How Traders Finance Big Oil

How Traders Finance Big Oil

Oil trading giants Glencore Xstrata, Vitol, and Mercuria are teaming with Nigerian banks and independent oil companies to buy Royal Dutch Shell's oilfields as Big Oil continues to divest Nigerian assets. Total , Eni , ConocoPhillips , and Chevron are all realigning their portfolios out of Africa and into Russian, North America, and China.

As Big Oil retreats form Africa, they enlist the help of indigenous oil companies and their banks. With tight credit based on even tighter commodity reserves, these deals are crowding out the capital available for new asset sales and capital for new African exploration.

Why oil?
The flight to value now continues to be a flight to oil. This is the one underlying commodity that is even better than gold. Energy, especially oil, underpins every industrial economy. The reason is simple. It takes energy to make everything, and live. Food (soy complex), metals (even gold doesn't mine itself), plastics (from petrochemicals) all depend on oil and roll up into currency and credit. It also takes energy in the form of coal, oil and gas to produce most of the planet's electricity. It takes lots of energy, and some silicon, to make the wafers at the core of the photovoltaic miracle of solar power.

Glencore's strategy has been one of equity participation, controlling interest, and operating upstream from trading. With its $62 billion acquisition of mining company Xstrata and consolidation of copper, cobalt, and zinc interests in the Congo and Kazakhstan, Glencore's emphasis had been mainly on metals and mining. Mining and metals pricings have been sliding for the past year and a half. Metal inventories have been rising. Like Vitol and other traders, Glencore is now more focused on securing oil assets to back oil trades for Brazil, India, Russia, and China.

Oil is also the the basis of the Petroyuan for China, and the core of Russia's ability to trade with Europe and China. Glencore is at the heart of the Russia-China oil trade especially with its Russneft and Rosneft relationships. Rosneft is a major crude oil suppler to PetroChina and Sinopec.

The Petroyuan, through the commodity reserve lending, is rapidly challenging the hegemony of the Petrodollar, the de facto standard for currency since the oil embargoes of the 1970's. Offtake agreements penned in yuan oil prices, are banked, borrowed against, and deposited, all in yuan, and all based on oil as collateral. If oil falls, then so will the yuan, the dollar, the ruble, and the economies that these currencies and credits stand in for.

For Glencore, the metals and energy trader, this means cross trading, and collateralization of trades between oil and copper all in yuan terms. It effectively becomes a yuan bank.

Why traders?
"Buy low, sell high" is the simple formula for any trader. For Glencore Xstrata and Vitol this means going long oil, holding the commodity in storage (and paying insurance, facility costs, and security), and finding a buyer (the short position on the other side of the long) who will be willing to pay more than the cost, insurance, and storage plus a risk premium. Sounds easy, but in the world of commodities finance, there are many paths to profit, and loss.

Glencore and Vitol will go long contracts for oil supply. Under "take or pay" terms, the traders will own the long oil reserve capacity option. With that option they can meet complex logistics risks to meet buyer requirements in perfect order deliveries (on time, in budget, at location, right quality). They can hedge their bets across portfolios, or trade around assets to earn speculative profits. They can use all of their physical assets as collateral for other deals in metals and agricultural commodities, all ultimately oil-contingent.

The bottom line, though, is that there will be no Shell-led asset sale in Nigeria without trader guarantees and pre-payments of oil lifted from wells.

Why Nigeria?
Widespread piracy, theft, and insurgency depressed production by about 20% of the 2.4 million barrels per day available. ConocoPhillips led the way in December 2012 with a complete sale of all of its assets to focus on North America and China. Its deal with Oanda Energy requires significant reserve based lending from local banks, propped up with credit facilities from BNP Paribas and other syndications.

Trading risk premiums in the Nigerian oil business are accelerating as bid-ask spreads are widening due to the severe security issues in the region. If traders can't get this premium they will begin to look to upstream integration of the commodity to realize returns.

Traders have been busy buying interests in Nigerian companies. Mercuria, a partner in the Shell Nigerian discussions, is reported to have purchased shares of Seplat, a Nigerian production company that has bought over $5 billion in assets from the majors.

Glencore is already producing oil in Equatorial Guinea, Cameroon, and Chad. Vitol has production in Nigeria, Ghana, Cameroon, and Congo Brazzaville. Traders are monetizing these asset sales to counter the heavy lift moving directly to China and away from Europe and North America.

Glencores's forward curve
For a trader, the forward curve tracks today's price for tomorrow's delivery. It reflects long and short positions over time, and incorporates storage, finance, insurance, and logistics. When the curve is in contango, expected future spot prices will be higher than the current spot price.

I suspect that Glencore Xstrata's forward curve is in contango. Its foray into African energy will help secure its commitment to future delivery of higher returns for investors.

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