Yes, IT can be sold like a barrel of oil (but it’s going to take some work)

8 Comments

Big companies use commodity contracts to ensure predictable prices for oil, wheat, electricity, metal and other crucial supplies that keep their businesses going. These days, a crucial supply for many companies is cloud computing power — raising the question of whether that too can be bought and traded in the same way as oil or oranges.

A recent partnership suggests the answer is yes, and that we’re heading to a world where companies won’t just turn to Amazon Web Services or Microsoft Azure for cloud services, but to a commodities market that offers the best price, on the spot or in the future, for a range of interchangeable IT infrastructure.

The financial platforms and the raw resource already exist to support cloud as a commodity. So do the people. But the question is whether someone can bring this all together, and overcome some big obstacles that stand in the way.

Cloud computing by the bushel

Earlier this year, a Raleigh, N.C.-based cloud company called 6Fusion signed a deal with the Chicago Mercantile Exchange, the world’s biggest market for commodities and derivatives contracts. If all works out, the deal will mean that buyers and sellers of cloud computing services can do business on a spot exchange and, in a few years, trade derivatives too.

The exchange will be a place to buy hours of “WAC,” a term invented by 6Fusion that stands for Workload Allocation Cube. The idea behind the WAC is to create a standard unit of cloud computing infrastructure that can be bought and sold by the thousands.

Under 6Fusion’s current definition, a WAC hour is composed of six metrics, including ones related to compute, networking and storage, that can be sold at a single price. Here is how 6Fusion portrays a WAC:

6Fusion WAC hour

According to 6Fusion spokesman Ryan Kraudel, the WAC is akin to a watt of power because it provides a standard measure of output, which in turn removes barriers to trading cloud computing as a commodity.

“The fundamental problem no one’s been able to solve till now is ‘what is the barrel or bushel’ [of cloud]? Now, there’s a basis for contracts in the future of infrastructure services,” said Kraudel.

6Fusion is not the only one proposing such an arrangement. In Europe, a company called Zimory is working with the German exchange Deutsche Boerse to sell cloud computing units.

In theory, the creation of these common metrics means companies can now use forward or futures contracts, based in WAC’s, to exercise more control over IT costs, which represent a growing percentage of many corporate budgets. Kraudel predicts that IT-intense enterprises like banks or universities will be among the first adopters.

What this could mean on the ground is that the IT infrastructure of a company like JP Morgan could soon consist of private cloud servers for sensitive data, supplemented by public cloud supplies purchased from an ever-changing roster of third party cloud computing providers. At the same time, such purchases of cloud computing “by the bushel” would also mean lower prices as traders, rather than vendors, start to set the price of key ingredients of IT infrastructure.

Skeptics might note that this idea of cloud computing brokers has been around for a while, but now its arrival finally appears close at hand. Kraudel says a spot exchange for bilateral contracts should be running by the end of the year, and that a derivatives market will be up and running by late 2015 or 2016. But that doesn’t mean, of course, those markets will succeed.

You can build it, but will anyone come?

The idea of WAC’s, and a derivatives market for IT infrastructure, is well and good in theory, but that doesn’t mean it’s actually going to happen.

6Fusion can define WACs and the Chicago Merc can provide a place to sell them, but the plan will only work if a critical mass of buyers and sellers agree they are worth trading. And that could be a challenge.

Unlike a barrel of oil or a bushel of wheat, there is no consensus on what a commodity unit of cloud computing should look like. While 6Fusion has offered a definition, not everyone will accept it and some will challenge the choice of metrics that make up a “WAC hour.” The task of defining the “cloud bushel” is harder still since the industry is evolving rapidly, and even accepted references points like an M3 instance from Amazon, may be soon outdated.

If no one can agree on what to trade, in other words, there will be no trading.

The problem is daunting but not insurmountable and, as it turns out, it’s hardly a new issue in the world of commodities. According to James Mitchell, a former commodities trader at Morgan Stanley, any traded good, no matter how standard it may seem, will be subject to changing definitions.

Mitchell, whose company Cloud Options has advised 6Fusion, points out that oil comes in a variety of standards — Brent Blend, West Texas, etc — and that orange juice contracts include a variety of conditions that let traders adjust the final price based on size, seeds and so on.

The same is likely to hold true when it comes to cloud computing commodities. Contracts for “WAC hour” futures, if the market adopts them, may include adjustment mechanisms for traders to tweak at the end of the deal.

“Everyone hedges against, then trues up against how off-spec it is,” said Mitchell, speculating on what would happen if a bundle of WAC hours didn’t correspond to the exact cloud resources that a buyer had sought to obtain.

“In the truing up process, you might have a disproportionate amount of CPU. If 6Fusion does a good job, they’ll choose a middle ground that doesn’t require a correction.”

Mitchell added that, for now, the biggest impediment to a functioning futures market is that traders and techies are still learning to speak to each other. IT people have a good idea of what a unit of cloud computing resources looks like, but this knowledge is still being translated into standard contract language of a sort that brokers can instantly recognize and trade upon, he said.

800-pound gorillas don’t like to trade

Let’s say the IT buyers and the traders do agree on a common cloud commodity (a WAC or otherwise) and the exchange is up-and-running as 6Fusion promises it will be. We’re still only halfway there since an exchange also needs sellers.

And right now, the cloud infrastructure industry is dominated by a giant called Amazon Web Services that will likely be reluctant to offer up its wares to a commodity exchange. The reason is that commodities, by definition, are interchangeable and sold at a price lower than any one seller can dictate.

So for Amazon, which is already selling cloud infrastructure at fire sale prices, a commodities exchange would not only depress prices further, but invite a host of other competitors to replace its branded AWS products with a generic bushel. But one way to prevent that from happening is for Amazon, and other big cloud service providers like Rackspace or Microsoft, to simply sit this out and try to ensure the commodities is not liquid enough to be viable.

6Fusion’s Kraudel acknowledged that Amazon, which declined to comment for this story, would be reluctant to participate, and noted that the company already offers its own on-the-spot cloud pricing as well as a form of futures called “reserve instances.” Still, he thinks the market will be liquid enough anyways.

“Amazon Web Services is an 800-pound gorilla, but there is a very long-tail to this market,” he said, explaining that there are many other providers capable of offering analogous cloud infrastructure, and that more will enter the market to meet what is still ever-growing demand. (It’s also possible that recent price pressure from two well-financed competitors, Google Cloud and Microsoft Azure, could nudge Amazon towards selling on an exchange).

Finally, the history of commodities markets may once again be instructive in trying to guess the future role of the current cloud gorillas. That history, according to Mitchell, shows that incumbents may dislike the loss of pricing power that comes with commoditization, but sooner or later the traders get the upper hand.

“Exxon tries not to use wholesale price of oil, but that doesn’t dictate the price of oil. It’s traders who are long and short who set the prices, not those like Amazon who are fundamentally long.”

8 Comments

James Mitchell

It is a stage of the market thing as John Cowan says. Bandwidth trading did fail in the aftermath of the downfall of Enron. It is no coincidence that Switch SuperNAP is now brokering bandwidth from the very same location (2nd best connected location globally) that Enron planned to do it from. It is also worth differentiating between wholesale and retail markets and the role of vertical integration. The price of cornflakes is pretty stable as a retail product, but the price of corn, as a wholesale product sold by corn producers and bought by Kelloggs, is pretty volatile. When this market matures some more (and this is happening very quickly now), we will see separate subsidiaries within the vertically integrated cloud providers hedging at least part of their portfolio in a wholesale traded market, just as the big vertically integrated energy providers/suppliers do.
And to agree with Robert – there will always be a subset of customers who want the entire relationship to be with the end provider, and those cloud providers who get a reputation for delivering well on that relationship will attract a high percentage of that type of customer. Its almost like the anthropic principle ;-)

John Cowan

Robert – I think what you may be observing about buyer behavior is simply a characteristic of early, nascent markets. You are absolutely correct that these customers need their hand held and they need lots of TLC. However the mature business that depends on multi-sourcing to deliver software and IT services to it’s constituents ABSOLUTELY wants two things: 1) They want price transparency to inform their negotiations and 2) They want an exchange value equivalent so that they can have an apples to apples economic conversation with multiple suppliers. In the first stages of the open market revolution this is exactly what you will be able to ascribe as the benefits to buying/selling as a commodity.

I see a lot of irony in statements about “value add” and the inpenetrable insulation it provides against the inevitability of commoditization and openness. I think if you look back over modern history of IT history you will find scores of now struggling or already extinct companies that said precisely the same thing about the server market, about the operating system market and about the Enterprise Software market.

I’m not sure about the accuracy of your statement regarding bandwidth brokerage. Are you aware that Switch SuperNap acts as a bandwidth broker today? In fact, they are a pretty big one. If you talk to the customers and suppliers of that bandwidth marketplace they will tell you they quite like buying and selling in that manner.

Cheers,

John
CEO – 6fusion

CloudSigma

@jeff

The biggest challenge I see is one of customer engagement. I agree brokerage for cloud is possible to do even when customers have disparate requirements. I do think however that buyers aren’t clamoring for this. Would they like things like data portability? Yes, cloud brokerage? It isn’t something they ask us about (in terms of participation) very often, despite us being on a number of such platforms.

We didn’t see brokerage happening for bandwidth (despite some very serious attempts) or server hardware. Both of which are arguably a lot more standadised the cloud services. That lends me to believe that buyers sought direct, more involved relationships with vendors in both those cases and I believe the majority will choose a similar model for cloud services.

Robert
CEO
http://www.CloudSigma.com

Jeff John Roberts

Thanks for the comment, Robert. That’s a good point –just because something can be sold as a commodity doesn’t mean it will be; as you suggest, buyers may prefer a supplier that provides some value-add to the underlying good.

James Mitchell

Hi Aaron – I’m going to have to argue with you here ;-)
You say: “prices are going lower — not higher. This strongly argues against purchasing anything for future delivery. ” So you are saying that backwardated markets never trade? That is just not the case. The natural gas market periodically goes from being contango (rising future prices) to backwardated (dropping future prices) and trading volumes remain high throughout. The reason you lock-in a future price today when there is an expectation of future price drops, is that you can lock-in a price that is LOWER than today’s price, allowing you to budget a firm price. This could mean that you can win a fixed price bid by beating rivals who pad their expected future costs by using today’s on-demand prices, without running the risk that prices don’t drop as quickly as expected. The ability to tailor the structure of that deal – e.g avoiding upfront payments, because someone is willing to finance the deal for you, increases liquidity in the market.
And you are focussed on the on-demand price, which just drops discontinuously now and gain in a hard-to-predict manner. There is considerable volatility in the expected price for FUTURE delivery, and there is NO transparency in that. What will the price of an m3.large instance be in March 2015? Your view on that will change the day after AWS drop the prices for delivery today. FUTURE prices are NOT open, transparent and predictable…
I’ll stop ranting now! James

aaronklein14

@ James

Yes, you are right — backwarded markets do trade. I was imprecise in my statement — I should have said prices are moving in a single predictable direction, lower.

This does not rule out future purchases, but without 2 way volatility, the window for profitability attached to those future purchases diminishes greatly.

The minimum check boxes would be as follows:
1. It has to be cheaper than today’s price and cheaper than any predictable price cuts (see Bezos law).
2. It also has to be cheap enough to offset the premium paid and counterparty risk (unless these become exchange traded).
3. It has to also be cheaper than what I think I can do buying RI.
4. It has to be cheaper than any expected improvements in delivery (M.1 were great but not anymore… so I have to price in risk that I am buying “old” capacity).
5. it has to be advantageous enough to offset the “hassle” factor (i.e. it is much easier to get approval to buy directly from the provider with less paperwork, contracts, etc. ).

2-way price risk – which exists in other markets – would dramatically alter the analysis.

aaronklein14

Just a thought here: why don’t we start the discussion by looking at derivative markets exist and grow? The answer is that end users need to offset risk (typically price volatility but sometime transaction difficulty, counterparty risk, or other concerns) over time. For example, the wheat farmer wants to ensure the value of their crop when harvested and the cereal maker wants to know their production costs.

Price volatility can come from a number of factors –weather, demand, geo-political situations, timing issues, and myriad other concerns. All, however, create a problem for both buyers and sellers.

This problem – for now, does not exist in cloud computing. There is no unpredictability in price timing – the standard “future” is a 1 or 3 year RI. There is also nearly no day-to day volatility — does AWS or anyone else change On-Demand prices daily? Further, prices are going lower — not higher. This strongly argues against purchasing anything for future delivery. Finally, derivative are designed to remove inefficiency from the market mechanism — that inefficiency does not seem to be present here. Prices are open, transparent, and predictable.

So, unless these factors change – for example, if AWS eliminated On-Demand and went to a pure spot model – it seems incredibly unlikely that there will be producer or consumer led demand for cloud computing derivatives.

That does not mean a market will not occur — I am under no illusions that markets need natural interest. The created market may simply dwarf the natural interest –foreign exchange is a good example where total transaction volume dwarfs necessary transaction volume. However, that merely means that traders are engaging in a zero-sum game ( gambling against each other). It does not mean that natural participants will emerge.

Last, this is not to say that the folks at CloudOptions do not address a viable need — creating bespoke purchasing agreements. That “market opportunity” makes sense — they are removing friction from the existing pricing structure by offering alternate terms for resources. However, the very nature of customization augurs for their “market” to be more akin to the pre-regulated OTC derivatives market as opposed to the exchange driven market that is currently being imagined.

James Mitchell

Ultimately it will become possible to fix the price of your IT by reference to Benchmark Price for “Brent Cloud” or the Benchmark Price of a “WAC”. It will not necessarily be crucial to actually be consuming or delivering a standardized cloud service, so long as the price for what you consume or deliver tracks the benchmark. This will even extend to private cloud deployments.

Comments are closed.