How Traders Make Money: Refined Metal
The world of refined trading (and value-added products) revolves around premiums. A premium is an amount that a trader will pay for a commodity over and above an exchange set price. For example, an aluminum trader buying 1,000mt of P1020 ingots FCA a warehouse in Baltimore, USA, might pay a premium of $400/mt. If the price of aluminum for that contract was set using an LME of $2,300/mt, that means the total the trader would pay per mt would be $2,700 - the LME price plus the $400/mt premium.
Premiums themselves reflect many different factors and change frequently. Premiums are based on many factors such as the geographical location of the commodity, the incoterm you are buying at, production costs, the shape of the metal, logistic costs, warehousing costs, finance costs, credit costs, insurance costs, and a host of other macro and micro factors. The job of a physical trader is to buy metal at a lower premium than they sell at, including all of their additional costs (as applicable) to move the metal to their end consumer. If X = purchase premium, Y = sales premium, and Z = a trader’s additional costs/mt, then put simply, if X + Z < Y the trader will make a profit. If X + Z > Y the trader will make a loss.
Take a trader who buys 1,000mt zinc warrants in an LME warehouse at a premium of $20/mt. On top of the premium, they pay FOT costs of $45/mt, LME rent of $5/mt, trucking costs to their customer of $50/mt, finance costs of $15/mt, and credit insurance costs of $2/mt. This means their breakeven sales premium for this metal is $137/mt. If they can achieve a sales premium above this number they will make a profit. If they achieve a sales premium lower than $137/mt they will lose money on the deal.
Refined Metal P&L Table
In this example the trader secured a sale basis DDP their customer at $180/mt. Their hedge protected them against the $100/mt LME zinc price drop between the purchase and the sale. Their sales premium of $180/mt generated a profit of $43/mt against their cost of $137/mt.
Given the global nature of most trader’s books and ever-changing supply/demand pictures, traders are required to perform P&L calculations on potential and existing deals almost daily. To manage their physical books, traders can simultaneously agree purchase and sales contracts with different counterparties to lock in P&L without taking risks on fluctuating premiums. They can go long the premium (book more physical purchases than sales) believing that by the time they square their position (sell physical), premiums will have risen. They can also go short the premium (book more physical sales than purchases) if they believe that by the time they square their position (buy physical), premiums will have fallen.
Instead of profiting from a price change, traders rely on their market intelligence, outlook, positioning (either long or short the premium), relationships, negotiation skills, and other advantages that allow them to effectively trade premiums.
Refined metal premiums are typically set individually on a deal-by-deal basis between the two parties transacting in the deal, and can be on a spot or long-term basis. However, in the case of aluminum in certain parts of the world, premiums are set by publications that poll producers, consumers, and traders to ascertain the daily, weekly, and monthly premiums. We will look specifically at how aluminum premiums trade and some ways traders can mitigate the inherent risk of changing premiums in a different post.
