The commodity trading industry has witnessed a remarkable upward trajectory over the past five years, presenting a landscape of opportunities and challenges that extend beyond the cyclical peaks and troughs common to all industries. Positioned on the brink of the next normal, the sector is undergoing a transformative phase driven by the ongoing energy transition, which spans across global food, energy, and materials systems. In this article, we delve into the trends shaping commodity trading, examine five critical success factors, and outline potential business models that could emerge in the years to come.

The Current State of the Industry

Commodity trading value pools have surged, nearly doubling from $27 billion in 2018 to an estimated $52 billion in EBIT by 2021. The growth has predominantly been fueled by a more than 90 percent increase in EBIT from oil trading, reaching $18 billion during this period. Power and gas trading closely followed suit, rising from $7 billion to $13 billion. These trends continued into 2022, with the market poised to attract new entrants, fostering competition and sustaining overall growth.

Four Key Developments Driving Growth

1. Structural Changes in the Energy Transition: The ongoing energy transition is resetting volatility and the value of flexibility across assets and demand. While decarbonization presents economic and environmental benefits, inconsistent incentives, value chain bottlenecks, and geopolitical turbulence cloud the supply and demand outlook. The volatility in both short- and long-term markets, exacerbated by factors like COVID-19, weather events, and geopolitical uncertainties, accentuates the importance of maintaining prompt inventory to respond to market dislocations.
2. Trade Flow Disruptions and Regionalization: Global commodity flows remain susceptible to disruptions, as seen during the COVID-19 pandemic and recent geopolitical events like the invasion of Ukraine. This has led to rerouting of trade flows, increased shipping costs, and potential formation of trade blocs. Longer distances and rerouting could further constrain the shipping market, prompting traders to reevaluate downstream exposure and customer commitments.
3. Financing Challenges: The volatility in commodity prices has tightened collateral requirements and increased the frequency of margin calls, particularly in the energy sector. Central bank policies have raised the cost of trade financing, posing challenges, especially for small and medium-sized commodity traders. This presents an opportunity for larger players to emerge as "financiers of last resort" for smaller entities.
4. Increased Liquidity and Tradable Products: Commodity markets have experienced a rise in overall liquidity over the past decade. Factors like increased price transparency, access to structured and unstructured data, contract standardization, and new exchanges have lowered barriers, fostering higher market participation and transaction volumes. Tradable products have expanded, with the LNG market witnessing a significant rise in spot transactions.

Emerging Trends in Commodity Trading

Source: FasterCapital

Five Critical Success Factors

1. Customer Centricity in the Energy Transition: As commodities undergo redefinition in the energy transition, traders need to prioritize customer centricity to meet evolving demands. Understanding the green premium and tailoring products accordingly, anticipating and locking in demand, and strategically shaping customer behavior will be key.
2. Embracing Short-Term Markets: The shift toward short-term markets, especially in new commodities, is essential. Producers need to balance the negative impact of long-term contracts with the loss of flexibility, arbitrage opportunities, and high costs of hedging illiquid long-term positions. This shift is particularly pertinent for new commodities that require responsiveness to market conditions.
3. Investing in Decarbonization as an Asset Class: Recognizing decarbonization as an asset class and understanding the green premium can provide a first-mover advantage. Traders must track the carbon exposure of their products, connect it with customer willingness to pay, and set up necessary processes for compliance.
4. Rapidly Scaling Up Trading Capabilities: With growing value pools and lower entry barriers, existing and new players need to rapidly scale up their trading capabilities. Achieving "smart scale" becomes crucial for risk-adjusted returns, global customer access, competitive financing, and success in times of higher volatility and changing trade flows.
5. Efficient and Agile Trading Platforms: Trading platforms must strike a balance between efficiency and agility to enable growth. The use of granular data requires solid data governance and modern IT infrastructure. Cloud migration, adherence to agile principles, and a competitive employee value proposition are vital for a successful trading platform.

Potential Business Models

1. Global Smart-Scale Trader: Enabled by digital advancements, automation, and market convergence, this model focuses on achieving scale globally. Incumbents and new entrants pursue growth through both organic and inorganic means, with an emphasis on capturing competitive financing and third-party volumes in the portfolio.
2. Niche Trader Mastering Complexity: In markets where scale is less critical, niche traders target regional or commodity-specific relationships. Specialization in new components of the carbon and ESG economy distinguishes this model, with barriers to entry attracting multiple players who develop competitive edges based on customer centricity or technological capabilities.
3. Tactical Trader–Investor: Capitalizing on cyclical imbalances in commodity-based industries, this model involves capturing value through positions that address supply and demand gaps. Players in this category possess a private equity mindset, utilizing strong balance sheets to take equity in illiquid physical positions aligned with long-term views.

Conclusion

The commodity trading industry stands at a pivotal juncture, navigating through a complex landscape shaped by the energy transition, trade flow disruptions, financing challenges, and increased liquidity. Success in the coming years requires a strategic focus on customer centricity, embracing short-term markets, understanding and investing in decarbonization, rapidly scaling up trading capabilities, and developing efficient and agile trading platforms. The evolution of potential business models further underscores the need for adaptability and innovation as the industry charts its course into the next normal.