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With the rapid growth in information and communication technology, the magnitude of transactions being contracted through electronic mediums like the internet has grown manifold. The term ‘Electronic Commerce’ or shortly ‘e-commerce’ is used to denote buying and selling of products and services over electronic systems. By adopting e-commerce systems a wide range of commercial activities is undertaken by businesses and professional service firms.
Although a large percentage of e-commerce is being conducted electronically for virtual items there are other e-commerce activities involving the physical transfer of goods and services. Thus electronic commerce is an emerging model of new selling and merchandising tools wherein the buyers use electronic mode to go through the process of a purchase decision instead of visiting a store physically or a seller in person or contacting them through telephone.
Electronic commerce encompasses the processes of enabling a customer to access the information on the products, choose the items the buyer wants to purchase, procure them securely and settle the bill financially. Despite the high cost of entry, electronic commerce is found to be highly useful for handling a large volume of transactions.
Even though electronic commerce has some definite advantages, the traders in oil and energy prefer to execute the trading transactions through voice outcry rather than through electronic trading. However, it may not be possible for them to shun electronic trading for a long time. This paper brings out the reasons for the decision of the oil traders to stay away from electronic commerce and the factors that will help to facilitate the oil trading to be done electronically.
Oil Trading and E-Commerce
Normally proprietary traders like investment banks and large hedge funds make use of electronic strategies resembling the trading in equities for trading in oil futures. Such strategies include co-locating their trading platforms in such a way that they are entitled to the benefit of the lowest latency between trade entry and execution. They also make use of algorithms that could undertake large trades and execute them in smaller chunks of fine-tune automated spread trading.
The volatility in the oil futures prices is driven up since the increased interest in oil futures contracts can be expected to come from various types of traders. Such traders include a range of traders from long-only pension funds to speculative hedge funds. The automation in such a market would flair up the volatility and volumes which may go disadvantageous to commercial traders. This is the main reason that the commercial traders in oil and energy want to continue their trading in the traditional outcry method rather than through electronic medium.
It may be noted that the oil prices recently have gone phenomenally high and have put a lot of pressure on the politicians and consumers worldwide. US and UK regulators are investigating the sudden price rise and there is a continuous demand from the US politicians to ban the speculators from the oil trade. According to an inquiry conducted by the US House of Representatives subcommittee on oversight and investigation points out to the fact that speculative oil trading accounted for nearly 70 percent of all trading in the New York Mercantile Exchange as of June 2008 compared with 37 percent in the year 2000.
According to the Commodity Futures Trading Commission, this figure is abnormally high. Therefore it is clear that speculative trading remains more active in oil futures. The speculative traders are using highly sophisticated algorithms. They also several other electronic trading tools in this market for making huge profits in speculative trading. On the other hand, commercial traders are not even using electronic trading platforms for accessing the markets directly. Most of them prefer to use still instant messaging and the telephone for their trading.
Another reason for the oil traders to avoid electronic trading is that the commercial traders do not find time to sit before a computer monitor and trade in the oil. They have to manage multifarious activities which make them busy and hence they do not find time for using electronic trading tools. They have to attend various business meetings, see different people, oil trade physically, and book tankers and vessels for shipping and forwarding. The commercial traders are not like hedge fund traders whose whole job is to do only futures and they can afford to sit before the computer screen all through the day.
The commercial oil traders do not want the market to move in a more volatile manner by their trading transactions. This is because most of the time the spread on the oil prices are too low where the traders would not like to trade.
Large block trades even when the market is busy trading are difficult to execute. This is so because such transactions are either spread based or in case they are outright contracts the traders do not want to cause major market impact. It is customary that many of the orders are flowing through voice brokers and large orders must be broken down into smaller pieces to avoid rapid market movements. Otherwise, the large orders are executed on the Nymex floor.
Although there are facilities in electronic trading using algorithms which apart from providing classic volume-weighted average price and time-weighted average price, may allow traders to implement more efficient and sophisticated execution strategies that can generate random iceberg orders to disguise large block quantity orders. However, the oil traders want to believe in their sense of the physical conditions of demand and supply in different market segments and they are sure that no algorithms would be able to replace their knowledge of the market conditions. (Melanie Wold, 2008)
Even though electronic commerce can transform the energy market, softening in those markets and the impact of the Enron debacle in the year 2002 has had major repercussions on the electronic trading in oil and energy. These factors have caused a drastic reduction in the number of trades and lack of liquidity is another major problem being faced by the traders in the market. However, it is to be noted that the adoption of electronic energy trading is not an issue connected with technology or a problem of lack of liquidity of the markets.
The difficulty in pushing up the electronic medium in oil and energy trading lies in the resistance from the commercial traders. The reluctance them to change is the main reason for their refusal to adopt electronic trading. Because of the strong presence of human element and relationship in energy trading, the e-commerce opportunities in energy trading has developed in a slower pace than expected. This is due to the existence of a relationship of bondage between the trader and the brokers.
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This relationship enables the trader to assimilate marker intelligence and the ability for transacting large volume trades without really moving the market. The traders are confident that screen trading cannot accomplish this feat. In addition, there is the space for personal relationships in the form of entertaining clients and customers which the machine cannot replace. It is more the fear of change that prevented the take-off of electronic trading in energy.
One other factor that was taken into consideration by the energy merchants was the credit concerns of the counterparty. The fall of Enron and its historic bankruptcy had caused financial distress among the energy merchants and created a significant liquidity crunch especially in the power derivatives market as well as in North American gas markets. With the credit concerns playing a major role in the energy trading due to the bilateral nature of the trade the Enron Online and Dynegy Direct have created a fear in the minds of the oil traders to deal with unknown counterparties whose creditworthiness are not known.
Energy traders wanted disparately to diversify their risks and hence they wanted to deal only with people whose credentials are well known. This also prevented them from using the electronic medium where it is not possible to know the financial standing of the counterparty which may affect the liquidity later if the counterparty fails to honor the contract.
Voice broking was still considered a strong way of doing business among the consolidating OTC brokerage community. Brokers were able to bundle their services by combining value-added services like providing market data, offering consulting services, and meeting other market intelligence information needs of the clients. The brokers can provide more flexibility in the dealings, enhanced market intelligence reports, and better handling of fast markets than the computers. The fact in oil trading remains that human beings are interacting with human beings and not with artificial intelligence. As a result of this, electronic trading in the oil sector has taken a long time to stabilize.
The affinity of oil traders to the open outcry system can be seen from the move of Nymex opening a new oil trading floor in Dublin Ireland in the year 2004 based on the open outcry system. This was due to the complaint of oil traders against the move of London’s International Petroleum Exchange to convert all its trading to the electronic medium. The traders complained that the electronic system was a less transparent one and leads to a less liquid market. (BBC News)
It is a fact to consider that the ending of the ‘open cry’ trading system was ended only after 18 months in March 2005 after the International Petroleum Exchange (IPE) introduced the electronic trading system. Most of the traders failed to adopt the system voluntarily with only 5 percent of trades in oil and gas futures were transacted in the first year of its introduction. It may be noted that IPE is the largest exchange of Europe for energy futures and options and one of the last open-outcry pits in London handling more than 1.1 billion pounds of oil trades in a day. In November 2004 the exchange restricted the number of hours for open outcry trading and it had to force its members to trade electronically. (Computer Weekly.com)
Future of Electronic Trading in Oil and Energy
The way forward for electronic trading in oil and energy is to get a grip on the human factors involved in the whole transaction. Moreover, it is the question of market liquidity that may affect the shifting to electronic trading. There exist a good potential for creating electronic trading platforms for trading in various forms of gas trading in the United States like electric power, emissions, weather, coal, and liquid natural gas trading. The hunt for liquidity holds the key to the success or failure of electronic trading in oil.
Whatever development has taken place in this direction can be termed only as a beginning and if the brokers are actively involved in the electronic trading then the electronic trading platforms would see their day. (Peter C. Fusaro)
It is another point to be noted that electronic trading is almost an infinite market with the rapid development of new technologies every day. The rate of advancement in electronic trading will render the current systems redundant very fast irrespective of the fact that the existing systems appear to be scalable.
It will be a necessity out of time that more refinement and technological improvement will come as there is recognition of such elements in the oil trading. For instance, there is the need that the gas markets in the United States must trade on a next-hour basis to match the power trading requirements. It can be expected that real-time will be real-time in the future with trading being done in the markets 24 hours of the day for all 365 days of the year.
Still, the greatest hurdle the electronic trading in oil and energy markets will face will be the human factor and not technological anymore. For achieving the desired increase in the volume of electronic trading the traders, as well as brokers, must be educated on the superiority of the utility of the electronic system of trading. The electronic trading platforms can only be considered as the beginning of a sea change in energy trading with more and more sophistication yet to come with the penetration of the internet into the world of energy trading. For sure such a transition will be witnessed by the world in the realm of electronic trading in oil and energy.
This is evident from the fact that the volumes in Nymex and Intercontinental Exchange (ICE) have grown to a large extent in the past two years. The monthly volume at ICE futures Europe in May 2008 was over 14 million contracts which are approximately two million contracts more than the year 2007 and this figure is almost twice that of 7.4 million traded in the year 2006. In the case of Nymex, there were 1.9 million contracts per day traded in May 2008 which accounts for a 38 percent increase over the number of contracts concluded in the year ending May 2007. The total number of contracts stood at 40 million during May against 30.3 million contracts done during May 2007.
Therefore it can reasonably be concluded that electronic trading will take off in the oil and energy market once the traders and brokers start accepting the change in the systems. It is their psychological feeling that the liquidity of the market will be affected when they transact with unknown counterparties. Since in electronic trading the traders cannot physically meet the parties with whom they are dealing they feel that electronic trading is less transparent.
Moreover, if the counterparties with whom transactions were entered electronically fail to meet their obligations it may lead to a situation of liquidity crunch. The earlier experiences with Enron Online trading and the loss of billions of dollars still prevent the oil traders to shy away from electronic trading.
The comfort of dealing with the brokers and the bondage and relationship established with the brokers by the traders is another element that prevents the traders to resort to electronic trading. The brokers also present several value-added services to the traders like market intelligence reports which make their services indispensable to the traders.
Another factor that makes the traders continue to deal in open voicing outcry mode is that they have a feeling of confidence when they meet the counterparty personally and the creditworthiness of the counterparty is another issue that always bothers the traders. They are also confident of their feelings of the market demand and supply position concerning most of the world markets which they feel cannot be replaced with computerized trading.
Hence so that electronic trading becomes popular and acceptable to the oil traders there should be complete training of the traders and brokers in how they can transact on e-commerce safely. The use of sophisticated tools of electronic trading technology should be introduced to the traders and brokers and once they use these tools and experience the convenience of electronic trading they will automatically come out of their inhibitions about electronic trading and start liking it.
But it may take some more years before a completely electronic trading mode can be seen in the oil and energy market. However, the future for electronic trading seems to be very positive with the rate of increase in the number of contracts concluded in Nymex and ICE. With more sophisticated tools and improved technology, the trading comfort for the traders will improve drastically and it is only a question of time that the oil traders shed their inhibitions and accepts electronic trading.
BBC News ‘Nymex Launches Dublin Oil Trading’, 2004. Web.
Computer Weekly. ‘Oil Traders Forced to use E-System’. Web.
Melanie Wold (2008) ‘Electronic Tools Fuel Oil Gusher’ Online Financial News. Web.
Peter S. Fusaro ‘Electric Perspectives: The Human Element in Electronic Trading’ Edison Electric Institute. Web.