Pretend you are a natural gas market maker hero (TM). Your goal is to buy gas from producers and sell it to consumers. “Aha!”, you think, “I’ll just use my magic teleportation and time machines to facilitate that transaction!” Unfortunately, real life is a little more complicated.

First, there’s often a tenor and size difference between how producers and consumers trade. Producers have far out production schedules that fix the amount of gas they can deliver. The’re going to want to hedge against market downswings far out in the future. For this purpose, producers are going to be selling you massive blocks of gas that delivers many years from now.

Conversely, consumers have less incentive to hedge against high gas prices far out in the future. Many consumers such as utility companies have the ability to pass on higher gas prices to their customers just by raising end heating/electricity prices. Additionally, in recent years, many utility providers have begun to downsize their hedge programs. There’s massive asymmetrical risk associated with running a “hedge” trading desk at a large corporate business. Let’s say you’re a multibillion dollar utility company. On a good year, your trading desk can generate ~$10M through proper hedge activity, whereas a bad year with runaway hedges can cost ~$100M. An electricity provider by day that doubles as a rogue trading desk at night, will understandably make shareholders antsy. Furthermore, the overall market conditions of decreasing gas prices since the shale revolution have made hedge programs at consumer a losing proposition. This means that consumers in general will buy gas at closer tenors and in significantly less volume because in the worst case, they can just go buy the gas in the spot market.

Compounding the tenor and size difference, there’s also a timing mismatch between when producers and consumers knock on your door. When it comes to hedging, producers show up when gas prices are high and consumers show up when prices are low. Even if the spread you charge is large enough to stay profitable, you may be unwilling to warehouse that risk long enough for the opposite side to show up.

As our plucky market maker hero, what are you to do? Usually, you’ll take that long dated, illiquid, esoteric risk and hedge it with a correlated, more liquid asset. This makes the risk less volatile and more manageable. It’s not a perfect hedge and you still need to be on your toes about managing this risk, but it’s less likely to run away from you. Additionally, if you have a strong view on this risk, you may choose not to immediately manage down your risk.

This brings us to the interesting point of why market making in commodities tends to see more principal trading and risk warehousing. In a world of illiquid risks and imperfect hedges, commodities market makers see holding onto risk as not only a cost of doing business, but also a profit opportunity. This is combined with a more relaxed regulatory environment for commodities (the concept of insider trading laws is much weaker for commodities than other asset classes covered to Dodd Frank). A market maker hero such as yourself stands to profit handsomely from properly managing risk inventory.