ENE 430

COMMODITY TRADING &

TRANSPORT

Lecture 1: Introduction
Professor Roar Ådland
 So, who’s this guy anyway....
• Studied marine engineering &
finance @ NTNU, NHH and MIT
250,000

• NHH Professor since 2012

200,000
• Worked for shipbroker Clarksons
in London for 8 years prior
150,000
- Drybulk analyst (coal, iron ore and grain
trade) – had Martin Stopford as boss
- Helped set up the Clarkson shipping hedge
fund in 2005/06 100,000

- Portfolio manager for freight derivatives

until 2011 – managed up to $100m
50,000

2
ENE 430 Commodity Trade and Transport (c) Roar Ådland

16-Jan-23
• Who are you?

• Why are you interested in taking the course?

• What are your expectations?

3
The elevator pitch

• Learn the nuts & bolts of commodity trading

• Learn the terminology of the business
• Understand how/why commodities move around the world
• Understand the physical & financial risks
• Know the drivers of markets and how they are connected
• Find interesting, relevant thesis topics!
• Be better prepared for an international job as an analyst or
trader in freight & commodities

4
What students say....

a focus on practical application was fantastic

It is the most interesting course I have taken in the ENE
degree so far
I really loved Questions of the day.
Brilliant guest lecturers!
Very positive to learn some
"hands-on" information that we
The practical approach and
can actually use.
the real and updated market
developments make this
I cannot be enthusiastic enough about this
course updated and course.
interesting to follow.
5
 This is an applied course

• Many fancy theories behind

international trade
• In reality it is one of the below
reasons:
- The commodity or a certain
quality/grade does not exist locally
(e.g. fuel for heating in Japan)
- Someone can make money trading it
(geographical arbitrage)
- Operational reasons (e.g. finding
storage – new)
- Politics (e.g. China building strategic
crude oil reserves)
• Focus will be on understanding and
reasoning, practical decision-making
and strategy
6
ENE 430 Commodity Trade and Transport (c) Roar Ådland

16-Jan-23
 Course plan

7
ENE 430 Commodity Trade and Transport (c) Roar Ådland

16-Jan-23
 Teaching

• Weekly modules dedicated to one topic or market

• Preparation in your own time:
- Go through the slides for the topic
- Read the book chapters or research papers for the week (average 1 per week, check
Leganto tab on Canvas)
- Note down any questions you may have
• Tuesdays 10:15 – 12:00: Introduction in Aud C. (Roar)
- We review and discuss the main takeaways for the week
- You solve a mini case in groups
- Will not be recorded, to facilitate an open discussion
• Fridays 10:15 – 12:00: Expert talks on market practice
- Mostly live (physical or digital in Aud. C), 1-2 may end up pre-recorded
• There will be no streaming of course content
8
16-Jan-23
Friday expert talks!
• 27th Jan: Practical ship operation, Gabriel Fuentes, NHH, ex-
Euronav
• 3rd Feb: Commodity derivatives and risk management, Stefan
Albertijn, Oficon, Antwerp (to be confirmed)
• 10th Feb: Freight trading, Egil Husby, Western Bulk, Oslo
• 17th Feb: Coal market, TBA
• 24th Feb: Oil products market, Anders Linden, Torm Tankers,
Copenhagen
• 28th Feb: Commodity markets and financial assets, TBA
• 3rd Mar: Commodity trade and sanctions, Windward, Tel Aviv
• 10th Mar: LNG market integration, Greg Molnar, International
Energy Agency, Paris
• 17th Mar: Iron ore market, Morten Aarup, D/S Norden, Copenhagen.

9
 Tentative course plan

Week Date Topic Lecturer Readings

Week 3 17-Jan-22 Course introduction RA Pirrong (2014) pages 4 - 8
Tutorship (2012) Introduction to shipping.
Commodity transport basics RA
20-Jan-22 Stopford (2009) Ch. 11 Commodity transport
Week 4 24-Jan-22 RA Adland et al (2016). Tutorship (2012) Ship
Chartering and operations
27-Jan-22 Guest: GF operations and Management
Week 5 31-Jan-22 RA
Risk management Pirrong (2014) pages 12 - 30, Hull (2011a,b)
03-Feb-22 Guest: SA (rec)
Week 6 07-Feb-22 RA
Freight trading
10-Feb-22 Guest: EB
Week 7 14-Feb-22 RA
Coal market He & Morse (2014)
17-Feb-22 Guest: NR (rec)
Week 8 21-Feb-22 Crude oil market RA
24-Feb-22 Oil products market Guest: AL (dig)
Regli & Adland (2019) Commodity trading
Week 9 28-Feb-22 Commodities and financial assets Guest: TBA
Guest:
03-Mar-22 Commodity trade and sanctions Windward
Week 10 07-Mar-22 RA Presentations in/Term paper topic out
Natural gas market
10-Mar-22 Guest: GM (dig) Bridge and Bradshaw (2017)
Week 11 14-Mar-22 RA
Iron ore market Wårell (2014)
17-Mar-22 Guest: MA
Week 12 21-Mar-22 Student presentations
24-Mar-22 Student presentations Student
Week 13 28-Mar-22 Student presentations presentations and
Submit term paper in Wiseflow term paper
31-Mar-22 (Deadline 14:00)
10
 Assignment for course approval

• Course approval is based on a submitted group

presentation:
- Lecture format, 15 minutes including Q&A
- Self-selected groups (no more than 4 students) on Canvas
- Try to join a group as soon as you are certain you will take the course.
• Presentation topic
- “Your top commodity/freight trading idea” - see published assignment text
on Canvas for details.
• Deadlines
- To ensure variety and suitability, please submit a sentence describing your
intended topic on Canvas by February 17th. Topics are approved on a first-
come basis.
- Upload the group’s presentation by March 7th (end of day)
- Presentation dates are 21st, 24th March and March 28th.

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16-Jan-23
 Graded term paper

• Structure
- The term paper is a large case study where your group writes a report
on the transportation requirements, commodity purchasing strategy
and risk management approach for a real company/asset such as a
power station, refinery, steel mill or similar.
• Practicalities
- Group size should be 3 - 4 students (no more than 4) – usually the
same group as for the course approval assignment.
- The full text for the term paper question will be on Canvas on 7th
March.
- The term paper must be submitted in Wiseflow by 14:00 on March
31st.
• A sample (old exam text) will be uploaded to Canvas
12
16-Jan-23
Questions?

13
Master thesis inspiration in shipping/trading
https://www.nhh.no/en/research-centres/shipping-and-logistics/topics-for-
master-theses/
Nice to know...

• Institute of Chartered
Shipbrokers professional
exams
- 7 exams (shipping economics,
offshore, law, tanker chartering, sale
& purchase etc.)
- Takes place in Nov/May
- More information on
http://www.ics.org.uk/exams-

https://www.nhh.no/om-nhh/nhhs-
fond/eksterne-fond/ 15
Part II: Group discussions – Question 1

China banned coal imports from Australia in 2021.

This has now been partially lifted. What do you think
the impact would be on the coal and freight market?

16
Question 2

How do the international coal, natural gas and

shipping markets affect your electricity bill currently?
(both direct and indirect effects)

17
Question 3

How does the current heavy rains in Brazil affect the

international commodity and shipping markets?

18
ENE 430
COMMODITY TRADING &
TRANSPORT
Lecture 2: Commodity market basics
Professor Roar Ådland
Agenda: Commodity market basics

• Topics:
- The geography of commodity trade: Exporters, importers and main
trading routes
- Main trade terms (a.k.a. INCOTERMS)
- Main ship types & sizes used for commodity transport
- Port infrastructure is needed (cargo handling, offshore terminals)

• Readings
- Tutorship (2012) Introduction to shipping, Chapter 3
- Recommended: Stopford (2009) Chapter 11, The transport of bulk
cargoes
Scope of “Commodity” in the course

• A homogeneous cargo, filling an entire ship (“bulk”)

and traded in large volume globally
• Wet bulk
- Crude oil: Raw material for refineries
- Liquid natural gas: Domestic heating/cooking, powerplants
• Dry bulk
- Iron ore: Steelmaking ingredient
- Coal: Thermal for powerplants, coking coal for steelmaking, cement

• We do not directly cover containerised cargo or the

minor bulks (sugar, steel, nickel ore, soybeans etc…)
Basic principles of trade

• Changing sources of supply and demand (location

and volumes) generates the network of trade
• The network is always changing!
• Ships are there to facilitate trade (derived demand)
- Can transportation drive demand?
• Some drivers of change are generic across many
commodities
- Example - temperatures drive power demand (heating, A/C), the size of
harvests, building activity etc.
- Global industrial production

4
Reasons for changing trade

• Supply/demand/price effects
- Local product mix does not meet local demand (e.g. oil products)
- Local deficit or surplus of a commodity
- Imports are cheaper and/or better quality than domestic production
- Exports obtain a higher price
- Inter-regional price differences that are greater than the cost of transportation
(arbitrage trades)
• Operational reasons for a changing network
- Insufficient local storage and production cannot be easily curtailed (e.g. crude
oil, supply push)
- Changing location of sources and consumers (new export terminals, new
refineries/steel mills)
- Maintenance, closures, bottlenecks in infrastructure
- Competing infrastructure (pipelines, rail, ships)
- Production requirements (US refinery crude oil quality)
- Weather and natural disasters (tsunami, hurricanes)
• Politics
- Environmental regulations, sanctions, export bans (e.g. US crude oil), supply
security, trade wars, political spats…
5
 Drybulk commodities

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Copyright: Norden AS
18-Jan-23 ENE 430 Commodity Trade and Transport (c) Roar Ådland
Main global drybulk trade patterns

Trans
Atlantic

TransPacific

Pacific
basin Pacific
basin
Fronthaul

Backhaul

Atlantic
basin
Laden (full) ship
Ballast (empty)
Commodity overview: Iron ore
• Used to make pig iron in steel mill
blast furnaces
• Raw ore is a mix of ferrous oxides
and rock
- Hematite (Fe2O3)
- Magnetite (Fe3O4)
• Direct shipping ore (export grade
magnetite) has Fe 58%-64%
• Lower grade ore requires
beneficiation (crushing, separation)
to improve Fe-concentration = fines
- Only economically viable with Fe content > 20-
25%
• What you pay for is the Fe content
of the raw ore but everything has to
be shipped

8
 The seaborne iron ore market

•Australia/Brazil only source of (low) growth

•Higher-cost producers are being marginalised

Sources: Stopford/Clarkson Research

Commodity overview: Coal

• Coal is classified by end

use:
- Coking coal is the basis for
producing coke used in the blast
furnace
- Thermal/Steam coal is used as
fuel in power stations
- Some substitution between
thermal and lower grade coking
coal
• Quality determinants Benchmark index coal specifications

- Calorific value (CV, kcal/kg)

- Total moisture (TM) content
- Sulphur content
- Ash content (incombustible)
Source: West (2011), NAR = Net As Received
Main coal exporting ports

Sources: Stopford (2009)

11
Import trends

Source: Clarksons Drybulk Trade Outlook

12
Oil & gas
trade

13
Crude oil & products market

•Biggest commodity market in the world: 2.1bn tonnes of inter-area crude oil trade, Source: BP
Statistical
1.1bn tonnes of oil products Review
•Biggest crude export areas: Middle East, FSU, West Africa, South America 2021 14

•Biggest crude import areas: Europe, US, China, Rest of Asia

Oil products
• Crude refining process:
- Heat crude oil using high-pressure
steam – turns into vapour
- Vapour rises up inside the fractional
distillation column “Clean”
- The various factions cools down and products
liquefies at different levels
• For transportation purposes “Dirty”
products
we distinguish between
- Clean products shipped in specialised
“coated” clean products tankers
- Some overlap with the chemical trades
- “Dirty” products which can be shipped
in standard tankers
- Coated tankers sometimes carry
“dirty” cargoes if much higher rates
15
The oil products trade

• Reasons for trade:

- Changing global structure of refinery location (e.g. Middle East vs India
vs China) – NIMBY effects and environmental regulations
- Balancing trade: Refinery product mix does not meet local demands
- Deficit trade: Local shortage or surplus of certain products
• Specific drivers:
- Inter-regional price differences that are greater than the cost of
transportation (arbitrage trades)
- Refinery profit margins (“crack spread”) affect throughput
- Refinery closures and maintenance periods
- Local oil product storage levels
- Availability of light vs heavy crude oil

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Natural gas
• Naturally occurring hydrocarbon gas • Gas processing & liquefaction
mixture (primarily methane)
plant (LNG train)
• Found in oil fields (associated gas)
- Removes water, heavy hydrocarbons and
or in natural gas fields (non- other impurities
associated) - Liquefies the remaining methane for
• Usage: storage & shipment
- Power generation
- Consumer fuel (heating, cooking & transport)
• Shipped in liquid form on LNG
- Feedstock for production of ammonia &
fertilizer carriers
• Storage • Discharge at purpose-made
- Depleted reservoirs
- Salt domes
- Overground gas tanks
receiving terminal
• Gas transport: - Cryogenic storage
- Pipelines in gaseous state - Re-gasification plant
- Compressed natural gas (CNG, high pressure - Possibly offshore (Floating Storage and
> 200 bars) Regasification Unit, FSRU)
- Liquid natural gas (LNG, reduce temperature
to minus 162C)

17
Global natural gas trade

Main LNG
exporters:
•Qatar
•Malaysia
•Australia
•Nigeria
•Indonesia
•Trinidad &
Tobago
•Algerie

Main importers:
•Japan
•Europe
•South Korea
•China

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Trade terms

• Most global trade based on Sellers obligations become more onerous

standardised trade terms to

avoid conflicts
• Apply only if incorporated
into the contract of sale
• INCOTERMS (2010)
- are governed by the
International Chamber of
Commerce, Paris
- Define who pays and has to
make the arrangements
But the risk passes to buyer when
goods has been placed onboard!
19
Free On Board (“Named port/area/country”)

• Seller
- Must prepare and transport the cargo to the designated sea port
- Bears the cost of loading the cargo onto the vessel designated in the
contract
- Has delivered when the cargo has been “placed onboard”
• Buyer
- Has to bear all costs and risks of loss or damage to the cargo from that
point
- Must pay demurrage (compensated damages for delays) to the
shipowner at the loading port unless delays are attributable to the seller
- Bear any costs if the vessel designated by the buyer (or buyer’s agent) is
unable to load

- The shipowner is typically just an agent (someone delegated to act on

behalf of a principal)
- The buyer of the cargo will be the charterer of the ship
20
CIF (“Named destination port”)

• Seller
- Must contract and pay for the transportation to the destination sea port
- Bear the cost of demurrage at the port of shipment
- Obtain and pay for export documents and Bill of Lading
- Arrange and pay for transferable insurance coverage for the risks, duration and
journey specified in the contract of sale

• Buyer
- Must (still) bear all risks from the time the cargo has been placed onboard at the
loading port
- Bear the cost of discharging, lighterage etc. at the destination

• Bill of Lading (B/L)

- Document issued by the shipowner as proof of shipment (receipt). B/L is also
the title to the cargo (ownership) and can be transferred to other parties
21
FOB vs CIF

• Historically many commodities are sold FOB, with

price quotes based on a specific port/terminal of
delivery
- e.g. Brent Blend crude oil, sold “FOB Sullum Voe”, UK
• Iron ore market has changed to CFR pricing (e.g.
spot price indices basis CFR China)
- Miners taking control of their supply chain – a rise in owned or
chartered-in tonnage (Rio Tinto Marine, Vale) since 2008
- A belief in lowering transport costs in-house = increasing margins of
sale
- Can influence the timing, size and numbers of (own) ships/arrivals =
more effective port utilisation
- Building up regional storage & distribution centres closer to the client
(e.g. Vale: Oman, Malaysia, China)
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 Structure of commodity shipping

Cargo transported Ship type Sub-segments Size range Typical size Unit
Capesize >=100000 180000 DWT
Panamax 60000 - 100000 76000 DWT
Drybulks Bulk carrier
Handymax 40000 - 60000 52000 DWT
Handysize 10000 - 40000 28000 DWT
VLCC >=200000 320000 DWT
Suezmax 120000 - 200000 160000 DWT
Crude oil & dirty petroleum products Crude tanker
Aframax 80000 - 120000 105000 DWT
Panamax 60000 - 80000 72000 DWT
Long Range 2 (LR2) 80000 - 160000 105000 DWT
Clean petroleum products Clean products carrier Long Range 1 (LR1) 55000 - 80000 74000 DWT
Medium Range (MR) 25000 - 55000 50000 DWT
Liquified Natural gas (LNG) LNG carrier LNG 120000 - 266000 140000 m3

DWT - deadweight - carrying capacity of a ship (including stores, fuel)

This you should memorize…

23
Parcel sizes & economies of scale
• The cost of building and
operating does not increase
proportionally with ship size
- Crew size relatively constant above
“minimum crew”
- Steel use and equipment cost
- Fuel cost
- Investment per DWT a decreasing
function of size
• But increasing size reduces
the number of available ports
and cargoes
- Lower flexibility of trading
- Higher volatility of earnings
- Few customers need that large parcel
size supplied at once
- May require multi-port visits = Source: Stopford (2009)
inefficient operation
24
The bulk carrier
• Simplest design
• Handymax & smaller
vessels usually have
cargo handling gear
(cranes)
• Capes & Panamax
vessels usually
dependent on shore-
based equipment
(gearless)
• Sub-categories with
modified designs
- Ore carrier
- Log carriers
- Cement carriers Handymax Panamax Capesize
25
Cargo hold design (iron ore carrier)
• Topside and wing tanks
used for water ballast
Topside tank to maintain stability and
a minimum draft when
the ship is empty
• During loading and
Wing tank
discharge operations
the ballast water is
pumped out/in to reflect
changes in the weight
of cargo onboard
• Diagonal slopes moves cargo towards the middle during
discharge (self trimming)
• Avoids the need for the trimming (flattening) of light
cargoes such as grain after loading
26
Tanker
• Mandatory double hull design
with tanks used for water ballast
• More complex design with piping
from cargo tanks via pump room
to manifolds (shore connections)
on deck
• May allow separate handling of
several different grades of crude
oil
• Very strict procedures for cargo
handling to avoid explosions
- E.g. Filling cargo tanks with inert gas (low-
oxygen air) as they are emptied

27
 LNG carriers
• Insulated cargo tanks to maintain
temperature below -160C
• Two main cargo containment
designs
- Spherical “Moss type”
- Membrane tanks – more efficient use of space
• Complex cargo handling cycle
- Gas free > inert gas > methane gas > cool down
tanks > bulk loading of tanks
• Some boil-off (vaporisation)
traditionally used as fuel for the
ship’s steam turbines when laden
• Trend towards onboard re-
liquefaction and a more efficient
dual-fuel diesel-electric engine
system

28
 Port infrastructure

29
ENE 430 Commodity Trade and Transport (c) Roar Ådland

18-Jan-23
 Drybulks loading
• Alternatives:
- Ship’s own gear
- Offshore terminal (floating crane,
transloader)
- Fixed equipment at berth
• Typical export terminal for
iron ore and coal:
- Moved from mine to port stockpile
by rail
- Stacked and reclaimed from the
stockpile using a system of
conveyors and a “stacker/reclaimer”
machine
- A “shiploader” drops the cargo into
the ship’s holds in a certain loading
sequence

30
Drybulk loading facilities
Coal loading at
berth in Richards
Bay, South Africa

Coal loading in
Myrtle Grove, Bucket wheel
US, using floating stacker/reclaimer
cranes & barges

31
 Drybulk cargoes discharge
• By ship’s own gear, offshore or
at berth using cranes with grabs
• Allowable time in port for
loading/discharge operations
(laytime) is set out in the
contract by
- Number of days
- Rate (tonnes/hour) at which cargo handling
operations must take place
- The term Customary Quick Despatch
(CQD) – “as fast as possible given the
circumstances”
• Contracted versus actual
loading/discharge rates is a
complex source of trouble &
profit for shipowners & shippers

32
Oil terminal infrastructure
• Loading by onshore pumps from
storage terminals
• Discharge using ship’s own
pumps
• High loading & discharge rates
- Around 18,000m3/hour for VLCC loading
- Around 15,000m3/hour for VLCC
discharge

33
ENE 430
COMMODITY TRADING &
TRANSPORT
Lecture 3: Ship chartering and freight rates
Professor Roar Ådland
Ship chartering and freight rates

• Topics:
- Types of contracts (charterparties)
- Formation of spot freight rates
- Voyage calculations in bulk shipping

• Readings:
- Adland et al (2016)
Terminology

• Charterer
- The company that enters into a contract with the shipowner to use a ship
- ...could be another shipowner, a cargo owner or a ship operator
• Charter party
- The name of the contract between the owner of a vessel and the charterer for
the use of a vessel
- A successful match between ship and cargo is called a “fixture”
• Open/fixed/re-let ship
- A ship looking for the next cargo is “open”
- Once a charter party has been signed the ship is “fixed”
- A ship that is chartered in on a timecharter and out on another charter is “re-let”
• Ship operator
- Companies that do not own ships, but commercially control (charter in) a fleet
through charterparties
3
Types of costs that shipowners face

• Capital costs (CAPEX)

- Interest and principal payments
- These are fixed costs
• Operating costs (OPEX)
- Crew
- Maintenance
- Insurance
- Spare parts and supplies
- Administration costs
- These are also “fixed costs” in the short run for a ship that is operational
• Voyage costs
- Variable costs that only accrue if the shipowner accepts a voyage
- Fuel costs – depends on fuel consumption, speed and fuel price
- Port and canal fees

4
Two main types of contracts in shipping:
«Taxi» vs. «Rental car»

Voyage charter («taxi») Timecharter («rental car»)

• Charterer pays an agreed • Charterer hires the ship for
freight rate ($/tonne cargo) a period of time at a certain
from port A to B $/day rate
• Owner pays all expenses - A single trip (Tripcharter)
- CAPEX - Multiple trips
- OPEX - A certain period of time, usually with
- Voyage costs some flexibility (e.g. 6 – 9 months)
• Owner controls the ship • Charterer pays the voyage
(destination, speed..) costs
• Variations:
- X consecutive voyages • Charterer has commercial
- Contract of Affreightment (COA): A
certain number of trips or tonnes per
control of the ship
year • Owner pays CAPEX/OPEX
5
Voyage or tripcharter? (charterer’s view)
• A voyage charter is most
suitable for:
- A single commodity from one
loading port to one discharge port
- When loading & discharge rates are
well established (laytime
compliance)
• Division of risks
- Shipowner bears the cost of delays
during the voyage (e.g. waiting/port
congestion, bad weather, strikes) as
the effective daily income is reduced
- Charterer bears the risk of not
completing cargo handling on time
and paying demurrage
• A tripcharter is most
suitable for:
- Many parcels/customers in
several ports – would make VC
complex
- Need more geographical
flexibility ("Delivery Kobe, trip
WC North America redelivery
Los Angeles - Vancouver Range
expected duration 90 days“
• Division of risks:
- Daily hire must be paid during
delays, except when due to the
ship breaking down
- No demurrage calculation
6
Main voyage charter terms
• Vessel particulars (name, DWT, flag)
• Cargo size
- Margins (+/- 10%). Often abbreviated as MOL (More or less)
- Charterer’s or owner’s option to decide (Abbreviations: OO, CHOPT)
• Loading/discharge port(s)
• Freight rate
- Fixed rate ($/tonne) or lump sum
- When/where payable
• Laycan - laydays & cancelling
- The owner has a time window during which the ship has to present for loading – the
«laycan» - e.g. 10/20 February
- The charterer is not obliged to commence loading until the first layday and may
have the option of canceling the charter if the ship arrives after
• Laytime
- Time allowed to the charterer to complete loading & discharge operations
- Specified in days/hours or as a loading/discharge rate (tonnes/day)
- Exceptions (bad weather, holidays, strikes etc.)
- SHINC/SHEX - Sundays & Holidays included/excluded in laytime calculation
7
Voyage terms (cont.)

• Demurrage
- Money paid ($/day) to the shipowner by the charterer for failing to complete
loading and/or discharging within the laytime
- «Once on demurrage, always on demurrage», no exceptions
• Despatch
- Amount of money payable by the shipowner to the for loading and/or
discharging in less than the time allowed
- Normally at the same rate as, or half the rate of the rate of demurrage
• Vessel speed
- Owner has the option to reduce the vessel’s speed as long as it stays above a
minimum agreed speed (optional contract clause) to save on fuel costs
• Cargo handling costs
- FIO - Free In and Out: Charterers (shippers / receivers) to arrange the loading /
discharge on their own account
8
Worldscale
• Tanker voyage rates are
measured by the Worldscale TD3 historical flat rates (WS100)
(WS) index 35 700.00

• The index reference point (100) 30 600.00

is called the “flat rate” and is set 25 500.00

$/tonne TD3 fkat rate

$/tonne fuel price

at a certain $/tonne 20 400.00

• Every tanker route in the world 15 300.00

has its own flat rate 10 200.00

- 320,000 routes! 5 100.00

- Changes every Jan 1st (based on changes in
voyage costs during the 12 months ending 0 0.00
30th September – introduces a lag effect)
• The WS rate for a fixture
represents a percentage of the NB! WS rates are not comparable
flat rate for the route across years because the
- The $/tonne equivalent of WS35 = 0.35*flat benchmark changes
rate for the route
Main time charter terms

• Ship details
- DWT, grain/bale cubic capacity
- Number of holds/hatches/cranes
• Time period & hire
- E.g. 5/7 months or 2 + 1 years
- Hire rate and payment frequency
- Limits on vessel trading & cargo carried
• Delivery/redelivery of ship
- Exact place of delivery
- Redelivery often a geographical range or
simply “worldwide”
- Delivery dates (period & cancelling)
• Speed & fuel consumption
- Speed of X knots on Y tonnes/day of Fuel
Oil
- Underperformance can lead to cancelling
10
The purpose of the period timecharter market
• Redistributing freight market risk according to
owners/charteres’ risk preferences
- Conservative shipowners may charter out their entire fleet on long-term period
TCs, earning a steady revenue but foregoing upside
- Cargo owners can secure long-term carrying capacity for their cargoes
- Risk-loving shipowners can charter in ships on a period TC and re-letting them
in the spot market, increasing their spot market exposure
- Ship operators can take advantage of perceived «arbitrage» opportunities
between the different types of freight contracts (spot, TC, COAs and FFAs)
• The TC market does not alter the total number of
cargoes or ships available in the freight market
• A period TC is not risk free – the risks merely changes:
- Primarily default risk (non-payment of charter hire)

11
 Supply of transportation from a single ship

$/tonne

Above a certain At very high rates the

breakeven rate the ship reaches capacity
ship accepts a voyage (max speed etc.). No
at minimum speed further increase in
supply is possible

As rates increase, the

ships productivity
increases (higher speed,
lower port time etc.)

What determines the shape of tonnemiles

this function? 12
What determines the shape of this function

• Ship speed
- Higher speed = more tonnemile
production per time unit
• Fuel costs
- Daily fuel consumption is a power
function of ship speed, F=α·Vβ
- Fuel price creates a vertical shift
• Cargo size carried
- Cargo carrying capacity (DWT)
and its utilization
• Other factors that affect
efficiency
- Port turnaround time
- Breakdowns, maintenance
13
Momentary market balance (regional)

• Fragmented market
- Regional equilibria,
disconnected from global
market
• Highly inelastic supply
- (Nearly) impossible to get
more ships in on time
- ...but can have «fewer» ships
as owners hold back from the
market
• Highly inelastic
demand
- Crude oil cargoes must be
shipped within a time slot
- Onshore storage constraints,
refinery requirements
14
Short run supply/demand balance

• In the short run, ships can move

around the world = integrated global
market
• Slightly higher elasticity at high rates
• The “kink” in the short-run supply
function defines two separate rate
regimes
• Low rates: Low sensitivity to changes
in demand due to high supply
elasticity
• High rates: Both supply and demand
are highly inelastic
• Leads to volatility clustering
Source: Stopford

15
Determinants of spot rates
• Horizon matters
- Regional or global
equilibrium?
- Capacity constraints?
• Shifts in the cost
structure
- Fuel prices
- Cost effectiveness (vessel
size, fuel efficiency)
- Vessel speed
• Demand volatility
- Long run: Business cycles
- Short run: Cargo availability
• Sentiment
- Leads to shifts in
supply/demand in the very
short run
16
What about individual contracts (fixtures)?

• Is it still a perfectly competitive market?

- Identical products? (ships, owners and charterers)
- Many buyers and sellers?
• Can some companies have pricing power?
• Which factors can affect individual fixture rates?

17
Which factors affect individual rates?

18
Do certain companies have pricing power?

19
Voyage estimation

• Purpose:
- Estimating the profit, breakeven or how much to bid/offer for a
particular trip
- Key skill for freight traders, commodity traders, chartering managers
and shipbrokers
• Objective for shipowners: Maximize timecharter
equivalent (TCE ) $/day earnings of ship
• Objective for charterers/cargo owners: Minimize
$/tonne cost

20
Competition between ship sizes

• Adjacent ship sizes generally

compete for cargoes 14.00

- 2 Panamaxes can take 1 Capesize cargo 12.00 C2 spot rate

(cargo splitting) 10.00

Voyage costs

- Vice versa (combining cargoes) Panamax TA

rate
- Cargo splitting never profitable in poor 8.00

markets due to ‘economies of scale’ of the 6.00

larger ship (lower rate)

4.00
- $/tonne rates for the larger ship is “never”
higher than a smaller ship 2.00

• But 0.00

- Combining cargoes onto a large ship may

not be possible due to physical size
constraints in port
- Competition from smaller vessels creates
a ceiling for the $/tonne rate, not a floor! 21
Calculating timecharter equivalent rate (TCE)
• For comparing different voyage charters and/or tripcharter
opportunities
gross _ revenue − voyage _ cos ts
TCE =
Tripduration
D
R ⋅ W − Pc − Pb ⋅ F ⋅
= 24 ⋅ V
D
Tp +
24 ⋅ V
• Where
- R is the voyage freight rate ($/tonne)
- W is the cargo size (tonnes)
- Pc is total port costs for the trip ($)
- D is total distance sailed (nautical miles)
- F is fuel consumption (tonnes/day) at speed V (knots, nm/hour)
- Tp is total days in port
- Pb is the price of fuel/bunkers ($/tonne)

22
 Question of the day

• The commodity trade • Voyage details

- Buy a cargo of low-sulphur ship - Cargo size W = 90,000 tonnes
fuel oil (VLSFO) at Pb=$516/tonne - Distance via Suez canal: 6330 nautical
miles (n.m.) each way
in Rotterdam and sell it in Fujairah
- Port days: 2 days each port
(UAE) at $633/tonne - Fueling in Rotterdam only
- The tripcharter rate for a return trip - Port and canal fees Pc=$500,000
between Arabian Gulf and
Rotterdam is $22,360/day • Ship specifications
- Vessel speed V=12.5 knots
• What is the potential profit (n.m./hour).
- Fuel consumption F=29.5 tonnes/day.
for an oil trader per cargo?
• Profit equals price difference
gross _ revenue − voyage _ cos ts
TCE =
Tripduration less transportation cost
R ⋅W − Pc − Pb ⋅ F ⋅
D
24 ⋅V
• Keep in mind who pays for
=
Tp +
D
24 ⋅ V
what…
23
 Answer of the day

Calculating fuel costs

Distance Speed (knots) Sailing days Daily cons. Fuel price Fuel cost
Ballast 12660 12.5 42.2 29.5 516 642,368

We want to find the voyage charter rate ($/tonne) given the TCE and voyage costs

R= (TCE*trip duration + fuel costs + port/canal fees)/cargo size =

(22360*(42.2+4 days) + 642368 + 500,000)/90000 = 24.17

Profit per cargo: 90000 tonnes * ($633/tonne - $516/tonne - $24.17/tonne) = 8,354,600

24
ENE 430
COMMODITY TRADING &
TRANSPORT
Lecture 5: Commodity derivatives and risk management
Professor Roar Ådland
Derivatives basics

• What is a derivative?
- A financial instrument whose price is derived from one or more
underlying “assets” (price, quantity, temperature, rainfall etc.)
- Also called ”contingent claims”: payoff contingent upon something else
• Why do derivatives market exist?
- They assist in transferring risk (typically price risk)
• from those who want to reduce risk (“hedgers”) to those who want
additional risk (“speculators”)
• “Arbitrageurs” use them to take offsetting positions in two or more
instruments to lock in a profit
- They assist in price discovery: Derivatives prices set in a liquid market
of buyers and sellers contain/signal information to the rest of the
economy

2
Two main types of markets
• ”Over-the-counter” (OTC) • Exchange-traded
- Voice brokered, privately
negotiated, bilateral contract
- Transaction can be kept ”off
market” (non-transparent)
- Can be customised to fit clients’
needs (but rarely is)
- Counterparty/default risk
- Fully standardised contract terms
- Transparent (trades, prices and
volumes are public)
- Regulated
- Clearing removes counterparty
risk
3
 Types of derivative contracts
• Forward contract
- Traded OTC
- Obligation to buy or sell a
certain quantity of something
at an agreed price at a
specified future time (the
settlement)
- No money changes hands
until settlement/delivery
• Futures contract
- Exchange traded
- Agreement to buy or sell a
fixed quantity of a specified
asset on a particular date
- Clearing requires an initial
margin (deposit) and daily
variation margin (marking-to-
market of the position)
4
 Types of derivative contracts (II)

• Swap contracts • Options

- An agreement to exchange
something variable for
something fixed (or vice versa)
- OTC but regulatory pressure to
put them on exchanges
- The right but not an obligation
to buy (call option) or sell (put
option) a quantity at an agreed
price (strike price) at some
future date/period

- Freight market example:

• A shipoperator pays a fixed
TC rate and receives the spot
rate from re-letting the vessel
• Effectively a long position in a
physical freight swap

5
The OTC problem Solution

• You are locked into a • A clearing house takes the

bilateral contract (until and role as a middleman
unless the same two between all buyers and
parties agree to do the sellers (directly or
opposite trade) indirectly via clearing
members)
• You can do an offsetting
• Largely removes the risk
trade with another party
of non-payment
and remove your market
exposure but credit
exposure to the original
party will remain
• Counterparty default risk
6
Clearing house functions

- Independent daily valuation of

positions
- Daily transfer of profits and loss
between accounts (“marking-to-
market”)
- Deposit for all trades (initial margin)
- Additional margin (variation margin)
if large loss
- Liquidation of position if margin not
maintained
- Margin size is set to cover the expected
loss if position has to be liquidated
- Additional costs of defaults are
absorbed by the capital base of the
clearing house
7
Cash settlement or physical delivery

• Cash settlement = the bet is settled in cash, e.g.

- I buy an iron ore swap from you at $40/tonne
- The settlement price for the contract ends up being $50
- You end up paying me (50-40)*500 (tonnes/contract)
- If the contract was not cash settled you would have to deliver 500
tonnes to the agreed place on the settlement date
• Even where the contract stipulates physical delivery
most futures contracts are not held until settlement
- The position is “closed out” by making the opposite trade before
settlement
- Traders have no intention to make or take physical delivery
- Purpose was hedging or speculation only

8
Long vs short positions

• A “long position” increases in value when the price (or rainfall, volume, temperature
etc.) of the underlying goes up
• A “short position” increases in value when the price goes down

• For forwards and futures the buyer is said to be “long” and the seller is “short”
• ....but the buyer of a put option will have a short position

9
Pricing the forward curve

• The forward curve for financial assets and

investment commodities will normally slope
upwards (“contango”)
- Cost-of-carry relationship: Forward prices must cover
storage and financing costs
- This holds when agents are indifferent about receiving the
asset now or later
- During times of physical shortage the curve can “invert” to a
downward slope which is then termed “backwardation”

10
The cost of carry relationship

• Assumptions • If F0 > ( S 0 + U ) ⋅ e r ⋅T
- r = risk free interest rate • Borrow (S0+U), buy the
- S0 = spot price
commodity and store it, sell
- F0 = today’s Forward price
- T = Maturity of the forward the forward
- U = NPV of storage costs
between 0 and T
• If F0 < ( S 0 + U ) ⋅ e r ⋅T
• The relationship between spot
and forward prices is • Sell the commodity, invest the
proceeds and buy the forward
F0 = ( S 0 + U ) ⋅ e r ⋅T
• If not there are arbitrage
possibilities (risk free profit)
11
Consumption commodities are different

• Commodities bought We only know there

is an upper bound for
for consumption forward prices:

cannot be sold (short)

in unlimited quantities
- Cannot execute the arbitrage
trade
- Even the upper bound need
not hold if storage is
unavailable
- “Supercontango”: Futures
prices exceed spot + normal
storage costs (oil market in
early 2009 and 2015/16,
2020)
12
Third category: Non-storable commodities
• Freight is a non-storable service
- Information or predictions about the future does not
have to affect current spot prices
- Example: known Asian refinery maintenance in April
may affect tanker forward prices for April but not the
spot rate in March
• There is no mathematical relationship linking
spot and forward freight prices!
- FFA curves can be both in contango (bad markets)
and backwardation (good markets)
- Forward curves reflect only expectations/sentiment (mean
reversion) and possibly a risk premium
13
Aggregating risk exposure
Fund/Company level

Coal book Iron ore book TransPacific TransAtlantic Book level

freight book freight book

Short 150,000t Long C4 June Instrument

iron ore FFA level
delivery June
Short 2014
Long 150,000t Capesize TC
May call option

• Risk exposure at an aggregate level is a function of

- Exposure (price dynamics, position sizes) at the instrument level
- Correlation between the prices of individual instruments/contracts
• Books are often independently managed (profit centres)
• Each book may have separate risk limits
- Gross/net exposure, VaR
14
Position limits

• The most basic of risk limits

- Gross exposure: The sum of the absolute notional dollar value of all individual
positions
- Net exposure: The sum of the dollar notional value of all individual positions
(i.e. short positions count as negative notional values)
- May include gross/net exposure by future time period (e.g. at least 60% of gross
exposure within the first three monthly contracts due to liquidity)
- Notional value of options are accounted for using the option’s “delta”
(sensitivity to changes in the price of the underlying price)
• Commodity trader example
- Owns a cargo of 150,000 tonnes of iron ore to be sold in March. Current
March forward price is $157/tonne
- A long position of 75,000 tonnes in an iron ore July put option with delta = -
0.30. The July forward price is $140/tonne.
- Gross exposure = 150,000*157 + |75,000*-0.30*140| = $2.67m
- Net exposure = 150,000*157 – 75000*0.3*140 = $2.04m
15
Value at Risk: Definition

• Value at Risk (V) of a portfolio

- “I am X per cent certain there will not be a loss of more than V dollars
in the next N days”
- N – time horizon (days)
- X – confidence level

- Risk limit example: One-day 95% VaR of $5m (or equivalently 5% for
$100m capital)
- Simple and intuitive but often based on strong assumptions
16
Estimating Value at Risk

• If daily returns are i.i.d. N(0,σ) then

N _ day _ VaR = 1 _ day _ VaR ⋅ N

• Estimating VaR using simulation

Historical simulation:
- Sample sets of previously observed daily changes in risk variables
- Calculate corresponding scenarios for the value of the portfolio
- Estimate VaR as the appropriate percentile of the simulated distribution
of portfolio value changes
- Pros: Can have non-normal distributions
- Cons: Limited to events that have occurred in your past sample period
Monte Carlo simulation:
- Sample risk variables from probability distributions rather than history
- Allows outcomes not already observed, but slow for complex problems
17
Estimating VaR using models
• Calculate portfolio volatility σp based on volatility estimates for the
individual instruments and their correlations
• In the case of two assets X and Y following a bivariate normal
distribution with
- Daily standard deviations σx and σy
- Portfolio weights wx and wy
- Correlation between asset prices ρxy

σ p = wX2 σ X2 + wY2σ Y2 + 2wX wY σ X σ Y ρ X ,Y

• Conversion from annual to daily (trading days) standard deviation
σ annual
σ daily =
250
• Portfolio weights indicate the fraction of the portfolio’s total value
held in each instrument, i.e.
- wi = (value held in the ith asset)/(total portfolio value)
- w1+ w2+....+ wi = 1 (must sum to one)

18
Introduction to hedging

• Hedging: Using derivatives to reduce the impact of a

particular risk (typically price risk)
- Making an opposite trade in a derivative that is highly correlated to the
exposure you have
- Short hedge: Natural longs (you own an asset or expect to receive it in the
future) would create a short position using derivatives
- Long hedge: Natural shorts (you expect to pay for an asset in the future) would
create a long position using derivatives
• Why hedge?
- Price speculation on your input/output factors is not part of your business
model (e.g. a steel mill producing steel, not forecasting iron ore prices)
- Your lenders require some stability in revenue
• Why not?
- Hedging will by definition produce a worse outcome a large part of the time
(when an unhedged position would be more profitable)

19
Hedging example using a forward contract
Long physical

A shipowner is “long”
physical freight and must
sell (“short”) the forward
contract to lock in the
forward price K

- Shipowners have natural “long” positions in the freight market and would hedge with a short
forward position
- Charterers have natural “short” positions in the freight market and would hedge with a long
forward position
- What is the physical commodity exposure and how should you hedge if you are:
• A grain farmer
• A steel mill
• A coal miner

20
Basis risk
• In practice hedges are not
perfect
- The specification of the futures
contract is not the same as the physical
commodity to be hedged (cross
hedging)
- Uncertain timing of physical
transactions
- Hedge is closed out before delivery
- Futures contract is settled based on
monthly averaging, physical
transaction is not
Basis =
• Basis risk spot price of asset to be hedged
- F and S do not necessarily move by the – futures price of contract used
same amount over time
- Some price risk remains unhedged An increase in the basis is
termed “strengthening”
- F and S converge at settlement only if
assets are identical and there is no A decrease in the basis is
monthly averaging termed “weakening” of the basis
21
Optimal hedge ratio
• What is the optimal size of the hedge position?
• No basis risk (spot and futures prices move in tandem)
- easy – a one-to-one ratio between futures and physical position will give a perfect
hedge
• With basis risk
- Optimal hedge ratio h* depends on the volatilities of ΔS (σS) and ΔF (σF) and their
correlation ρS,F
- We want to minimize the variance of the portfolio of a spot contract and (h units of
) a futures contract
Taking first derivative and equating
to zero gives

2hσ F2 − 2σ Sσ F ρ S , F = 0

σS
h* = ρ S ,F
σF

22
Optimal hedge ratio (continued)
• Also possible to estimate h*
using regression
• h* is also called the minimum
variance hedge ratio
• Notes:
- The R2 of the regression tells us
how much of the variance of ΔS
is explained by the variance of
ΔF (hedging efficiency)
- A high R2 (>0.80) would suggest
a “good” hedge
- In a short hedge h* can be read as
“short h* tonnes of futures for
every tonne long position in the
underlying”
- Vice versa for a long hedge
23
Forward Freight Agreements (FFA)

• An FFA is a cash settled “bet” on the average monthly spot

freight rate
- The buyer takes the view that the arithmetic average spot rate during the month
will be higher than the agreed forward price
- The seller contracts to differ
- NB! You can trade out of the position before you enter the settlement month
- Your realized profit/loss depends on the entry/exit price of the FFA only
• Each FFA contract relates to the spot rate for a -
- Voyage charter (VC): Specific load ports, measured in $/tonne (drybulk) or
Worldscale, traded in lots of 1000 tonnes
- Drybulk VC contracts have low liquidity
- Trip charter (global average), measured in $/day, traded in days
• You can also trade baskets of monthly contracts settled
individually
- Quarterly contracts are baskets of three individual months
- Calendar year contracts are baskets of 12 individual months

24
 FFA curve Monday 30 January 2023

Source: www.braemarscreen.com

- The forward curve is a snapshot in time

- Each price reflects the forward price at which buyers and sellers
will agree to transact

- Contracts are settled against the global tripcharter rate averages

(”5TC average” for Cape/Panamax, 10TCs for Supramax) 25
Main drybulk routes

Trans
Atlantic

TransPacific

Pacific
basin Pacific
basin
Fronthaul

Atlantic Backhaul
basin

Additional: China – Brazil round voyage as the fifth trip

NB! Routes are not equally weighted
Question of the day

• You are a commodity trader at Goldman Sachs running

your own book with $10m capital
• You have the following risk limits:
- Max gross exposure: $20m
- Max net exposure: +/-$10m σ p = wX2 σ X2 + wY2σ Y2 + 2wX wY σ X σ Y ρ X ,Y
- One-day 95% VaR: 2%
• You have the following two positions in the book
- Long position in 150,000t Richards Bay March coal futures priced at
$100/tonne
- Short 500,000t of Capesize freight (Route C4 Richards Bay – Rotterdam)
priced at $10/tonne
- Daily standard deviations and correlation are σcoal = 1.5%, σfreight = 2.1% and ρ
= 0.30
• Calculate gross exposure, net exposure and VaR of the
book. Are you in compliance with your risk limits?
27
Answer of the day

28
ENE 430
COMMODITY TRADING &
TRANSPORT
Lecture 7: Freight trading
Professor Roar Ådland
Risk management in shipping is not
limited to financial contracts

• Also about managing your financial risk exposure

- Debt vs equity used in buying ships
- How much cash is set aside to cover derivatives exposure
- Modern expensive fleet versus old cheap fleet

• ...and operational risk exposure

- Spot market operation versus long-term timecharters
- Quality of counterparts (default and renegotiation risk)
- The use of FFAs to increase/reduce risk
- Spot rates for bigger ships are more volatile than small ships
- Freight rates for certain ship types are more volatile than others
- Diversification of sector exposure

2
How to make money in freight trading
(without buying ships...)
• 1. Speculate on FFAs and freight options
- Go long/short and bet on direction
- Long Capesize/short Panamax and bet on inter-size spreads
- Bet on the shape of the forward curve (long/short different maturities)
• 2. Take in ships on timecharter (go long physical freight)
- Re-let in the spot market and make money on the difference
- Re-let (if you can) on a higher timecharter rate
- Smarter operation – move ships between regions to optimise earnings
- Find a COA at a higher rate
• 3. Take on cargoes to be shipped in a COA (short
physical freight)
- Find ships to transport at a lower cost (spot or timecharter)
• 4. Speculate on the difference between CFR and FOB
commodity futures (implied freight)
- Outright long/short or spread trading against FFAs
3
Freight derivatives trading is not for the faint
hearted....

4
Forward Freight Agreements (FFA)

• An FFA is a cash settled “bet” on the average monthly spot

freight rate
- The buyer takes the view that the arithmetic average spot rate during the month
will be higher than the agreed forward price
- The seller contracts to differ
- NB! You can trade out of the position before you enter the settlement month
- Your realized profit/loss depends on the entry/exit price of the FFA only
• Each FFA contract relates to the spot rate for a -
- Voyage charter (VC): Specific load ports, measured in $/tonne (drybulk) or
Worldscale, traded in lots of 1000 tonnes
- Drybulk VC contracts have low liquidity
- Trip charter (global average), measured in $/day, traded in days
• You can also trade baskets of monthly contracts settled
individually
- Quarterly contracts are baskets of three individual months
- Calendar year contracts are baskets of 12 individual months

5
The FFA market is a hybrid market

• A hybrid market/contract combines features of a

forward and a futures contract
• Features from the OTC market:
- FFAs are voice brokered by specialist brokers (Clarksons, FIS, SSY,
GFI) with clearing houses EEX, SGX
- Privately negotiated, less transparent
- There is no centralized market/exchange
- Trades and bids/offers are not available to the public
• Features from the futures market
- Fully standardised contract terms
- Once a trade is executed it is handed over to the clearing house with the
usual mark-to-market procedures & margin requirements
- Clearing removes counterparty risk (like exchange-traded products)
6
 The settlement of FFAs

• Based on daily spot freight rates

published by the Baltic Exchange:
- Not an exchange but an information compiler
and distributor
- Sets up panels of shipbrokers for each main
route
- Each broker submits a daily estimate of what
the spot rate “should be”
- The Baltic Exchange takes the average and
publishes the result online, Bloomberg etc.
- This series of daily spot rates forms the basis
for the monthly settlement of FFA contracts

7
Main drybulk routes

Trans
Atlantic

TransPacific

Pacific
basin Pacific
basin
Fronthaul

Atlantic Backhaul
basin

Additional: China – Brazil round voyage as the fifth trip

NB! Routes are not equally weighted
Trading example
• Sell (go short) one May Capesize
25000
FFA contract at $21,200/day on
April 1
20000
• A full contract equals 31 days
• May average spot rate settles at 15000
$10,681/day
• If contract is held until settlement 10000
the difference ($21,200 -
$10,681)*31 = $326,000 will have 5000 May FFA
been transferred to you account Spot

• The FFA price always converges 0

MTD spot average

to the monthly spot average

Points of note
• The price for each one-month FFA will always
converge to the spot average at the end of the
month
• Positions can be closed out (reverse trade) before
settlement
• The initial margin (deposit) to do this trade is
probably less than 20% of the nominal contract
value (FFA price * volume)
• Return on employed capital
- $326,000/(0.2*$21200*31) = 248% in one month
• Easy to leverage up the already huge volatility
 The forward curve of freight

• The non-storable nature of freight means that:

- Information or predictions about the future does not affect
current spot prices
- Forward curves reflect only expectations (and possibly a
risk premium)
• FFA curves can be both in contango (upward
sloping) and backwardation (downward sloping)
- Depends on spot market conditions and
sentiment/projections about the future
- Expectations reflect mean reversion
• There is no fixed mathematical relationship
between spot and forward prices (cost of carry) 11
 FFA curve Tuesday 3 February 2023

Source: www.braemarscreen.com

- The forward curve is a snapshot in time

- Each price reflects the forward price at which buyers and sellers
will agree to transact

- Contracts are settled against the global tripcharter rate averages

(”5TC average” for Cape/Panamax, 10TCs for Supramax) 12
 13

Freight options

• Calls and puts

• The payoff depends on the average spot freight rate over
a month (the settlement period - Asian options)
• Quarter/calendar year contracts are baskets of individual
monthly options settled individually
• Automatically settled in cash at the end of each month
• Traded in a similar way as FFAs
- Same routes and vessel sizes ($/day or WS)
- Premium, strike and period negotiated between a buyer and a
seller via a FFA broker
- An executed deal is handed over to a clearing house
- The premium transferred from buyer to seller in full
Volatility term structure
Freight derivative trading strategies
• Outright long/short position through FFAs or
options
- Reflects trader’s view on future direction of any given part of the
curve
- May be long October and short Cal 17 (i.e. the 2017 calendar year)
• Calendar spread
- For example: Short July + Long August
- A play on a flattening/steepening of the forward curve
• Size spreads
- For example: Short Capesize Q4 + Long 2*Panamax Q4
- A play on inter-market competition (cargo splitting/combination)
- Reflects trader’s view that Capes are “too expensive” compared to
Panamax in the above case
A note on trading ”implied freight”

....not a ”given” that implied freight correlates

with real freight costs!
16
Hedging with FFAs

Figure illustrates the payoff

from a forward contract
where X is the forward price
at the time of entry

The payoffs from the

physical and FFA positions
offset each other, thereby
locking in the initial price X

• Shipowners have natural “long” positions in the freight

market and would hedge with a short FFA position
• Charterers have natural “short” positions in the freight
market and would hedge with a long FFA position
17
The alternative to FFAs is a timecharter

• Volatile freight revenue can be managed by changing

from spot to timecharter operation
- Provides stable revenue, no unemployment risk
- But introduces default risk
- May not be available
• Availability dictated by charterers (e.g. oil companies)
• Your vessel may not be an attractive candidate for a T/C due to its age, quality,
or physical characteristics
- Owner may prefer to operate in the spot market
• Potential for higher vessel utilization through better voyage planning
• Maintain flexibility of operation and ship sales
• Better information from shipbrokers

18
Hedging with FFAs: Benefits & challenges

• Benefits compared to a physical T/C:

- Quick execution in relative anonymity
- Clearing eliminates default/renegotiation risk
- More counterparts to trade with, no limits on ship age
- Hedges can be unwound at any time
- Continue to trade the physical ship in the spot market for better
access to market information
• Challenges:
- Can be illiquid for a large hedging program
- Mismatch in the timing of fixtures in the physical market and
settling against a continuous daily index in the FFA market
- Mismatch between the technical specifications of your ship and
those of the standard Baltic ship
- Basis risk: Added risk from using imperfect hedging instruments
19
Basis risk in freight hedging

• Hedging: to exchange price risk for basis risk

- Low correlation between spot and FFA contract returns
- Technical specifications of your ship differs from the standard
Baltic type
- Your ship is fixed only once during a month but the FFA contract
represents an arithmetic average of spot rates in the entire month
- Your ship moves slowly around the world, obtaining regional spot
rates as it is fixed, not the global average tripcharter rate that
long-term FFA contracts are settled in
• Only case of a perfect hedge is if your ship is
chartered on an index-based TC

20
Mini case of the day

• You have just chartered in a Capesize vessel for 3-5

months trading at $8,000/day, taking delivery in
Shanghai today
• Your options for chartering are as follows:
- Tripcharter rates for trans-Pacific roundtrips are $8,500/day and one trip takes
one month. Rates are expected to remain the same.
- You can fix a Shanghai – Brazil roundtrip for a 160,000 iron ore cargo. The
trip takes 75 days of which 5 days are in port. The vessel burns 50 tonnes
fuel/day at sea at a cost of $600/tonne. Total port costs are $200,000.
- Currently the Brazil – China freight rate is $17.42/tonne The June FFA contract
for the route is trading at $19.32/tonne
• What is the profit from your optimal freight trading
strategy?
21
Answer of the day
Transpacific strategy (five consecutive trips

Net profit = (8500-8000)*5*30 = 75000

Pacific - Atlantic strategy

You can do two consecutive trips.
You hedge the rate for the second trip using the June FFA

Timecharter-equivalent (TCE) for first trip

(17.42*160,000-70*50*600-200000)/75 = 6496

TCE for second trip

(19.32*160000-70*50*600-200000)/75 = 10549

Net profit = (75*6496 + 75*10549)-8000*150 = 78375

Mixed strategy

Trade in the Pacific for two months, then do a China - Brazil

roundtrip at the higher (hedged) freight rate

TCE for first two months = 8,500

TCE for final 2.5 months = 10549

Net profit = (60days*8500 + 75days*10549) - 8000*135days = 221175

As you would not be able to complete another trip you would

redeliver the ship after 4.5 months as allowed under the terms
(3-5 months trading)
22
The mixed strategy has the highest profit even with early
redelivery
ENE 430
COMMODITY TRADING &
TRANSPORT
Lecture 9: Crude oil market
Professor Roar Ådland
2
The crude oil refining process
• Stage I: Distillation
- Heat crude oil using high-pressure
steam – turns into vapour Applications
- Fractions with the lowest boiling •Heating
•Feedstock
points evaporates first and rises
the highest inside the distillation
•Motor vehicles
column
- Fractions cool down and liquefy at •Jet fuel

different levels (boiling points) •Motor vehicles

•Heating
• Stage II: Conversion into
•Power station
intermediate products & marine fuel

- “Cracking” heavy hydrocarbons

into lighter molecules
• Stage III: Modification
- Ensure formulation guidelines for
retail products are met (e.g.
gasoline)
3
Crude oil quality

• Quality established through

an “assay” (lab testing)
- Also establishes the percentage of
different products that can be
extracted
• Characteristics
- Density (volume-to-weight ratio)
measured as API gravity value
• High API value = less dense
(“light”) and yields more distillates
• Low API value = “Heavy” crude,
more difficult to refine, lower
yields
- Sulphur content
• Sweet crude (sulphur content <
0.5%) vs sour crude
• Sour crudes require more
processing/energy for refining
- Viscosity (“thickness”)
4
 Maximising refiners’ revenue

• “Gross production value” (GPV, Example: Yield from 1 barrel of WTI

revenue/bbl crude) depends on:

- Refinery yield: the percentage output of
different products from a particular crude grade
- Refinery yield depends on the configuration
and complexity of the refinery (e.g. choice of
temperature “cut points”)
- The prevailing prices of the products
- Optimisation of revenue as a function of yield
becomes a linear programming problem
• Metrics:
- Refinery margin = GPV – Crude oil cost
- Netback value of crude = GPV – variable costs
(transport, OPEX, finance, insurance)
- Refinery netback = GPV – Crude cost –
Variable costs
•Negative yield = product added to the process
•Sum < 100% because of losses or because some 5
crude equivalent is used as fuel in the process
The “Crack spread”
• An approximation of the profit margin for a generic refinery
• Basis for comparisons of profitability between different
sources/blends of crude
• Example – the 6-3-2-1 crack
- 6 barrels of crude oil input yields
- 3 barrels of gasoline
- 2 barrels of diesel
- 1 barrel of residual fuel oil
• Refiners can hedge crack spreads using futures or OTC
swaps
• Exchange-traded futures will have certain basis risks
- Priced at particular delivery points
- Quality differences

6
 Volatility of refining margins

$/bbl

Source: Neste Oil

https://www.neste.com/en/corporate-info/investors/market-
data/refining-margins/calculating-neste-reference-margin
7
The oil pricing system

• Volume and pricing are often separate issues

- Market for spot cargoes
- Long-term contracts negotiated bilaterally between parties for delivery of a
series of shipments (anecdotally 90% of trade volume)
• The price of an oil cargo is based on formula pricing
- Price of crude X = Benchmark crude price +/- price differential
- May agree on price only when loading the cargo
• Who decides the price differential?
- The oil exporting country (official selling price, OSP) or
- Price reporting agencies (PRAs – Platts, Argus Petroleum etc.)

- Countries use different benchmarks or differentials depending on destination –

e.g. Saudia Arabia to US (differential to WTI), Europe (differential to BWAVE)
and Asia (FOB)
- Differential can vary over time depending on season and refinery yield of the
particular crude
8
Benchmark pricing (“marker crudes”)

• Main “marker” crudes (WTI, Brent, Dubai) dominate

the pricing system
- Additionally third-party price indices (Platts, Petroleum Argus, Asian
Petroleum Price Index) exist
• Main benchmarks
- Brent (the de facto global crude benchmark)
- West Texas Intermediate (US benchmark)
- Dubai (Middle East origin, Gulf benchmark)
- Urals (Russia/Eastern Europe origin, Med./NWE benchmark)
• Sales contract will additionally contain FOB price +
Freight costs +
- Quality specifications (API, sulphur content) Pipeline costs +
Cost of physical loss +
- When/where delivered Insurance +
- FOB (most common) or CIF basis Finance cost
= CIF price 9
 Introduction to the Brent pricing benchmark

• Brent marker crude

- The reference price for
most European, African and
westbound Middle-East
crude oil
- Directly or indirectly used
to price about 70% of world
crude oil trade
• Refers to physical
transactions in any
four North Sea crude
grades (BFOE)
- Brent Blend
- Forties
- Oseberg
- Ekofisk

10
Physical trading in the Brent market

• Participants trade full cargoes of 600,000bbl

• BFOE producers can sell their cargoes on a forward
basis during the months before they are allocated crude
- If a cargo is sold prior to knowing the laydays it is considered a ”paper” trade
- Cargoes sold with known laydays are part of the ”dated Brent” market – it is
considered a physical (”wet”) trade
- Cargoes are scheduled one full month ahead (SUKO 90 contract)
- You can deliver any of the 4 crude streams against these forward commitments
– in practice: cheapest-to-deliver (Forties)
• Until about 2010 the dated Brent market was a major
component in pricing formulas
- E.g. cargo of Nigerian Bonny Light crude sold based on dated Brent prices
quoted during the 5 days around the date the cargo was physically delivered
(Bill of Lading date) + quality differential
11
Declining BFOE production creates problems

• Fewer cargoes of crude available to trade in the physical

market = higher risk of market manipulation
• Solution??
- The Brent Index is effectively an average of BFOE market prices for crude to
be delivered in the next calendar month
- Brent ICE futures contract is “cash settled” against the Brent index price (i.e.
what it should converge to in the physical market)
- Use a Brent ICE futures related price as the actual benchmark, e.g. Brent
Weighted Average (BWAVE) - a volume-weighted average of the day’s trade
prices for prompt month Brent ICE futures
• ICE Brent futures trades >500 times the physical BFOE
crude production volumes each day
• ...still 50 cargoes a month that indirectly prices billions in
brent oil futures trading and physical cargoes
12
Urals – Brent price spread

13
Where’s this?

14
The US crude oil markets

• West Texas Intermediate

(WTI)
- US “marker” crude for delivery in
Cushing, Oklahoma
- Mainly a US domestic benchmark
• WTI futures allows delivery
of alternative grades
- Must have similar quality
characteristics (sulphur content,
API)
- You can also deliver foreign crudes:
UK Brent, Norwegian Oseberg,
Nigerian Bonny Light, Colombian
Cusiana
15
Cushing has long been a bottleneck

• Several factors led to WTI

discount between 2010 and
2014
- Increasing US shale oil production in
North Dakota & Canadian imports by
pipeline
- Cushing ran out of oil storage despite
increasing capacity
- Historically limited pipeline capacity
out of Cushing (improved in 2014
with the Keystone pipeline)
- WTI still seen as “landlocked”
compared to seaborne Brent
benchmark
• The US energy network
used to be geared for
Cost of pipeline shipment from Cushing
imports to Gulf coast refinery abt. $3.82/bbl
16
WTI – Brent price spread
Source: Ycharts

• Because Brent can be delivered under a WTI futures contract we know that
PWTI <= PBrent+ freight or
PWTI – PBrent >= freight
• The spread is bounded by the cost of freight (trans-Atlantic shipping &
pipeline)
• Close substitutes since 1. Jan 2016 when the US allowed crude exports
(but WTI is considered better quality, light, sweet crude)
17
The term structure of oil prices
• Backwardated markets
- Futures prices < spot price
- Scarcity of the commodity
- Low inventories
- Volatile, likely rising, prices
- A “fear premium” – having
immediate access to supplies in
the spot market is valuable
(convenience yield)
- Crude inventories are generally
low relative to consumption
levels = more prone to
backwardation
- Contrast with precious metals
• Contango markets
- Oversupply
- High inventories
- Relative price stability
- General price weakness
- A “complacency” discount in the
spot price
- The marginal cost of storage
increases as levels approach
capacity
• Higher storage costs increases the
basis (degree of contango)
• If storage capacity runs out the cost-
of-carry relationship breaks down
(“supercontango”)
18
The convenience yield
• Academic concept introduced to explain why commodity markets
can be backwardated
• Effectively the residual connecting the spot price, forward price and
the cost of carry

• Storage cost will consist of

- Fixed costs (insurance and warehousing expenses)
- Variable costs (maintenance, financing, deterioration and obsolescence)
• The existence of a convenience yield restores the “no arbitrage”
relationship for storable commodities
19
Crude oil storage and the tanker freight market

Source: Financial Times 20

Floating storage economics

21
Profitability of TC vs activity for the vessel

22
Main takeaways from Adland & Regli (2019)

• Tanker storage is a cause of marginal demand

during (positive) supply shocks or (negative) demand
shocks in the crude oil market
• Oil futures spread puts a floor under tanker TC rates,
but this constraint is rarely met in practice
• Older vessels are more likely to be used for storage
• Floating storage trade is difficult to implement in
practice (access to cargo, very high financing cost)

23
Question of the day

• The tanker storage arbitrage play

- On February 5th 2016 the April Brent crude oil futures traded at
$34.13/bbl and October 2016 traded at $38.40/bbl
- Land-based storage costs $0.95/barrel/month
- A 6-month period timecharter for a VLCC with 2mbbl capacity is
$50,000/day
- The interest and insurance cost is 2% per 6 months

- How much money can you make on an optimally structured storage

trade?
- What is the breakeven tanker TC rate for floating storage to make
sense?

24
Answer of the day
You can sell the oil in October for
$38.401/bbl * 2m bbl = 76.8 $m

Less April purchase cost

$34.13/bbl * 2mbbl = 68.26 $m

Less financing cost

$68.26m * 2% = 1.3652 $m

Less storage costs

Land-based $0.95*2m*6 = 11.4 $m
VLCC $50,000/day*182 days = 9.1 $m cheapest

Net profit from arbitrage trade -1.9252 $m

If tanker TC rates fall to approx. $39,000/day the floating storage

play is in the money
25
ENE 430
COMMODITY TRADING &
TRANSPORT
Lecture 10: Coal market: Quality differences
Professor Roar Ådland
Coal basics

• “.....a combustible sedimentary organic rock, which is

composed mainly of carbon, hydrogen and oxygen”
• High-rank (“hard”) coals with high energy and low
moisture content
- Anthracite (about 1% of world reserves)
- Bituminous coals (about 52% of world reserves)
• Metallurgical/coking coal – produce coke for iron making
• Thermal/steam coal – used in power generation and cement manufacturing
• Low-rank coals with lower energy and higher moisture
content
- Sub-bituminous coals used for power generation and cement making
- Lignite (“red coal”) for power generation
- Not suitable for international trade (mainly local use)
2
The importance of coal quality

• There is not one commodity

• Coal from different mines are different in
terms of
- Heating value (Calorific value, CV)
- CO2 content
- Sulphur content
- Moisture content
- Ash

• Buyers of coal often have specific

preferences depending on
- Burning facilities (boilers optimised for a particular
quality)
- Availability of storage facilities
- Ability to blend different grades
- EU/governmental regulations

3
Energy generation from thermal coal

4
Source: Wikipedia
Physical supply chain
• Production at mine site
- Open cast or underground
- Typically requires crushing and mechanical removal of
impurities
• Inland transportation
- to local end user or port facility by rail/trucks/barges
• Storage
- Gradual deterioration of quality (fragmentation, varying
moisture content)
- Risk of spontaneous combustion
• Transshipment or loading
- Indonesian terminals typically offshore

5
Coal supply and demand
• All net demand growth in Asia
• Substitution to cheaper natural gas in
the US
• Emission regulations and renewables
are having an impact in Europe

Proven reserves to last about 132 years – Source: BP Statistical Review (2021) 6
the most for any fossil fuel
Global coal trade

7
Price drivers
• Demand
- Economic expansion – affects
electricity, cement and steel
demand
- Seasonality in electricity demand
and alternative hydro-based
production
- Power plant gross margins (dark
spread, clean dark spread)
- Environmental pressure and
regulation (CO2, NOx, SOx,
methane from extraction)
- Demand from conversion to
alternative fuels (coal-to-liquids,
synthetic gas)
- Restocking demand (port stocks
& power plant stocks)
• Supply
- Cost of technology for emission
reduction, increased thermal
efficiency
- Marginal cost of production
(surface or underground
deposits, transport costs)
- Production disruption,
bottlenecks in port & rail system
- Capital spending and exploration
(long lead times)
- Freight rates. Low rates enable
long-haul shipments from US &
Colombia into Asia
- Destocking activity
8
Global thermal coal cost curve

9
 Pricing of thermal coal
• Thermal coal pricing
varies between source
and destination countries
- Heterogeneous coal quality
- Historical practice
- Australian coal exports to
Japan/Korea based mostly on
long-term delivery contracts
with annual pricing (JFY
contract price)
- Other destinations (e.g. China)
sold mainly as spot cargoes
• Main spot price indices
- Pacific benchmark: Globalcoal
FOB Newcastle
- Atlantic benchmark: API#2 CIF
Northwest Europe
- CFR China spot price indices
becoming more important

10
Price vs quality

https://www.theice.com/products/243/API2-Rotterdam-Coal-Futures
https://www.theice.com/products/241/API4-Richards-Bay-Coal-Futures
https://www.theice.com/products/1137/globalCOAL-Newcastle-Coal-Futures

Gross as Received (GAR) includes the energy required to turn latent moisture into vapour
Net as Received (NAR) excludes this from the calorific value
11
Coking vs thermal coal: Limited substitutes

12
Who trades coal derivatives?

• Mining companies • Industrial companies

- Alter the mix of fixed and floating- - Cement producers are exposed to
price revenue from coal thermal coal input costs
- Hedging coal prices and FX rates to - Steel producers are exposed to
obtain financing coking coal price risk, but thermal
• Utilities coal derivative contracts are more
active (correlation between the two
- Hedging of coal price risk is a basis risk)
- Preference for cash-settled derivative
contracts in order to control physical
delivery
- Natural buyers in the emission
trading market
• Financial institutions
- Executing trades for clients (flow
trading)
- Tailoring OTC contract to client-
specific risks
- Speculation adds liquidity

13
The Australia – China coal arbitrage

• Observation: China does

not “need” any imported
coal
- World’s third largest reserves (after
US and Russia) at 114.5bn tonnes
- “Only” 33 years worth of
consumption, compared to 239 years
for the US
• Conclusion of He & Morse
(2014)
- China is the world’s largest arbitrage
trader of coal
- Importing only when international
prices are lower than domestic
- India is structurally short on coal and
has to import rapidly increasing
volumes
14
Chinese domestic coal market

• Shanxi, Shaanxi,
Mongolia 70% of proven
reserves
• Railed to eastern
seaboard (Qinhuangdao,
Tianjin, Qingdao etc.)
• Shipped on Handysize
bulkers to consuming
regions in the south
• Cheaper and more
reliable than congested
North-South rail lines

15
Determining the price arbitrage

• Goal: Determine the price

difference between
domestic and imported
coal delivered CIF
Guangzhou
• Adjustments:
- Normalise energy content to
6,700kcal/kg GAD on a linear Unadjusted FOB prices, source:
basis Morse & He (2014)
- Add 17% Chinese VAT to all
imported coals NAR – Net as received
- Adjust for RMB/USD exchange GAD – Gross air dried
rate
- Add $3/tonne additional
transaction costs to imported coal 16
Price advantage vs import volume

17
Why did this arbitrage window open?
• Chinese energy demand was • Regulatory efforts to
sustained through the
financial crisis while non-
Chinese demand fell away
• International freight rates
collapsed while Chinese
domestic freight rates held up
well
- Only Chinese-flagged ships can trade
domestically in China – no competition
from international fleet
• International FOB coal prices
fell more than Chinese FOB
prices
consolidate the coal mining
industry affected domestic
supply
- Shutdown or consolidation of small
mines
- Implementation of more rigorous
safety standards
• Domestic negotiations
between power generators
and coal producers on 2009
contract prices failed
• Other factors:
- Policy encouraged imports if cheaper
- Weather interruptions of transport
- Reduced power generation due to
drought 18
Factors outside the Morse & He model

• Does not distinguish between coking & thermal coal

imports
• Does not account for the likely existence of a “two-tier”
domestic market
- Power companies buy some coal on “term contacts”
- Term contract prices were capped by government agencies in 2010
- Qinhuangdao spot price may not be representative
• Does not account for quality differences other than
energy content
- Sulphur content, ash, moisture content, gross/net calorific value
- The relationship between spot price and energy content is likely to be non-
linear (deeper discounts for low-CV coals)
• Assumes all coal delivered Guangzhou
- Results skewed in favour of Southern sourcing
19
Question of the day

• Background: Your company operates a coal-fired

power plant in Shanghai
- Chinese thermal coal prices (FOB Qinhuangdao, 5,800kcal/kg NAR) is
$49.20/tonne (incl. VAT)
- The FOB Newcastle (6,000kcal/kg NAR) price is $39/tonne
- The freight cost from Newcastle to Shanghai is $3.30/tonne
- Chinese VAT is 17% and there is a 6% tariff on imports of Australian
thermal coal
- The coastal coal trade in China uses 25,000 DWT Handysize bulk
carriers burning about 20t/day of bunker fuel at a cost of $120/tonne
• Questions:
- At what level of domestic freight rates ($/tonne, Qinhuangdao to
Shanghai) are Australian imports currently competitive?
- If the Qinhuangdao – Shanghai return trip takes 4 sailing days – is the
arbitrage window for imports open?
20
Answer of the day
Delivered cost of 6,000kcal Australian coal in Shanghai

$39/tonne*(1+17%+6%) + $3.30 = 51.27 $/tonne

You have to buy more domestic coal to achieve the same energy content

Let X = domestic freight cost ($/tonne), then breakeven is where

($49.20/tonne + X)*6000/5800 = $51.27

X= 0.36 $/tonne

A handysize vessel burns around 20 tonnes of fuel per day

Fuel cost would be in the order of

$120/tonne * 20t/day * 4 days = 9600
Freight revenue
25,000 tonnes * $0.36/tonne = 9000

Domestic ship would operate at a loss - Australian imports are the most competitive
21
ENE 430
COMMODITY TRADING &
TRANSPORT
Natural gas market
Professor Roar Ådland
Measuring natural gas

• Volume of gas transported

typically measured in
cubic meters (m3)
- E.g. carrying capacity of LNG
carriers
• But gas typically traded in
terms of energy content
- British Thermal Unit (Btu): Heat
required to raise temperature of 1
pound of water by 1ºF
- Therm (10 therm = 1mBtu)
- MWh (megawatthours): 1 Mw of
energy expended for 1 hour

2
 The physical natural gas supply chain
Offshore LNG
rigs carriers • Processing removes natural
gas liquids (NGL) from the
“wet” gas
Beach Regasification
terminal plant • “Dry” gas is sent through high-
pressure national pipelines to
Onshore Local Distribution Networks,
rigs Processing
(LDNs, retail suppliers),
Interconnector storage or wholesale industrial
consumers
• Low-pressure local pipelines
Pricing Storage connect national system to
points/ retail consumers
“Citygates”
Wholesale • Interconnectors connect the
Local consumers national transmission systems
distribution (e.g. Norway to the UK)
network

3
Price drivers: Supply side

• Levels of domestic production

• Production outages
- Accidents, weather (US Gulf hurricanes), scheduled maintenance
• Infrastructure developments
- Additional interconnectors, LNG import/export terminals
- Affects the degree of integration between national markets
• Security of supplies (political risks)
- Example: Western Europe sources natural gas from
• UK, Norwegian, Dutch offshore fields
• Onshore European fields
• Russia
• Algeria
- Pipeline system runs across several countries
- Risks reduced by diversification, increasing strategic storage, redundancy in
transmission infrastructure

4
Price drivers: Demand side
• Natural gas demand is
driven by
- Seasonal demand/weather affecting
domestic heating/cooking
requirements (e.g. current mild
winter supressing demand)
- Ability of power generation
infrastructure to switch between
fuels
- Export demand
- Storage demand: cheap gas injected
in the summer

5
Demand seasonality (US)

Residential use

Commercial use

Source: EIA Monthly

Energy Review Jan
2020
6
Natural gas hub spot prices

• Basis certain delivery locations

- Where the transfer of natural gas ownership occurs
- Can be physical or “virtual”
• United States
- Over 30 major market hubs
- Most common: Henry Hub (Louisiana), hub for US Gulf gas distribution to the
Northeast and Midwest
- Other locations often quoted as a “location differential” to Henry Hub
• Europe
- Main physical hub: Zeebrugge (Belgium)
- Virtual hubs:
• NBP (National Balancing Point, UK)
• TTF (Title Transfer Facility, Netherland)
- A virtual delivery point is a notional point within the national transmission
system through which all gas is deemed to flow and balance
7
The oil price link

• Contract prices in Europe (ex-UK) and Asia have

historically been indexed to the oil market
- Legacy from when industrial users initially switched from alternative
fuels to gas (e.g. coal or fuel oil for power generation)
- Attractive with liquid oil contracts for hedging (e.g. lending banks)
- Also indirect effect due to gas/oil being substitutes for some end uses
• Structure of long-term delivery contract
- About 60% of LNG is sold on long-term contracts
- Pre-defined maturity (e.g. 15 or 20 years)
- “Take or pay” clause – take delivery of agreed quantity or pay anyway
- Gas price ($/mBTU) priced as a fraction of the (Brent) oil price

8
The impact of US shale gas

• Initially sharp decline in US

import requirements
- LNG exports originally planned for
US is displaced to Europe/Asia
- Canadian pipeline exports looking
for new markets – planned LNG
exports to Asia
• Low domestic gas prices
displaced coal for US
power generation
- Increased US coal exports to Europe
& Asia
- Cheaper European coal prices
reduced demand for natural gas
• Rapid increase in US LNG
exports from Feb 1, 2016
9
Pricing structure of US gas exports

• Sabine Pass LNG terminal

- Commenced operations in 3Q 2009
but was not needed and idled since
- Started exports in Feb 2016 with
liquefaction capacity of 18mtpa
• Contract structure
- BG, Kogas, Gas Natural, GAIL will
buy up to 16mtpa
- Remainder (2mtpa) is traded on the
spot market by operator Cheniere
Energy
- Price is 115% of Henry Hub spot
prices + fixed liquefaction fee at
around $2.25/mmBtu
- No “take or pay” clause but
liquefaction costs paid regardless
10
Historical stages of natural gas pricing

Oversupply
leads to lower
and more
convergent
regional pricing

Within bounds!

Source: Ernst & Young

11
Barriers to LNG price parity

• Insufficient price differential

- Must cover transaction costs and profit sharing
• Lack of LNG supply
- Not possible to replace cargo or no/few divertible cargoes in the market
- Buyers have a physical need
• Non-transparent market
- LNG traders/producers are an exclusive “club” not a global market
- Lack of price transparency (outside of UK/US)
- Lack of experienced personnel
• Contractual limitations
- Destination clauses and “ex-ship” sales terms
• Quality and technical considerations
- LNG quality specifications, vessel size restrictions and ship-shore connections
• Lack of shipping or regasification capacity
12
Changing contracts are removing barriers

Bridge & Bradshaw (2018)

• From “floating pipelines” to integrated market

- Removing destination clause, right to covert cargoes
- From DES to FOB terms, buyer can take advantage of arbitrage opportunities
• From oil indexation to “gas on gas competition”
- Possible where there is competition from domestic or pipeline gas (US, UK,
Netherlands)
- Example: Japanese LNG import contracts priced against Henry Hub (US
marker)
- Move towards the structure of the oil market (Brent, WTI ‘marker’ prices)
13
Question of the day

• You’re working for Korea Gas Corporation (KOGAS)

- KOGAS has a contract to buy natural gas from the US Gulf Sabine Pass
terminal at 115% of the Henry Hub spot price of $2/mBtu
- You have to pay an additional $2.25/mBtu fixed charge
- The LNG carrier spot rate is $28,000/day and fuel costs $18,000/day
- The Boil-off rate for the LNG cargo is 0.15% per day
- The roundtrip takes 95 days. Ignore port costs/days.

- 1 tonne of LNG is approx. equal to 52mBtu

- A 135,000 cbm cargo of LNG = 60,000 tonnes

- The CFR Korea LNG price is $6/mBtu

- Is the arbitrage window open?

14
Answer of the day
Calculate the total cost of buying and shipping a 135,000cbm cargo (in $)

Energy content: 60,000 tonnes * 52mBtu/tonne = 3,120,000

Buying the cargo: 3,120,000mBtu*115%*$2/mBtu = 7,176,000

Fixed liquefaction fee: 3,120,000,Btu*$2.25/mBtu = 7,020,000
Timecharter cost: 95 days*$28,000/day = 2,660,000
Fuel cost: 95 days * $18,000/day = 1,710,000
Sum costs 18,566,000

In Korea you can sell the remaining cargo, net of the gas volume lost due to
boil-off, at $6/mBtu

Remaining volume on board after the laden leg (47.5 days) is given by:
3,120,000*(100%-0.15%)^47.5 = 2,905,279

Value in Korea: 2,905,279mBtu * $6/mBtu 17,431,675

Total loss ($17,431,675 - $18,566,000) = - 1,134,325

The arbitrage window is not open. US exports are not competitive even at
today's very low LNG freight rates.

15
The loss on a per mBtu basis is: $-1.134m/3.120mmBtu = $ (0.36)
ENE 430
COMMODITY TRADING
& TRANSPORT
Iron ore market: Pricing regimes BHP Billiton iron ore train typically
336 cars, 44,500 tonnes of iron
ore, over 3 km long, six to eight
Professor Roar Ådland locomotives.
Iron ore basics
• 98% of mined iron ore used to
make steel in blast furnaces
• Raw ore is a mix of ferrous oxides
and rock
- Hematite (Fe2O3)
- Magnetite (Fe3O4)
• Direct shipping ore (magnetite) has
Fe >60%
• Lower grade ore requires
beneficiation to improve Fe-
concentration
• Processed ore sold in three
On average 1 tonne of steel requires
categories approximately:
- Ore fines (<10mm) 1.725t of iron ore
- Lump ore (>10mm) 0.645t of coking coal
- Pellets
0.15t of limestone
0.138t of recycled steel
2
Open pit mining

3
 Physical supply chain

Mining

Integrated Processing (crushing,

mining concentration, pelletisation)
company

Rail to port

Shipping

Blast furnace (pig/primary iron)

Integrated
Steel mill Basic oxygen furnace (crude steel)

Steel products (longs & flats)

4
 Driverless trucks weighing 500t fully laden...

Autonomous hauling system is GPS/wifi controlled

Some are remotely operated from 1000km away 5
Iron ore quality

• Specifications varies by
source (mining area)
- Brazil: Carajas
- Australia: Mount Newman,
Hamersley/Pilbara, Yandi, Robe
River
- Canada: Bloom Lake fines
• Main quality factor is
ferrous (Fe) content
- Other impurities are moisture, silicon
dioxide and aluminium dioxide
- Average Fe-content decreasing as
high-quality resources are exhausted
(by about 1-1.5%-point since 2003)
- Lower Fe-content requires more
coking coal use
6
 Global iron ore trade

Share of global steel production

(2020)

• The “Big Four” mining companies (Vale, FMG, Source: Clarkson Research

BHP and Rio Tinto) control over 75% of

seaborne iron ore trade
Source: AXSMarine 8
 Cost drivers in iron ore production
- Changes in energy & labour
costs
- Declining ore grade leads to less
efficient mining and more
energy intensive processing
- Inland transportation costs
(location of mine relative to
mill/port)
- Resource tax levels and
willingness to collect
- Exchange rates (particularly
RMB, AUD, BRL vs USD)
- Export duties (e.g. India raised
to 30% in Jan 2012)
WAIO – West Australia iron ore, Source: BHP

9
Cost curve, CFR China

2018

10
Impact of supply disruptions

Source: JP Morgan/Wood Mackenzie

11
 Demand drivers

• Steel demand can be

satisfied by
- Production of new steel in blast
furnaces (requires iron ore)
- Recycling of steel in electric arc
furnaces (no iron ore)
- Steel is infinitely recyclable without
loss of strength and 80% of post-
consumer steel is recycled
• Mature economies can show
negative demand growth
- E.g. EU(27) produced 191.8mt in
1990 vs. 166mt in 2015
- Why? Steel is “consumed” over
decades in long-life products and can
be recycled
- Replacement demand is low once
infrastructure has been built
12
Steel mill margins key to short-term demand

• Betting on profit margins for steel mills can also be a

trading strategy
- Margins should revert towards a “mean” in a competitive market
- Similar approach to crack spread for refineries and dark spreads for power
stations
13
Iron ore pricing negotiations: History

• The “Champion negotiations” existed for ~50 years

• Post World War II
- European buyer groups (led by ThyssenKrupp) negotiated privately with
Atlantic-based sellers (Brazil, Canada)
- Settled annual deals (calendar year) for CIF Rotterdam prices
• From late 1970s
- Japan steel mills fronted by Nippon Steel starts to negotiate privately with
miners for 10-year volume contracts with annual pricing
- Japanese mills owned ships so prices were FOB West Australia
- Contract price follows Japanese fiscal year (April – March)
• Worked as long as iron ore market was oversupplied
- Once the price was settled by the first miner, it became the benchmark global
price for the next year (but local discounts/premium existed)
- “First setter” would get the most favourable volumes with the buyers – miners
competed on volume
- Japanese negotiating approach based on stability, security of supplies, co-
operation and long-term relationships

14
Changing pricing mechanims

• Sharp increase in Chinese imports means supplies

tighten from 2005 onwards
- China (Baosteel) demands a voice in negotiations
- 2008: Australian settlement for Asia differs from Brazil to account for
freight differential – first sign of price differentiation
- 2009 negotiations: Chinese government allows decentralised
negotiation by mills, coordinated by CISA
- Internal competition among Chinese importers, fragmented buyer side
– weakens their position
- Spot prices rise above contract prices, weakening miners’ incentive to
sell under the contract price
- May 2010: Contract negotiations fail and miners get quarterly index-
linked pricing
- From 2011: Further move to “spot” pricing away from initial quarterly
lagged contract prices

15
Changing pricing regimes

16
 Spot price benchmarks

• Several competing index

providers and benchmarks
but similar specifications
- Platts IODEX 62% CFR China has
become the de facto global physical
benchmark as it is used by
Vale/BHP/Rio Tinto
- The Steel Index (TSI) 62% CFR
China
• Iron ore swaps/futures are
settled against both
- IO futures are traded on SGX, DCE,
CME

17
Recent spot price development

$/tonne

18
Question of the day

• Assume China is producing 720mt of iron

- Domestic raw iron ore production is 1,400mt at average Fe of 20%
- Imported iron ore has average Fe-content of 62%
• Consider two possible trading patterns for iron ore
- Case 1:
• 40% of imported ore from India (20 days roundtrip)
• 30% from Brazil (100 days roundtrip)
• 30% from Australia (30 days roundtrip)
- Case 2:
• 10% imported from India
• 40% imported from Brazil
• 50% imported from Australia
• Questions:
- A) How many million tonnes of ore must China import
- B) How many million DWT of ships will be used in the two cases?
19
Answer of the day
A) Import requirement

Domestic production of iron

1400mt *0.20Fe = 280 mt

Imported volume
(720mt - 280mt)/62% = 710 mt

B) DWT requirement

Average roundtrip duration

Case 1: 40%*20 + 30%*100 + 30%*30 = 47 days
Case 2: 10%*20 + 40%*100 + 50%*30 = 57 days

Trips pear year

Case 1: 365/47 = 7.77
Case 2: 365/57 = 6.40

DWT requirement
Case 1: 710/7.77 91.4 mDWT
Case 2: 710/6.40 110.8 mDWT

More long-haul sources needs 21% more ships 20