Transcript: Javier Blas Explains How Commodity Trading Shops Really Work

One of the big themes these days is the return of the 'real' economy. You can't solve problems these days with just money. Not everything can be done by sitting behind a screen. And so some of the most important players in this new environment are the commodity trading shops, which help arrange financing and delivery of oil, coal, natural gas, nickel and everything else you can think of across the far-flung corners of the globe. It's a very different type of business than most trading, which is mostly just about charts on a screen. On this episode we speak with long-time commodities journalist turned Bloomberg Opinion columnist Javier Blas — the co-author of “The World For Sale: Money, Power, and the Traders Who Barter the Earth's Resources” — to get a deeper understanding of how these firms operate, and how they're dealing with this environment of surging commodity prices and extreme volatility.

Points of interest in the pod:
Why do commodities trading houses exist? — 4:09
What happens to commodities trading during volatility — 06:51
A sample commodities trade — 10:16
Are people hedging more or less — 13:15
Who’s making lots of money? — 18:12
On diesel futures in New York and localized shortages — 20:54
Lack of commodities trading regulation and transparency — 25:04
Should central banks backstop commodities traders — 28:37 
Were people paid to buy oil in 2020? — 36:13
What are commodities exchanges doing? — 37:29
Impact of ESG, plus tightness in coal — 40:38
Paying for commodities in non-dollar currencies — 45:06

Tracy Alloway: (00:10)
Hello, and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway

Joe Weisenthal: (00:14)
And I'm Joe Weisenthal.

Tracy: (00:16)
Joe, big news today from Europe, which is that Russia is cutting off supplies of gas to countries — Poland and Bulgaria specifically — that refuse to pay in rubles. And you know, this is something that has sort of been expected in some sense, but lots of people are viewing this as the beginning of the weaponization of commodities.

Joe: (00:48)
Yeah. And it fits with, you know, a theme we've talked about several times, which is this sort of, I guess there's two things. I mean, on some level it's like this fracturing of the commodity supply chain, trade routes changing, but then also the changing nature of the financing side of commodities. And so the idea that, okay, you can can buy the same commodities, but you have to do it differently in different currency. This fundamentally is beginning to shift just the way commodities are paid for in finance.

Tracy: (01:21)
Right. So this is a point that I think a number of our guests at this point have made so Zoltan Pozsar, Pierre Andurand, Jeff Currie — if countries aren't importing Russian gas anymore or oil, they need to find that from somewhere else. And simultaneously it means Russian gas and oil might be going elsewhere, like to China, to the east. And all of that re-routing is going to take additional money. And we've seen lots of players in the commodities space talk about this. They've talked not only about the upfront costs of transportation of commodities, but they've also talked about what all of this means for the market itself. And we've seen intense amounts of volatility, which to some extent, mean that the commodities traders are making loads of money, but on the other hand, they are having to deal with this volatility and it can disrupt their business.

Joe: (02:11)
Right. And of course, and you know, this is obviously, and you mentioned it, it's something that Zoltan has been talking a lot about. You know, all these trades are financed. There's leverage involved, there's borrowing. And when you have a really big jump in volatility, then of course financing gets more expensive. You have to put up more collateral, you get margin calls, things like that. Also add in the complications of, you know, some banks have been sanctioned and you can't deal with some institutions. So the financing side of all these trades just gets much more costly and complex.

Tracy: (02:47)
Yeah. And it's not exactly as if it was transparent to begin, and now it's just become even murkier in some respects. So today I am very pleased to say we are going to be digging into the financing side of commodities trading, and we really do have the perfect person to talk about it with, we're going to be speaking with Javier Blas. He is of course a Bloomberg Opinion columnist, but he is also the author of ‘The World for Sale,’ which is a book on the commodities trading houses, an excellent book on the commodities trading houses. So again, the perfect guest.

Joe: (03:21)
I'm looking forward to it. Let's do it.

Tracy: (03:23)
Alright, Javier, thank you so much for coming on Odd Lots.

Javier: (03:25)
Thank you for having me.

Tracy: (03:26)
I'm sort of amazed we haven't done this sooner.

Joe: (03:29)
You're one of the most requested guests on Twitter. People are always saying, when are you getting Javier? And it's like, we're going to get around to it. And then we ran into Javier in the newsroom and were like, let's just do a right now.

Javier: (03:39)
I think that's my parents probably on Twitter reaching out to you.

Joe: (03:43)
Good parents.

Tracy: (03:46)
Why don't we start, I guess, with the basics, I mean sort of a potted history of your book, but how did we wind up with a situation where we have all these independent commodities traders who are dealing with, you know, important goods, things like oil and gas that we depend on for transport and heating, food supply, vital strategic goods with seemingly not that much oversight?

Javier: (04:09)
Well, yeah, you are absolutely right. We need the commodity traders because commodities are not produced generally where they are consumed. So you need someone to take the risk of moving the stuff from A to B and that's the role that the physical commodity traders play. I mean, these are not guys who are betting on the futures market or the options market behind a screen. These are guys who go into upcountry, as we call it, a mine in the DRC deep into Africa, Peru, oil fields in Iran, and they get the oil, they put it in a tanker and they transport it to the consuming markets and they finance all that process. They deal with all the logistics, which are mind-blowingly complicated in some cases. And, you know, the main reason is because commodities are not produced where they are consumed and they need someone to intermediate that risk. And that's quite a lot of risk. It's financial, it's logistics, it's credit, it's operational, it's weather. It’s risky in terms that, you know, some of these commodity traders are often operating in war zones and you still need them to get the commodities out and they get paid very well for that service.

Joe: (05:22)
Yeah. So when I think about like traders, typically in my mind, you know, I imagine someone looking at a screen and there's like, you know, one basis point difference between a 10-year Treasury and a 10-year Treasury future. And let’s find some way to like, make a penny off of that. But when we're talking about commodities, we might be talking about equivalent barrel of oil, moving out of Russia that's $60 cheaper than something, you know, the same barrel of oil in continental Europe, and then someone, their job is to find a way to get that cheaper barrel of oil to someone who wants it. And if you can do that, that seems lucrative.

Javier: (05:59)
Yeah. That's exactly what they do. And at times that is very complicated because, well, you know, you are dealing with all those logistics, you are dealing with all that risk. And because you actually have to put a lot of money at work. The size of the business, I mean, some of these companies they have turnover of $300 billion, $400 billion a year, which is a mind blowing number. And obviously they don't have the profits equivalent to what Apple or Coca-Cola or Amazon will make if they were having those sales. But the size of the turnover is just amazing because of the volumes that they move. I mean, Vitol, which is the world’s largest oil trader moves enough oil to supply five or six of their largest European economies.

Tracy: (06:51)
So it's not an easy business at the best of times, you just described it as really complex. What's it like in a moment like we've just experienced over the past month where we've seen intense volatility, we've had drama with a particular commodities exchange over this volatility and canceling trades and things like that, what actually happens in a period of intense volatility for the commodities traders?

Javier: (07:18)
Well, the first thing to, to understand which is very important is that physical commodity trading is a highly leveraged business. These companies operate with thin equity and they borrow money from banks. And these are not typically borrowing from Wall Dtreet banks. They're borrowing money from commodity trade finance, which are the typical European bank where you may have a mortgage. Actually, my mortgage bank for my flat in London probably is a big financier of the commodity trading houses. They’re not borrowing money from the likes of Goldman Sachs. They’re just borrowing money from European commercial banks.

Tracy: (08:00)
Sorry, just to be specific, like a BNP Paribas, that sort of thing?

Javier: (08:03)
Yeah. I mean, BNP Paribas was the largest lender to the industry. It just decided a few years ago to shut down the business after they got involved in some bad case with the U.S. Department of Justice. But we are talking about the likes of Societe Generale, of ING, Credit Suisse, UniCredit of Italy, that kind of European bank. And when commodity prices go through the roof as has happened in recent days and weeks, two things happen for the commodity trading houses. First of all, they need to borrow a lot more money because a barrel of oil is more expensive. So if a barrel oil a year ago was close to – actually [it was] almost negative, but, you know, say that it was $25. And you were moving a million barrels of oil in a super tanker. You needed $25 million to borrow. Today at more than a hundred, it means that you need a hundred million.

So the borrowing needs have increased significantly. Also because of all the volatility in the futures market, if you are hedging that operation on the futures market, meaning that you are long physical, you are short on the paper side, the price continues to go up, so you are getting hit by margin calls and those margin calls could get very high. We have seen some commodities trading houses getting a billion dollars a day of additional variation margin calls. And that combination has really put a lot of pressure on the finance of some of these companies that, as I said, for the starting point, they don't have a lot of equity and they rely on banks and banks are really reaching the limits of how much money they can lend to them.

Joe: (09:44)
Why don’t you walk us through a trade? I mean, you walked us through some of the prices of oil on a tanker, but is the idea that, okay, there's some buyer who wants oil. There's some seller halfway around the world and then the trading house makes it happen, but to make it happen, they borrow, they don't want to put up the money to make it. They don't want to put up their own money to transport that oil. They borrow for the duration. Like how long are they borrowing for? Are they revolving lines of credit? Walk us through a little bit more like how the trade works.

Javier: (10:16)
They have all kinds of different borrowing facilities from revolvings to bilateral deals to just at a ad hoc for a transaction. But a typical transaction right now will be buying Russian oil, which is still legal if you are moving it into say the Netherlands, Rotterdam is the center of the European oil industry. So say that you are a trading house, Joe Commodities Incorporated -- obviously in a tax haven because all of these companies are incorporated in some places like the British Virgin Islands and similar -- and you are buying a million barrels of oil from Rosneft, the Russia and state-controlled company, you will have put, that's going to of cost you around $80 million because Rosneft is selling at a big discount to the market. You probably are going to put perhaps as little as $5 million of your money, and you're going to go to a bank and you are going to borrow all the rest of the money.

And then you will, at that moment you own a million barrels of Russian oil. So you are long physical. You want to protect yourself because you don't want to see a price drop hurting you. So you will take a short position on the futures market, right? To make sure that you are hedged. Long physical, short paper, everything should be fine. And then you get a vessel, which is complicated because there are not many companies who want to go to a Russian port to pick up the crude. You will have to deal with all the operationals. Sometimes there is bad weather and you cannot send the trip. So it gets complicated on that.

Say that you get everything right. You get the oil into the tanker and then you move it to Rotterdam. You try to discharge into a refinery. But in that period, just imagine that the price of oil goes from a hundred to $150, you are fine because you are hedge. But obviously the margins, the exchange is going to start demanding significant variation margin on that short position. And then you have this cash flow mismatch. You have not yet delivered the oil. So you have not really cashed in your own physical position. At the same time, your short on the paper is massively underwater. You are getting the margin calls. So you are going to have to go to another bank and say, please, can you give me some money? Can I borrow your money? Because I need to pay to this exchange. All of this is not just one tanker, but hundreds of tankers a day floating around and billions of dollars in borrowing is when it gets very difficult, and when some of the companies reach the limit of how much they are borrowing from the banks, and when the banks say we cannot continue lending to you. And that's where we saw the lobby group of the European energy traders go to several central banks and say ‘we are running out of liquidity. We have a big problem, margin calls are effectively killing us.’

Tracy: (13:15)
I want to get into this idea of whether or not central banks or governments should support commodities trading and finance. But before we do one thing I've been wondering, given the volatility and given the types of margin calls that we've seen, do people hedge more or less in this environment? Because you can kind of argue it either away, right? You know, you don't have as much credit so everything you have is sort of just used up in the trade -- less can be used for the hedge. But on the other hand, there's so much volatility at the moment that you would want to make sure that you're hedged.

Javier: (13:48)
I mean this is the time that everyone should be hedged as well as they can because the market is moving in huge price increases. I mean we have seen Brent crude, a market that for many years had never traded more than $30 or $40. We have seen price movements of $30 to $40 in the space of a week. If you are not hedged, the market could kill you, but you are absolutely right. My suspicion is that a lot of the trading houses have reduced significantly the hedging just simply because they cannot afford it, which is extremely risky. And that's what could bring a company down.

Joe: (14:28)
You know, I want to go back to something just in like the ‘why?’ of these companies and, you know, just your explanation and it's like, look, the commodities made somewhere. It's probably going to be consumed somewhere else. You need someone to take on the risks and the process of doing that. Why did these companies emerge separately from the major banks? Why in theory, is this not just something that's done inside a Goldman Sachs or inside a JP Morgan?

Javier: (14:55)
Very good point. And indeed at some point, Goldman Sachs and Morgan Stanley were big physical traders. They were moving millions of barrels a day of crude and refined products. Goldman Sachs pre-IPO owned an oil refinery in Rotterdam. Morgan Stanley was a big trader of all kinds of commodities, including metals, agricultural, etc. But over time, this business gravitated to privately owned-independents because you have to go to difficult places on earth, places that usually regulators will not like banks to be there and because over the years, the good money on commodity trading has been made in operating on those kind of, what is the nice word? Gray areas of the global economy?

Joe: (15:42)
Yeah, it feels like you have to have a somewhat mercenary attitude where it's like, this is the job,

Javier: (15:47)
The word that Jack and I use in “The World for Sale,” in our book was you have to be a bit swashbuckling. I think that that probably is a nice way to say buccaneer or mercenary, but look, the commodity trade has made a lot of money over the last 30 or 40 years helping Saddam Hussein to bypass UN sanctions, helping Apartheid South Africa government to get oil, helping Fidel Castro/Cuba barter sugar for oil and keeping the communist revolution alive. And they never have a problem, whether it was a communist regime or a right-wing regime, the same commodities traders that were helping Castro were dealing with Pinochet in Chile to sell the copper. But you need to have the appetite to go right to where no one goes. I mean, when I said earlier that these commodity traders are often in war zones, they are. They have executives that have been in Libya during the civil war and the hotel lobby where, it was an interesting combination. You were in Benghazi. The frontline was not far away. There were checkpoints in the city everywhere and it was a hotel where it was kind of the hotel to be in town during the Libyan War. And the people who were living in that hotel were a combination of a few diplomats, cultural attaches of those diplomats, meaning they’re spies, a few war reporters and then the commodity traders buying Libyan oil to put it into the global market.

Tracy: (17:25)
So setting aside, I guess the issue of morality -- as many traders have done historically -- you mentioned the fact that commodities traders just make tons of money over time. And I'm curious what the money making opportunity is like right now, because again, it kind of feels like a best of times, worst of times scenario. So the opportunity to make profit is there, if you can secure the funding and navigate the volatility, but it seems like the industry is also starting to split a little bit. The big guys are taking even more market share. Some of the smaller players seem to be really squeezed by the financing pressures what's going on there?

Javier: (18:12)
You are right. The banking financing is gravitating towards the big players because the banks feel that they have the enough equity to withstand the volatility and the small and medium-sized traders are really struggling to get support from the banks, the opportunity right now, [if] you can make it through, you can weather the volatility, you could make a ton of money in this market. I mean, think about Russian oil. The flagship of Russian crude is something that we call Urals, that is selling around $35 discount to Brent, which is the main benchmark. So if you are a commodity trader, you could buy from Rosneft, oil at a $35 discount, put it on a boat and ship it to India where you could sell it at $5 discount. You could make 30% margin on a barrel of oil right now, which is a lot of money. I mean, this is an industry where making 50 cents on a barrel of oil is a big profit. And all of a sudden you have $30 profitability options. And that's what they're doing. I mean, you see the same traders who are buying Russian oil at a discount of $35, they're selling it to India at a $5 discount.

Joe: (19:28)
For anyone who's interested, or you have a terminal, we have a Urals-Brent spread ticker – FUDBM1. And you could see, you know, up until basically the beginning of February, this was a, you know, it looked like Russian oil typically traded for about $1.50 cheaper than Brent. And currently it's $31 cheaper. So basically there's this huge opportunity. All you need to do is find the boat.

Tracy: (19:56)
It's such a crazy chart.

Joe: (19:57)
That's the basic idea. If you can find a boat that can get it, can ship to India for less than $30 a barrel.

Javier: (20:03)
You need the boat and you need also a bank who’s willing to finance that, or you need to have the equity to finance this operation on your own balance sheet. And then, I mean, but here’s the question, will Joe Commodities Incorporated on the British Virgin Islands, want to get involved in this? Will you want to be trading Russian oil? And many, many people will say, no, I  don't want to do anything with Russia, but a lot of the commodities traders say, well, we are not involved in politics. We are above politics and we are about making money and it's legal to move the oil. So we are going to move it. And they're obviously making a lot of money.

Joe: (20:41)
Tracy, it actually reminds me a little bit of the Sam Bankman-Fried Bitcoin trade from 2018. Like the huge gap in Bitcoin pricing in the U.S. and Japan and finding a way to like wire the money across.

Tracy: (20:54)
But there's a reason why that gap exists, right? So, okay. Speaking of gaps and crazy charts, there was something that you tweeted this morning, Javier, about the ultra low sulfur diesel futures closing at like a crazy amount. And there have been a couple charts that just look like something weird is going on in the market. We’re getting these odd technical squeezes higher. What's going on there? And how is related to the financing situation?

Javier: (21:29)
Well, the diesel market, I mean, I have been warning that we are talking a lot about the problem in the oil market, the crude market, but where real tightness is, what we call the middle of the barrel, when it's refined, that's diesel and jet fuel. And we have very little of it, because consumption is booming. Because Russia produces a lot of diesel. What's happening there is that on commodities markets, when you are on the futures market, at the end of the day, some of those contracts are still physically deliverable. You take a long or short position and you may take or have to deliver the commodity to the exchange. Inventories of diesel in the east coast of the United States are at the moment at the lowest seasonal level since we have data -- that's 32 years. The pricing point for the futures market for diesel in the United States is here in New York harbor.

Javier: (22:24)
That is New York harbor is where you price diesel for basically the whole of the Americas. And what happens here really matters. It's so important that there was a big energy trader in the nineties at Morgan Stanley he was known as the King of New York Harbor, because he controlled all the leases of all the oil tanks. And he could, in some ways I think that the word ‘manipulate’ would be wrong, but he could sway the market in his favor very, very often. Because we have so little inventory, everyone who is short in this market is trying to close their positions because come Friday they need to deliver the diesel. There is no diesel around. The loans are very happy holding their positions. And what we had was a hell of a squeeze over the last 48 hours where the premium for May to June contract ballooned to an incredibly high level. I mean, it's something that, again, you know, this is a chart that where we should see a spread of no more than five, 10 cents, 25 cents will be something unprecedented. And yesterday we went beyond 70 cents, the chart went magical. And it was a clear sign that it was a short position in deep trouble, knowing that in three days he has to deliver the barrels. He doesn't have any barrels and he needs to get out and he will pay whatever is needed to get out of the position.

Joe: (23:53)
So it's a pretty big societal disaster, if certain commodities simply cannot be delivered. If planes can't get jet fuel, that's a really a big economic problem. In fact, it briefly happened at the airport in Austin, Texas that they ran out of fuel at that location. But other things, obviously food, obviously huge implications, you know, this stuff really matters. And so it's interesting. You know, talk to us a little bit about the role of regulators and the central banks, because, you know, there was talk last month with the whole nickel blow up about should the central banks be backstopping or bailing out some of the players in this space, because it's so crucial. I mean, does there need to be more of a regulatory infrastructure such that if there is need for a bailout or emergency financing, the central banks are in a position to provide it?

Javier: (24:53)
Well, using the, the example that I gave you, you know, Joe Commodities Incorporated, well, you have no regulation. No one is looking at you. You could do whatever you please and, and you know, this happened – keep in mind that trade buying a barrel of Russian oil and delivering it to Rotterdam – then you will encounter not a single regulator, other than on the financial side. On the financial side, when you are putting your hedge, you will have the CFTC looking at you, what you are doing, but on the physical, there is absolutely nothing.  You put it on the ship and there is no regulation. And sometimes there is not even a single country because you may not even buy the oil from the terminal. You may buy the oil on the high seas from, you know, sometimes two oil tankers get together. We call it ship-to-ship transfer. They get together on the high seas. They can move the oil from one tanker to the other.

Joe: (25:54)
I didn't know that happened.

Javier: (25:55)
And you are on the high seas. The only rules there is the United Nations convention of the Sea, kind of piracy level. So you don't have any regulation and it’s quite interesting, the things that you could get away, or you could almost get away until very recently, for example, if you were incorporated in Switzerland and you decide to bribe someone to get business overseas, not only that was considered legal until very recently, but it was tax deductible. So the Swiss were rather accommodative to what the commodity traders needed to do. And in the book, we tell the story of some commodity traders telling us that they were traveling to London with half a million pounds in the briefcase to make payments to people. I mean, they call it commissions, but those are brown envelopes.

Tracy: (26:48)
There's also, there's a great story in your book about the Soviet Union, basically owning the U.S. and the commodities traders in the 1970s, by going like from from commodities house to commodities house buying up grain. And no one realized they were doing this with everyone.

Javier: (27:07)
Because they don't talk to each other. They keep everything secret. And because there is no one that they need to report all of these transactions to. There is not a registry. If you are trading on the financial market, you are buying oil futures or options, all of those trades are registered somewhere. There is a trade repository. The CFTC could look into it, the Fed can look into it. Any there’s any indication of wrongdoing someone can go and see exactly who bought what, at what price, with whom. On the physical market, you could buy oil, metals, agricultural commodities, and you do not have to disclose anything. There have been times, I mean, in 1979, the G-7 agreed to create an international repository of oil physical deals. And of course, what is it now? 43 years later we are here, and that has not happened because opposition from the industry.

Tracy: (28:02)
I can't even imagine getting to point where people would agree to it now, much less enact it.

Javier: (28:10)
When I recently was speaking to people in the regulatory world and say, well, you could do, you could create a registry. And they were absolutely bemused that I indicated, look at the G-7 1979 communique, it was the summit in Tokyo, it’s there. It says we agree, the G-7 agrees to create an international database of trades. And they were like, well, that will not happen now. No way all the countries will agree.

Tracy: (28:37)
So just going back to the central bank point though, so it seems like so far, most of the major central banks have swatted away this idea of providing support. So the ECB kind of did it more definitively. The Fed has made noises that suggest that it's not interested in backstopping commodities traders. A) why not? I guess moral hazard is the sort of big one there, but B) Is part of the idea that they support through banks that are back-stopped by the Fed?

Javier: (29:09)
Yeah. I mean, I think that the central banks have looked into commodity trading recently, and they found two things that I think that they didn't like. One, and you know, the Bank of England was rather candid about it. They put out a position paper just indicating that they could not really even understand what was going on because of the opacity of the market. And you know, to see a central bank recognizing publicly, we looked at this, we found it to be very opaque, so we don't really know what's going on. That was rather concerning. Both the ECB and the Fed say, well, the threshold for intervention of an unregulated market, as they call, it is very high. And the Fed, using Fed speak, effectively told the industry, it will be a good idea if you raise equity and you shore up your own finances. I mean, let's not forget a lot of these companies are privately-owned, there are very few that they are listed on the market. But they're also owned by extremely wealthy individuals. I mean, they're making billions of dollars every year and the partners could put money back into the business.

The problem for the central banks is what if a big commodities trading company was to fail? And it goes under with billions of dollars on credit lines to a bunch of European banks. And all the sudden you realize that the likes of what we were commenting earlier, you know, banks who have branches on the high street in Europe have $2, $3, $5, $6 billion of exposure, and you don't know if is anyone else going to come down? The industry gets under massive stress. I think that we can get into a position in which central banks’ hands maybe forced to act in supporting the industry, but it gets complicated because a difference of a lot of the banks, a lot of these commodity trading houses are not even incorporated in Europe. You are going to be bailing out companies that are in the British Virgin Islands, in Dubai, in Singapore, right? And companies also that you could discuss whether what Lehman Brothers Bear Stearns were doing were good for society and so on, but these companies, a lot of the trouble that they're getting in now is because they're trading Russian oil, right? So just imagine a situation in which a central bank effectively has to bail out a commodity trading house. And the central bank is either the Fed or the ECB. And you are bailing out a commodity trading house, which is involved in shifting Russian oil, which is more or less against what…

Joe: (31:48)
A trading house in a tax haven, making it easier for Vladimir Putin to get revenue. And now coming potentially to the ECB or the Bank of England or the Fed...

Javier: (32:00)
Just imagine the hearing in Capitol Hill, when they ask, you know, Chairman Powell and Secretary Yellen, why did you bail out these guys? I mean, you know, you understand why the Fed and the ECB were terrified at that situation. But on the other hand, while both the ECB and the Fed have said, no, I think that they’re very aware that it could be a situation in which they may have to, because the financial health of a number of European banks is at risk, but the political consequences of having to bail out these guys are terrifying.

Joe: (32:34)
Yeah. I hadn't thought about that at all. Something that you talk about is, and I'm, you know, again, I guess I'm going back to like the ‘why’ of these companies, is that in the past, and maybe it's with oil, but I think other commodities as well, the supply chains were much more vertically integrated. And so whether from the drilling to the literal gas station where someone would get their fuel, it might have been all one company. And then that fragmented. Can you talk a little bit about how the trading houses emerged out of essentially a restructuring of the industry itself?

Javier: (33:14)
It happened mostly around the seventies, sixties and seventies, and, you know, oil was particularly the, the one that broke down. I mean, it was a time where everything was vertically-integrated in the oil industry. Exxon oil fields will produce oil. They will put it on Exxon-owned pipelines, into Exxon owned-tankers to Exxon refineries and to Exxon gas stations. And that broke down for a number of reasons. Very importantly, nationalization of the oil resources in the Middle East and North Africa through the seventies. The commodity traders, when the Middle East countries nationalized their oil, all of a sudden those countries have never sold their own oil have plenty to sell. And they needed someone to help. And then came the oil traders who became the big intermediaries. And the industry has really broke down. There is not that vertical integration anymore. And the traders have benefited from that.

Tracy: (34:16)
Would you expect some form of vertical integration to return? Like, the obvious one given the shipping shortage or shipping issues would be for commodities traders to just start buying or building a bunch of huge, very large crude carriers or stuff like that, would that kind of thing come back?

Javier: (34:35)
I think that what you may have some vertical integration is companies have come to realize now out that if they need a particular supply that is, you know, critical for their business and no one is investing, they may have to do it themselves. I mean, Tesla is, is kind of a good example of this. I mean, Elon Musk is talking about the shortages of lithium. So you could see, at some point, Tesla having to go into mining lithium, or co-investing with some traders into that, because you know, in effect you have a market failure. So you may want to integrate. The one thing that I see, which is not vertical integration, the commodity traders have benefited a lot from the movement by every to just in time.

They were the ones who were holding inventories for everyone else. And they made money from that. I mean, a lot of companies, they didn't have to carry inventories. The inventories were in the hands of the trade. The traders were financing those inventories. So a lot of chief financial officers of companies that need resources were very happy not to carry those financing costs. All of a sudden you realize that just in time may not be a great idea. And if you are a company that needs a lot of aluminum, or a lot of copper, you may want to move from relying a bit less on the commodity traders and controlling a lot more of those inventories, which is really bad right now, because we have low inventories everywhere. Supply is struggling with demand. And we are having a number of companies building their own inventories right now at the worst possible time, which is exacerbating the shortage.

Joe: (36:12)
You know, this is a real diversion, but while you're here, I'm just going to ask, did anyone actually get paid to take oil in spring 2020 when it went negative? Were there some people in a position where they like took oil and got paid to warehouse it and made a fortune?

Javier: (36:29)
Yep. There were. There were some commodities traders certainly buying oil in Cushing, and, you know, by buying I mean,getting paid to take the oil. There was not a lot of it. And, you know, the reason that we went negative was a lot of technicality around the contract and probably some people pushing the market at closing in the right direction for their positions. But yes, there were commodity traders who that day, and not only that day, I mean, on the physical market in the U.S. for a few weeks before the WTI went negative, we have domestic grades on kind of areas where it’s very difficult to move the oil out where prices were negative. And some of the commodity traders were taking the oil. I mean, Mercuria, a big oil trader who takes oil in some areas of the U.S. which had lockdown, with very difficult access to pipelines and so on, was buying at negative prices for about two weeks.

Tracy: (37:29)
There's one part of the commodities ecosystem that we haven't really discussed yet. And it was the drama that I was referring to in the intro and that's the exchanges. And the big drama was the London Metals Exchange canceling a bunch of nickels trades after the price just went absolutely nuts. And this was really controversial at the time. But you know, obviously a lot of what the commodities traders are doing are through futures contracts that go through an exchange. What sort of response have we from the exchanges in terms of adapting to this new environment?

Javier: (38:04)
Well, the response from the exchanges have been to increase margins massively to everyone and particularly not just variation margins but initiation margins. It's very expensive right now to put a trade on energy commodities, oil, power, gas. It’s just gotten very, very expensive. I think that, you know, the reaction from the exchanges have been, oh my gosh, we got very, very close to disaster with LME. I mean, if the LME had not shut down the nickel market and then canceled the trades, which is an extremely controversial decision and many people on the market will say illegal decision and this is going to go into lawsuits, etc., but the exchanges have been quite open. Four or five brokers would have defaulted that morning. The market was shut down at 8:15 in the morning, and the trades were canceled at 8:15 in the morning, margin calls were due at 9:00. So we can say that four or five big brokers at the LME were 45 minutes from going belly up.

If the brokers go what happens to – because then the brokers default -- to the exchange and the clearing house? What would have happened to the clearing house? The exchange said that the clearing house would have survived, but we don't know the reality and what will have happened to some of the banks, which are behind the brokers? I mean the financial consequences could have been significant -- billions of dollars of losses. And, you know, a lot of the risk today, we have moved the risk out of OTC markets into clearing houses, and you know, we don't know, and this was a test. I mean, having to cancel the trades is a massive decision. I mean that, my word is my bond. I have a trade, I have a contract and that's done, and those contracts were evaporated in minutes.

So the exchanges’ reactions so far is to increase margins and trying to make sure that the buffer on the clearing house is there for a potential default. Cut obviously that's draining a lot of liquidity from the exchange. We have seen liquidity in the oil market at a six, seven year low. That's not coming back. At times the oil market, I think I said that the bid-ask spread on WTI, which usually is no more than 1 cent, there were times that was seven, eight cents wide, which I said, well, that's wide enough to put an oil tanker through. I mean, like you could make eight cents of a dollar just basically arbitraging bid-ask spread on WTI, which is a insane as it's almost free money.

Joe: (40:38)
Crazy. So I want to talk a little bit, you know, one of the themes that comes up on Odd Lots all the time, you know, we talk about like, oh, these commodity traders are making a ton of money, but they weren't always. I mean, you know, prior to 2020, prior to Covid, commodities was not a booming business, and one of the themes that comes up a lot on Odd Lots is, you know, this idea of like underinvestment -- underinvestment in physical resources, etc. But I'm curious also about like the sort of, I guess, the ESG aspect, cause my impression is, and I think some people want to dismiss that. Other people say it's everything, but my impression is a lot of people, just either different kinds of financial companies just sort of  cut all of their units related to these industries related to mining and so forth. They're like, we're just going to get out of this business. It does feel like the sort of negative attitude towards dirty industries really caused a lot of these sort of financing and to disappear.

Javier: (41:43)
Yeah. I mean, you know, the Russian invasion of Ukraine has been really the final straw on the market that has tighten things on lot, but the market was already tightening a lot in the run-up. And one reason is that we have underinvestment in fossil fuel, in mining, it just generally has been seen as a dirty industry. ESG has kicked in and yeah, we are not having probably enough investment. And I mean, here we are at unprecedented prices for coal. I mean, a good price, if you have a coal miner a couple of years ago, that $250 a ton where they will take it, I mean, they will have signed a contract right now. Thank you very much. That's a great price. And the market is now at $400. Oh. And no one is building a mine.

Joe: (42:35)
Because everybody got out of coal finance, right?

Javier: (42:38)
Everyone is out of coal finance. You could not get a bank to finance a coal mine. And you know, some of the coal companies, I speak to the CEOs and say, why are you not now announcing a big expansion, and so on? They say because, if I announce that we are spending products on capacity, my share price goes down 10%. Because that's the last thing that, you know, we have targets that we have to reduce. And, you know, the sad thing right now of the energy transition is that we have been talking about cutting emissions and reducing CO2 and so on and in 2022, we are going to see record demand for oil, record demand for natural gas, and record demand for the thermal coal. And that's despite the fact that we have been trying to reduce reliance on thermal coal for the last, I mean, some people will say 150 years, but seriously, for the last 20 years.

Tracy: (43:26)
I have a related but slightly weird question. But speaking of underinvestment, you know, central banks around the world are gearing up for rate hikes if they haven't done so already. And the whole intent there is to try to bring down inflation, which presumably would lower commodities prices. But I'm curious how do commodities traders feel about rate hikes at the moment? Because the other argument you could make is that you're increasing the cost of capital, the cost of funding, at precisely time for that particular industry?

Javier: (43:59)
I think commodity traders, they feel that demand is outstripping supply. And that the only thing that could bring down the market is just a good old fashioned recession. So can you reduce commodity prices via interest rates hikes? Yes. But at the cost of killing the economy, but if you are going to achieve the soft landing, I don't think that you are, I mean, the demand is going to still be there. And, yeah, I don't see how that's just going to reduce inflation. I mean, nothing that the Fed can do other than killing the economy can bring more oil or more coal or more wheat. I mean, you know, we have a problem with with supplies right now because we have lost the number one and number three supplier to the world. And the ECB, the Bank of England, or the Fed cannot do anything about that. I mean, you know, higher interest rates are not going to produce more wheat and they're not going to produce more oil. But you know, interestingly, I mean, interesting is the statement of the obvious, right now the global economy faces much higher energy cost, much higher food cost and higher cost of money.

Joe: (45:06)
So, you know, I have a hard time wrapping my head around how big of a deal it is to say, okay, some European countries are going to buy Russian gas in rubles, or maybe China is going to enter into some contract with Saudi Arabia to use yuan. Some people when these headlines hit, they’re like, ‘oh, this is a huge deal. It's the end of the dollar.’ And I'm always not sure how to think about it. How significant is pricing commodity sales and non-dollar currencies? Is it a big deal or is it sort of just accounting?

Javier: (45:40)
Depends on what we are talking about. If we are talking about pricing the commodity in a non-dollar currency, then I think it’s a big deal. But a lot of what we are talking about is about invoicing. You are priced in dollars, but when you transfer the money, you wire the money in a different currency, which is a very different thing from, you know, not pricing in dollars. Look, I do think that it does have an impact, obviously there are a number of countries that tried to reduce their reliance on the dollar. But it was quite interesting, I was recently speaking to a senior executive of a Middle East company about would you want to get paid in yuan and, you know, he's not a friend of the United States, this particular gentleman, but he said, ‘and then what we do with the yuan, right? We get paid with the yuan. It's not properly convertible. We can pay for Chinese goods, but do we have enough demand for Chinese stuff.’ They may not like the dollar, they may not like the policies with the United States, but they know that the moment that they have the dollars, they can convert that to anything that they want. They can move it, etc.

Tracy: (46:55)
So you've been covering commodities for a very long time. And obviously your book deals with the long-term history of commodities trading. What about the past month or so has surprised you? What's been the most striking to you?

Javier: (47:11)
A couple of things, I have been in struck by how little regulators in this day know about the industry. The fact that a lot of them seem to be completely in the dark of what's going on and who are the big players and how things work. And, considering that we have had several wake up calls, I would have thought that the regulators will have really been getting up to a speed onto that. And that is really concerning because I am not a big believer that you need super extra-heavy regulation on commodities, but it really concerns me when regulators and policy makers basically have no idea what's going on. That remains a surprise.

The other one, on the other hand, has been self-sanctioning. How, you know, public pressure has led to so many players to say, even if this is legal, we are not going to touch it. I don't know, if this is an era of social media where public pressure goes quicker to companies, but in the past, I would have expected a lot more companies to continue dealing Russian oil with no problem. And we have seen a number of companies just, you know, taking a step back. And the companies that tried to use their old tricks, like do blending and things like that, getting named and shamed and very, very quickly saying, ‘oh yeah, our mistake. We're not going to do that.’

Joe: (48:32)
Yeah. You've heard some great columns about blending and they call it Latvian oil. The Latvian blend. It’s like coffee.

Javier: (48:40)
It's like coffee or cocktails. You kind of, you know, you mix it. So it’s when Russian oil is not really Russian and oil. I mean, for some companies, they will say that as long as 51% of the oil is from somewhere else, the other 49% could be Russian. And then they invent all these names, which are kind of, you know, cocktail names. Latvian blend, Turkmenistani blend, to avoid calling it 49% Russian .

Joe: (49:05)
I just have one more question. And I guess it's like a culture thing again, but you know, in this world of commodities being so important, you know, when I think of traditional traders, maybe they're like physicists these days or electrical engineers or mathematicians or something. Who becomes commodity traders. I imagine language skills might be useful if we're talking about all these like international…

Javier: (49:30)
I think language skills, you have to have a sense of adventure and, you know, be willing to live in the middle of nowhere, travel 250 days a year, take quite a lot of personal risk. There is a commodity trading house called Olam, which is based in Singapore. And the CEO is a gentleman called Sunny Verghese and Mr. Verghese started in Nigeria. So he still sends all the junior traders up country in the middle of nowhere for a couple of years, so they learned the business kind of the hard way. I mean you need to be prepared to go to live somewhere quite distant. If all you want to do is be sitting in Mayfair in London or, you know, Wall Street here in New York. That's not the business for you. You you have to be willing to go to Democratic Republic of Congo and know everyone there, know the president, know your ways to get the copper and cobalt out of the country.

Joe: (50:29)
I think a lot of people would like that. Just you describing that. I bet a bunch of people I want that.

Tracy: (50:35)
Yeah. Even in journalism, when I started out in financial journalism, I wanted to report on commodities and it didn't happen for me. So I had to make it happen through Odd Lots at various times.

Javier: (50:44)
Well, I mean, you know, you are commodities reporter, you end up visiting a lot of countries that are not the traditional, you know, holiday destination. It's kind of, my dad used to say, so you look at the list of countries that the Foreign Office recommends not to travel and you basically go there.

Joe: (51:00)
What's your favorite place that you've visited that hardly anyone else has been?

Javier: (51:05)
Look, I have a great time every time I have been in Iraq is one of those. My favorite places, Baghdad is a great place. I have favorite restaurants in Baghdad and things like that. I mean, you get to travel a lot to the Middle East and Iraq and Iran are kind of favorite places, but also you get, you need to get used to, from time to time, getting deported from a few countries, you know,.

Joe: (51:31)
Well Javier. That was fantastic. I think I said at the beginning, you're one of the most requested guests and I can see why - so appreciate you so much for coming on Odd Lots.

Javier: (51:41)
Thank you for having me.

Tracy: (51:42)
That was great. Thanks so much Javier. I'm glad we could make it happen.

Tracy: (52:02)
So Joe, obviously that was a really enjoyable conversation. One of the things that struck me is just how untransparent this market seems to be, and you know, Javier's point about how we still don't have a trade repository for physical commodities. It’s just like in this day and age, on the one hand, everything in the world seems to be tracked except actual physical vital goods, which is insane. But on the other hand, I cannot see anyone in the current environment actually agreeing to do it.

Joe: (52:35)
Yeah, that's what I thought too. And when you actually think about what it would take, it's like, how would you even do that? Like how would you regulate and create a central repository for something in which you can literally swap the oil from one boat to another boat and you could mix the oil so that, you know, he was talking about the lot via blend of, okay, you have a barrel of oil, that's 49.9, 9% Russian and 50.01, something else like the, just the, the, the complexity of that. Like how would you even like start to conceptualize, tracking every tray when there's so many ways to just do a unilateral, one to one handoff of a good, you could see why it's so tough.

Tracy: (53:17)
Absolutely. And then the other thing that was striking to me, I don't know a lot of it felt like confirmation of this idea that going forward, getting commodities is just going to cost more money. It's going to be more difficult to get financing, there's going to be extra volatility, it seems like, which means you have to pay additional variation margin. The exchanges have already upped the initial margin. So the whole thing, and I haven't even mentioned shipping, shipping costs through the roof — and insurance —  it feels like everything is coming together to make it more expensive,

Joe: (53:55)
Expensive and complicated. And so this idea of like localized shortages, where even if you ostensibly have the money to pay for the price of a commodity that appears on the screen, can you actually get it delivered in a predictable manner? It feels like that's going to get tougher or going to stay tough.

Tracy: (54:14)
Right. It's the sort of disconnect between the financial and the physical, which we've been talking about. And that's also why what was happening with the New York diesel contract that Javier was describing is so interesting as well. Because that's the kind of localized stress that could happen

Joe: (54:29)
Or you know, he made this point, which is that everybody remembers when WTI oil went down into negative $40, but there were other regional benchmarks. We don't talk about them. But if you look on the terminal, there's like dozens of North American oil prices depending on what pipelines they have access to and the cost to get them out. And some of those were already negative and it's like, well, who has some empty space just at the right moment to charge someone for getting their oil off a boat or out of a pipeline. Just incredibly complicated during volatile times.

Tracy: (55:05)
Yeah. Like, an industry that was already insanely granular, is just getting even more granular and specific, it feels like.

Joe: (55:13)
I thought that was interesting too. It's like the oil traders, like what am I going to do with Chinese yuan, okay. Even if you don’t really love the idea of having your entire business being denominated in dollars, other currencies may not be that appealing.

Tracy: (55:28)
It's nice to have a fungible global reserve currency that’s for sure. 

Joe: (55:31)
There are some benefits.

Tracy: (55:32)
All right. Shall we leave it there?

Joe: (55:34)
Let's leave it there. 

You can follow Javier Blast on Twitter at @JavierBlas.