Physical oil trade may be next step for Wall Street

Morgan Stanley and Goldman Sachs, the reigning heavyweights in energy derivatives, are now sharpening their profile in physical oil markets, raising the bar for competitors chasing their mammoth trading profits.

The move, though limited so far, may force up-and-comers like Merrill Lynch, JPMorgan Chase and Barclays Capital to consider spending billions on oil assets if they hope to challenge the duo's decades-long dominance in paper markets.

The added edge of having a foot in the physical market - dealing with real cargoes of crude or shipments of oil products - is more important than ever as increased competition threatens to narrow margins on the core business of hedging volatile energy prices for airlines, producers and industrials.

Many investment banks have already made large investments in US and European power assets, supporting their electricity trading efforts and possibly setting a precedent for oil.

"Many banks coming into the (energy) market will not be successful as they are not prepared to take positions into the physical side of the market," said New York-based Panos Ninios, an industry analyst with consultancy McKinsey and Company.

Morgan Stanley and Goldman Sachs - known as "Wall Street refiners" for their big but asset-light positions - have upped the ante this year, helping protect a business that generates huge profits, both from fee-based risk management and proprietary activity - trading with the banks' own money.

Goldman Sachs's private equity arm together with Kelso & Co. purchased Kansas City-based refiner Coffeyville in July, while a consortium led by Morgan Stanley Emerging Markets also launched a failed bid for South Korean refiner Inchon Oil.

Morgan Stanley hired several crude traders away from major oil companies earlier this year and both have surfaced more frequently in physical markets, traders at other companies say.

Industry sources say the rising cost of buying billion-dollar energy infrastructure and the risks attached to operating it means such deals must first pass muster in their own right.

"You don't look to find assets that make you trade better, but to find assets that have value and that can leverage your trading compatibility," said a Singapore-based banking source.

Some players are taking advantage of soaring oil prices to offload non-essential physical assets. Louis Dreyfus, a big commodity trader but a small player in oil, agreed to sell its only refinery to ConocoPhillips last month.

But owning a refinery, a pipeline or storage tanks can give a trader additional insight on the market and the potential for more creative - and lucrative - trading strategies.

"Physical pricing knowledge in crude and refined products represents the keys to the castle," said Bernstein Research Call's analyst Brad Hintz, in a detailed report earlier this year on commodity trading at major investment banks.

Coupled with the banks' already huge hedging businesses, which give them unrivalled market knowledge on money flows, the benefits of more insight into the physical market could be enormous.

BP, with one of the industry's biggest physical and paper trading teams, made $2 billion last year in energy trading.

Bernstein Research estimated Goldman Sachs and Morgan Stanley's crude and refined products businesses had revenues of about $145 million and $207 million last year - more than double 2003. Total commodities trading proceeds came to about $1.3 billion, with just over half of that in derivatives trade.

Both banks declined to comment on trading profits or strategies.

"At the end of the day, physical asset acquisition is going to give banks more leverage over their trading positions," said Victor Shum of energy consultancy Purvin and Gertz.

The report said commodity revenues at Wall Street banks may grow annually by about 15 per cent in the coming years as volatility provides trading opportunities, more demand for risk management and increasing interest from investors.