A Few Ideas About Hedging

It’s been said that humans are best equipped for learning during the late morning hours, as our brains are most ‘awake’ and thus, more receptive to new ideas around 11 a.m. If this is the case, then Richard Larkin, president of Hedge Solutions, had a near-perfect timeslot for his Eastern Energy Expo presentation, “Rethinking Your Purchasing and Hedging Strategies,” given at 11:15 in the Bravo Room at Foxwoods’ Fox Tower.

Larkin, a veteran of the heating oil industry who founded Hedge Solutions in 1993, prefaced his talk by telling the audience that he was operating under the assumption that everyone in the room was at least familiar with basic hedging terminology like ‘puts’ and ‘call options.’ With no objections from the audience — a sizeable turnout for a Monday morning — Larkin proceeded to outline several innovative approaches to looking at fuel buying and hedging.

 

Flipping the Heat Curve

As every heating professional knows, 80% of degree days typically fall between November and March. With this established, Larkin proffered a seemingly radical, though also historically grounded, hedging and purchasing strategy. As volume weighting a heat curve changes average prices and incomes, Larkin proposed that flipping the equation changes the outcome.

For every day in January that a buyer misses her target margin, Larkin reasoned, she needs three more days above margin in April. Knowing this, one must examine margins carefully, looking at five specific indicators: target, basis, demand, weather, and lastly, price trends. Larkin reiterated that buyers should first consider their margins reflective to their targets; that is, if the margin is below target, the buyer should do nothing, but if the margin is above target, a hedge equation has presented itself.

It’s during the second step — looking at basis — when Larkin most often spots missed opportunities. “Here’s where money gets left on the table all the time with portals,” he said, encouraging buyers to check supplier portals and examine hedge costs at this stage. That price trends are left for last in Hedge Solutions’ list is no accident. The company’s mantra is one of accounting — not trading — Larkin stressed. “Honestly, if you have a system, the last thing you should be doing is trying to figure out what the market’s going to do over the next 10 days,” Larkin said.

“If you have a system, that won’t matter.”

 

Changing Risk Profiles

The second concept Larkin proposed involved taking a step back to reconsider daily risk factors, such as having no cap fee, a fee lower than the premium paid, not enough margin in one’s cap price, and “poor hedging practices” like buying wet barrels with no downside or trying to time the market. The idea is that there is some degree of risk inherent in buying and selling fuel, no matter what; why not then look for a play to redistribute that risk in a way that could potentially yield better rewards without costing anything extra?

“I’m simply taking that risk that’s inherent in your margin — we’ll still spend the same amount — but we’ll look at changing your risk profile,” Larkin said. “We couldn’t do this without modeling.” Because there are so many different pricing models available, Larkin explained, hedgers now have tools at their disposal that allow them to readily project profits and losses based on virtually limitless permutations of sales and hedge performances. Therefore, it is easy enough for hedgers to redistribute inherent risks and maintain the same loss potential while exploring different opportunities for greater profit.
This is perhaps a more philosophical hedging strategy than the first concept, in that it asks players to reconsider the game pieces rather than the order in which they move.

 

It Comes Down to the Diff.

During the Q&A segment of the session, one audience member asked Larkin to explain the difference between Platts and Argus, two of the market’s leading price indices. “The difference is in how they calculate their daily numbers,” he responded. “Platts takes the last 30 minutes of the day, whereas Argus takes the whole day’s activity to get that index, the argument being that you want something more representative of the day. This gets very important if you’re buying for a wholesaler,” he continued. “The scramble at the end of the day can give you an artificial measure of what’s going on. It does come down to the diff.,” i.e., the difference between spot and future prices.

That being said, Larkin acknowledged Platts’ status as “the king of reporting on cash markets around the world” and returned to his winter 2017-2018 examples as a way of showing how the company’s index “does very well when the market is stressed due to cold weather and you get a blowout,” as was the case from January to February.

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