By Stanislav Ermilov, founder and CEO of Tallarium
Of the thousands of investors that attended Shell and BP’s annual general meetings over the last month, many may have hoped to gain greater insight into the extent to which energy trading has contributed to the bumper profits realised by oil majors this year. Yet again, they will have been left without a great amount of insight.
The fact is that the precise impacts that trading divisions have on the bottom lines of the titans of the energy world are hard to accurately glean. One industry commentator labelled energy trading the black box of European energy conglomerates – the opaque, yet apparently highly lucrative, arm of the business shareholders have little understanding of. This begs the question: why keep investors in the dark? After all, with big oil embarking on a historic transition to net zero, it seems greater transparency into how they might fund such a seismic shift could hardly be viewed negatively.
Several theories have emerged, including that the current state of play suits oil majors. That because trading profits are not well understood, the market perceives them as risky, putting off the amateurs and leaving those with expertise in pole position to deliver stellar returns. While there may be some truth in this, the main reason energy trading remains a black box is much simpler: energy traders – whether big or small – operate largely in the dark.
Over-the-counter but under the radar
The reasons that make it so difficult to accurately account for trading profits become clearer, when the wide array and complex nature of many over-the-counter (OTC) energy contracts is considered. For instance there are a variety of intertwined financial (paper) and physical contracts which may or may not be linked to trading functions. Which include opportunistic trades, paper & physical contracts for future production, trade margin hedging and asset risk management positions (using traded derivatives).
All those may not have clear divisions between business lines. Certain contracts can even involve confidentiality clauses, whereby disclosing a transaction’s profitability could be in breach of contract law. Other transactions are intricate in that they consist of energy products traded as part of a more complex, multi-stage deal. On top of this, firms are always in a position where they need to find the right balance between providing accurate financial reporting and executing sensible business confidentiality to ensure that trading strategies are protected. In a market where information is power, nobody wants to give an advantage to their competitors.
A massive portion of the energy derivatives market – particularly with regards to crude oil and natural gas contracts – is traded on an OTC and off-exchange basis, whereby bilateral parties negotiate contracts according to their specific needs, uninhibited by the restrictions typically imposed on market participants by exchanges.
This also means a considerable chunk of energy trading contracts are traded through an inherently opaque process, where price negotiations take place on communication channels that the wider company – and indeed, the wider field of traders – have little or no visibility of. For practically all energy trading firms – including the trading divisions of the likes of BP, TOTAL, Trafigura, Glencore and Shell – the result is information surrounding OTC contracts becomes siloed, with its collection and access within the organisation labour intensive, prone to manual risk, slow and inefficient. This is largely due to the nature of these markets, rather than any particular fault of energy trading businesses and divisions.
Establishing an accurate profit figure for a trading function is inefficient and breaking that down for shareholder reporting is not very straightforward due to combination of market dynamics, contracting terms and internal processes.
Darkness spreads across more than just profits
The debate around trading profitability must be approached with a great deal of nuance, as there clearly isn’t one single driving factor for the lack of transparency currently provided. However, it does speak to a much broader issue at hand in energy markets in general – that, as a market, there are many areas that aren’t fully understood. It is simply one of many opaque processes that all those who trade international energy markets encounter on a regular basis.
Given the industry largely still relies on gathering pricing data through broker networks over the phone and via text, pricing information for example will often quickly become outdated – especially during periods of elevated market volatility, when fast-paced energy trading activity really shifts into fifth gear. On these days, by the time traders gather all the bid/offer prices to paint a clear picture of the market, the wider market has likely already moved on. For many, executing OTC trades at the best prices is not always possible, due to a distinct lack of market pricing visibility.
Indeed, many trading firms will not have any kind of modern data architecture in place, relying on spreadsheets that are often siloed, with data not being efficiently analysed and consumed across desks. If firms are able to deploy automated and centralised data processing systems that are capable of standardising and rapidly disseminating vast pools of rag-tag data, they will be much better positioned to make effective use of the myriad bid/offer prices they receive from brokers every day.
This is just another example of the type of antiquated process that contributes to the broader ‘energy trading black box’ – and one that can undeniably be helped by firms willing to embrace automation. Until this sort of transformation takes place across the industry and more clarity is offered into opaque OTC commodities communications, the lid will never be fully opened on the market’s best prices.
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