Venerating Volatility

How to overcome implementation risks in a new commodity trading business.

Most companies curse the unpredictability that volatile commodity prices introduce into their earnings. But traders have a very different point of view. For them, volatile prices spell opportunity. Without them, many struggle to eke out above-average earnings. Indeed, our research shows that commodity traders earned 35 percent less in revenues in 2010 than they did in 2009 in large part because commodity prices remained relatively stable until the end of that year.

With volatility racing back to the markets in 2011 and the success of commodity traders such as Switzerland-based Glencore, which is currently preparing for an initial public offering estimated to be worth more than $55 billion, it is not surprising that organizations ranging from vertically integrated oil and gas players to independent commodity traders are now racing to ramp up new trading operations. Commodity producers who used to sit on the sidelines, letting other traders capture trading margin, are now setting up their own trading businesses. For example, Saudi Arabia’s Saudi Aramco, South Korea’s KEPCO and Abu Dhabi Resources have all announced plans to enter the commodity trading business in the past few months. They are betting that current commodity market conditions will continue due to factors ranging from increasing global supply- demand imbalances, to extreme weather, to political unrest.

But setting up new trading operations isn’t easy. As with any large project, it involves myriad details that need to be worked out diligently. Only then will a company be able to launch a new trading business on time, within budget and with an end result that is what was originally envisioned.

In our experience, mastering three key risks will determine whether a new commodity trading operation will be successful. Overcoming these three areas of implementation risk involve: articulating a future trading model clearly, aligning stakeholders and achieving excellence in execution. Trading organizations that focus on these critical success factors for setting up new trading operations in a timely manner will set themselves apart from their competitors.

Articulating a trading business model clearly

Most of the trading businesses now being launched are basing their business models on physical production from their parent company. In theory, this gives them the advantage of securing long-term supply positions from the very start. In practice, however, it is difficult to reach a decision on what part of, and how much of, the physical supply should be transferred and at what price. That means a well-governed process needs to gain support from many stakeholders for this advantage to actually pan out.

To gain broad support, the amount of physical production that will be transferred to the trading business, the new trading model, as well as the plans for building the new business, all need to be decided in detail. They also need to be communicated proactively in a clear and transparent way.

Moving from trading physical flows in order to optimize their value to proprietary trading for profit is a major shift in a business paradigm. Most vertically integrated oil companies are unfamiliar with the nature of proprietary trading. In fact, many have made a point of steering clear of buying and selling third party volumes for a profit or entering into positions that can not easily be offset by their own physical positions in the past.

Making matters more complicated, there is a high barrier to entry into trading. For instance, for an oil trading company to be successful, it must build substantial operations. Consider: A world-class oil trader requires the equivalent of the amount of oil that Spain and France each use in a day, or 1.5 million – 2 million barrels of oil per day, to generate gross margins ranging from $400 million – $600 million. In our experience, a company will need to build an organization with 50 to 120 traders and approximately 150 to 400 support staff, to support handling that amount of physical product and the associated paper deals.

Aligning stakeholders

Another key success factor is to engage key stakeholders continuously throughout the project from early on. For vertically integrated oil and gas companies, the trading company will be a new entity within an organization that has traditionally been made up of a strong upstream, midstream and downstream business. That means the establishment of a new trading company could have implications for these other business units. It might even weaken their positions since a strong trading company can act as a central optimizer of all of the parent company’s commodity risks.

An effective and continuous communication strategy must ensure that all of these key stakeholders are part of the design and implementation. Their voices should be heard and their contributions acknowledged.

The first step to achieving this is to have an influential project sponsor who can represent the project team at the same level of key stakeholders and steer the project team safely through the complex maze of corporate relationships. We recently observed a case where a project was executed very effectively in large part because a client made the company’s chief operating officer and a board member the project’s sponsor. As a result, he could represent and manage the new trading operation’s interests at the executive management and board level vis-à-vis other members.

Achieving excellence in execution

Finally, a comprehensive plan for setting up a trading organization is crucial. With a well-structured and executed plan, a company can set up a new commodity trading organization in 12 months. Without one, there is a much higher risk that it will be executed poorly and take more than 18 months.

While many companies build work streams around the support functions needed for an individual trader, projects organized along the key responsibilities of the company’s top five senior executives—the chief executive officer, chief commercial officer, chief risk officer, chief financial officer and chief information technology officer—are much more effective. That’s in large part because the second approach clarifies the ownership of each of the required work streams.

Successful project management requires proactively coordinating people who can manage work stream interfaces and dependencies. The greatest challenge is striking the right balance between the pace at which a project is being carried out and the pace at which it is gaining broad support. Stakeholders who are crucial to the success of a new trading business can easily lose interest if the project is moving forward too fast without sufficient communication. The project team leadership’s detailed knowledge of commodity trading can dramatically reduce delivery risk by continuously and rigorously tracking the project and asking key questions, while proactively identifying potential delivery risks.

Top executive work streams

At a higher level, the CEO should be handling many important initiatives. For example, the CEO needs to promote the business model and the business continuously internally and externally in a coordinated manner. It’s also up to the CEO to make sure the commodity trading business is designed so that it will function well within its parent organization, and yet have enough independence to meet a company’s desired financial targets.

As part of achieving that goal, the CEO should be intimately involved in recruiting the right people to lead the new business and define their reporting lines both within the trading business as well as in the broader organization. In our experience, clients who have the foresight to recruit and appoint the top and middle management of a new trading organization early on benefit from these managers participating and contributing to the project almost from the start. Otherwise, a client may have to revisit the project team’s decisions every time a new manager is appointed since each new manager will have his or her own perspective on issues particularly pertaining to his or her area of responsibility.

The CEO should also take charge of defining the tasks and responsibilities that need to be performed from the first day of trading, including defining what will need to be checked. Clients can potentially suffer significantly if the aspirations and requirements of the first day of a new trading operation are not well-articulated. In our experience, there’s a serious risk that the project team can become confused about what the endgame is, resulting in a potentially significant delay.

At the same time, the CCO should be working on a third work stream that involves developing and sharing the details of the future business. Unless this executive develops a clear and detailed vision of the trading business model, the scope of trading activities as well as the interface requirements with other business units, stakeholders may draw different conclusions about how risks should be transferred from business units to the new trading operation. Indeed, without the right leadership, even with clearly defined principles, drafting commercial contracts that govern transfer mechanisms can take more than a year.

The CRO’s main responsibility is organizing an independent and powerful risk management function. Few trading businesses succeed unless a risk and controls culture is firmly established. One step to achieve this is for the CRO to develop the risk analytics capabilities necessary to support the trading business’ complex analysis. However, this can only be achieved if the CRO has a clear picture of the scope of trading and the risks that will need to be managed by the new trading operation. In complex situations that involve large and cross-commodity portfolios with many stakeholders, such clarity does not necessarily emerge quickly, preventing a CRO from properly building up his or her organization on time.

On a different front, the CFO needs to establish an organization capable of supporting a new trading business financially. Since traders will need access to financing instruments as well as short and longer-term funding, the CFO should be solidifying a financing strategy and stable banking relationships. He or she also needs to make sure the tax regime that the trading business operates in is well-understood.

Finally, the CIO needs to be involved early on to evaluate the optimal information technology systems for the trading operation from several perspectives. First, the CIO needs to asses to what degree the trading company has specific needs that necessitate its systems being run on a stand-alone basis. Next, the CIO should select the trading business’ systems as early as possible so that enough input from the other work streams can be gathered to tailor the system to the business’ future needs. Then, the CIO must select and manage the appropriate vendors.

We have seen more than one case in which systems have been selected without taking into consideration how the business will evolve. This has resulted in multiple legacy systems on the trading floor that are not seamlessly inter-connected or connected to the risk management and back office systems.

As a result, they become prohibitively expensive to maintain and possibly simply left idle.


Highly volatile commodity prices and changing market structures are creating huge potential opportunities for new trading businesses. But these new players are entering an increasingly competitive environment. Companies that place the responsibility for the success of a new trading business squarely on the agenda of their top executives early on will have a much greater chance of successfully establishing new businesses on budget and on time. The firm foundations of these new trading businesses will also be a key differentiator of their performance over the long term.

Venerating Volatility