chain is complex and interlinks suppliers and customers with logistic companies, control agencies, financing partners and others worldwide. While the digitization of core elements such as e-docs, e-bills of lading, e-signatures etc. are available, digitalization of the trading process is not established.
The commodity market has revealed several initiatives, platforms and specific solutions towards a digitalization of the trade and logistics process, but an end-to-end standard is not yet established. Such uncertain times showed the importance of an immutable and tamper-proof record of a trade or a document. Such a tamper-proof record would ensure the link of the trade ledger to the cash ledger natively and also to fiat money. A true digital redesign of the trade process would support many currently challenging areas; credit risk on non-cleared OTC transactions, multiple sales of the same cargo, multiple use of the same collateral etc. and make worldwide collaboration across different market participants standard.
Conclusion
Commodity trading – in its core the matching and fulfillment of supply and demand of goods – needs robust ways of working and adequate methodologies on valuing contracts and managing risk or liquidity. The Covid-19 crisis showed that commodity trading companies adapted quickly to new working models, but a digitalized end-to-end trading process is still work in progress. Based on our experience, a key-success factor on this journey is to have the basics right: an appropriate CTRM fundament in place, upskilled and agile workforces able to operate in dynamic environments, and a clear view on the business case and drivers for a digital transformation.
This article is based on the “Commodity Management in the Times of Uncertainty” webinar, hosted by Eka Software Solution and facilitated by PwC, focusing on building a resilient commodity management to combat disruptive market events like the recent Covid-19 pandemic. More than 400 industry leaders from major commodity companies joined the webinar and participated in the poll questions. Click here to view the webinar recording for more insights.
SUMMARY
The Covid-19 crisis showed that commodity trading companies adapted quickly to new working models, but a digitalized end-to-end trading process is still work in progress. Based on our experience, a key-success factor on this journey is to have the basics right:
- an appropriate CTRM fundament in place
- upskilled and agile workforces able to operate in dynamic environments
- a clear view on the business case and drivers for a digital transformation
