Thursday, June 4, 2020

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2020 Hedging Survey


Before we jump in, it’s worth taking a look at the editorial calendar that helps Oil & Energy keep its Annual Hedging Survey on track each year.

Typically, this editor begins drafting questions for the survey in late January/early February. The questions are then finalized and sent out to prospective participants in mid-February along with a schedule that lists survey benchmarks (e.g., “Monday, February 24: Check in to confirm participation ... discuss any ‘questions about the questions’”) and deadlines. This year, answers were due by Friday, March 13.  

By now, we all know what else happened between February 24 and March 13. Negotiations between OPEC+ and Russia collapsed and along with them so did fuel prices. Also, the COVID-19 (coronavirus) pandemic engulfed the world economy, causing markets to nosedive. The Dow Jones Industrial Average plummeted to bear market territory, ending a record 11-year bull run.

At press time (March 27), uncertainty abounds. What may have seemed relevant in January — say IMO 2020, for example — now looks like less than a blip. At the same time, the coronavirus situation evolves daily. Yet, as one survey respondent said, “It is in times like these that the value and necessity of hedging becomes clear.” Or, as another noted, “I don’t think anyone saw this coming but it defines the very essence of why you need to be disciplined about hedging your risk...”

Oil & Energy reached out to hedging providers who support the heating fuel market for their thoughts about the current marketplace and prospects for 2020-2021. We’d like to thank the companies that took the time to participate: Hedge Solutions, Sprague Operating Resources, Angus Energy and Aletheia Consulting Group.

Average wholesale heating oil prices started the 2019-2020 heating season at about 30 cents lower than in the previous year (October), jumped to over 30 cents higher than in the previous year (late December), and then dropped back down to 20-30 cents lower than in the previous year (early February). Which hedging and purchasing strategies served retailers best over this stretch?  
Hedge: I think, regardless of the strategy, hedging always works better than not hedging. The difference between buying wet barrels with put options versus buying calls always comes down to basis and, to a certain degree, the weather. Since weather predictions are unreliable, I find it makes sense to have a mix.

Sprague: All of that amounts to market volatility. It tells us that nothing is predictable about oil prices. The generally “lower in summer and higher in winter” price patterns are long gone. Many more variables influence oil prices than in the past. The best purchasing strategies are the ones that leverage the volatility to the retailer’s advantage or protect against it.  

Sprague Real-Time® is our tool that allows retailers to leverage near-term price volatility to their advantage. Sprague’s downside protections programs like PhysCap® and PriceFlex® allow retailers to protect against price volatility in the future. We discourage retailers from taking unnecessary speculative positions. Degree-day weighted programs and smaller volume purchase thresholds allow them to do that. We continue to encourage this strategy.    

Angus: As is always the case, there is no “best” strategy in a vacuum. It depends upon what you are seeking to hedge. Historically, customer surveys have indicated that a pricing program is the best retention tool, with Caps outpacing Fixed offers as the best way of keeping customers from shopping around for a better price. This past winter was the poster child for capped prices – due to market flexibility as well as weather.

Capping can be done several ways – call options, long (physical, wetbarrel future, or futures contract) with puts, etc. They all work, and none is “best.” We recommend that a dealer consider price, volume and basis. Each type of hedge is available, and you should discuss the structure that is right for your company with your commodity trading advisor. Remember hedging is hedging and not speculating.

Aletheia: The strategy chosen — e.g., fixed, capped, or rack plus hedging — will depend on the end goal. Once a strategy is established, all that is left is to buy at the right time. As a commodity trading advisor, it is my responsibility to communicate with clients as to when a good time to buy is. Notice I didn’t say “best” time to buy, but “good” time based on the fundamentals and technicals. The key is to take the emotion out of the purchasing decision and instead have a levelheaded, commonsense dialogue for entry points.

Were these prices in keeping with past years’ market movements? Which factors had the greatest influence on prices this heating season, and do you see this continuing?

Sprague: In our view, no two years are similar. While each year has the basic supply and demand influences, there are always other market variables that make that year unique. This year, it was the potential impact of IMO 2020. In prior years, we had the transition to 15-ppm sulfur. Every year holds uncertainty around weather. For the 2019-2020 season, certainly, IMO 2020 was a big potential issue but warm weather during the peak demands periods muted everything.

Now in Q1 2020, we have the impact of coronavirus. We are already seeing its impacts on world oil demand and future production policies. It is not unreasonable to expect these factors to continue to influence prices for the near term.

Angus: Prices gyrate each year, usually for a combination of fundamental, technical and geopolitical reasons. This year, while a little more volatile, was not out of the ordinary. Combining a cool start to the season with a very warm mid-winter drove a lot of heating volume away. While that might have impacted prices a bit, it likely impacted “basis” more than the actual price of oil.

For that we can thank OPEC+, excess supply, talk of production cuts, and the unfortunate coronavirus outbreak. We need to remember that understanding that prices cannot be predicted too far into the future is key to managing price risk.

Hedge: I know that at the time that this survey/questionnaire was put in place, there was little information around the epic event that was about to arrive. The coronavirus will likely take its place with the 2008 financial collapse as one of those extreme and unpredictable phenomena known as a Black Swan. Add in the breakup of the Saudi-Russian cooperation on oil production and now you’re really talking cataclysmic and unusual. I don’t think anyone saw this coming but it defines the very essence of why you need to be disciplined about hedging your risk and should never bet on oil price direction.

Aletheia: Before the coronavirus outbreak, the China-U.S. trade deal was one of the biggest influences on prices. The Federal Reserve’s decision to lower interest rates in response to the coronavirus pandemic did not have the efficacy that was expected. Instead economic uncertainty has grown even worse after the Fed’s decision.

Historically, bull markets do not last more than 10 years. We were in year 11 when two major issues arose. It started with the coronavirus and then the decision by OPEC and Russia to battle for market share instead of agreeing to further cuts exacerbated market volatility. As we stand today, both the stock market and commodity market are looking for some reassurance that the worst is behind us.

How did the IMO 2020 mandate end up affecting the markets, if at all? Do you think we’ve seen the last of its impacts?

Hedge: We wrote several articles on the IMO 2020 topic. We also advised our clients not to speculate on any outcome from this in spite of the numerous calls and predictions of shortages and price spikes. It’s unlikely we will see an impact directly attributed to IMO. That doesn’t mean it won’t eventually become a contributor to price action. But because the sulfur change has now been assimilated into the ULSD pool, it will be difficult to identify the new IMO rule as the root cause of any price action.

Sprague: IMO 2020 turned out to be the quintessential “buy the rumor, sell the fact” event as the market went long in anticipation of the new regulations and sold when they actually came into effect. The impact on distillates was negligible as most of the anticipated volatility was confined to the residual fuel oil market. There could still be some lingering price effect on heating oil, depending on the price relationship between distillates and residual fuel oil, and some switching back and forth between the two may occur but it should not be too disruptive. As it turns out, the oil industry was well prepared for IMO 2020 and kept a lid on the anticipated problems and price volatility.

Aletheia: I didn’t see any impact and don’t foresee there being a problem moving forward based on supply-demand forecasts.

Angus: I am not enough of an expert, but I do not think the impacts are done.

There was a brief threat to the supply chain when Canadian rail workers went on strike in November and then again in February as protestors blockaded the lines. As New England relies on rail terminals for a good portion of its supply, was there anything that could have been done better to prepare for these disruptions?

Angus: On a global basis, you can look at pipelines, the Jones Act, and storage facilities all as possible ways to unclog a bottleneck. If the question were being asked of distributors, I would think that, depending upon the realistic likelihood and timing of a supply disruption, they needed to look at a percentage of their supply as “wet” and perhaps have relied a bit more heavily on fixed-diffs (basis).

Sprague: No comment as Sprague’s U.S. terminals are not supplied by rail.

Aletheia: New England has always been reliant mainly on deep water terminals and rail terminals to a lesser extent. The lack of a substantial pipeline infrastructure has historically left New England vulnerable to supply disruptions. My advice is to diversify supply points. Have a logistical contingency plan in place. Your transportation companies need to be authorized to haul product for you in multiple locations. These have to be set up individually. So, even if you don’t use a particular terminal frequently, it is wise to get set up as a company and have your hauler set up at a few locations that are even outside your normal rack purchasing locations.

Hedge: It’s important to note that you are referencing propane here. The rail worker strike in Canada could have caused a much bigger disruption to supply if it wasn’t resolved so quickly. It is a reminder of the tenuous nature of propane logistics. It often is not so much about supply as it is the supply chain. The answer is diversification. Propane dealers should not only have multiple sources for supply, but also look at where the sources of supply are coming from; rail, water terminal (if available), and pipeline supply should be part of that portfolio.

Earlier this year the Dow Jones Industrial Average topped 30,000 points. Was there any implication there for the heating fuel markets? Without attempting to predict how stocks and commodities will behave from now until next heating season, do you see any correlation between the larger financial index and fuel prices heading into next heating season?

Aletheia: Low oil prices, along with record highs for the stock market, point to successful economic and energy policies of the Trump administration. The reduction of tax rates on businesses, along with the removal of anti-energy regulations, has created an atmosphere of potential continued prosperity and energy independence. As a result, we had an economy that was flourishing and have a domestic energy infrastructure that alleviates much of our need for foreign oil. Unfortunately markets get overvalued, and there are also unforeseen factors (e.g., coronavirus pandemic, lack of OPEC-Russia supply cut agreement). What looked like a thriving economy has quickly turned into talk of recession. It is in times like these that the value and necessity of hedging become clear.

Hedge: Under normal circumstances, because equities are a bellwether for the overall economy, oil prices will often track the stock market. But not always. In the recent case of the coronavirus, it certainly looks like oil prices are tracking equities. In reality, the commodity is falling because the effects from the pandemic are directly impacting the demand for energy. If and when things return to normal, oil prices are likely to rise. Of course, if Russia and OPEC (Saudi Arabia specifically) continue their production war, then we are looking at a very different dynamic. As a general statement the answer to this question is no. One cannot rely solely on stock prices as a predictor of oil price direction.

Sprague: Stock markets are obviously very concerned and susceptible to the threat of a recession and so are oil prices. The correlation between the two varies depending on what macro factors are driving each market.

Angus: There are theoretical approaches to this – i.e., if the economy is doing well, then there will be inflation, and all commodity prices will rise. However, if you look at the two items — equities and oil — the direct correlation just doesn’t seem to be there. From December to February, we had a rallying equity market but a collapsing oil market. Though that is just a short period of time, the long-term tracking of the two doesn’t appear to show statistically significant correlation.

With 2020 being an election year, is the potential for market disruption any different than usual? Should heating fuel sellers have the election in mind when making hedging and pricing decisions for next heating season, or are the best strategies for success essentially the same as ever?

Angus: That is a great question. The election and the economic, tax, and political implications will definitely play into the future of the economy, and to a lesser extent into the price of oil. However, determining the impact — let alone handicapping who the eventual winner will be in November — is very difficult. The best strategies are simple strategies.

Sprague: Would anyone argue that the current political environment (both national and international) does not hold the potential for market disruption? Certainly, during an election year it draws more attention as differing ideologies enter the spotlight. Nonetheless, the strategy for retailers should remain the same as described above. Buy what you sell and sell what you buy. Do not take unnecessary risk. There are better tools than ever to protect yourself.

Hedge: Prices will always be difficult to predict. There are too many variables to rely on any one indicator. The best strategy for success is to hedge whatever you are selling. That said, I believe this year’s election certainly presents a unique problem for the industry, as there are candidates who have expressed very definitively their opposition to fossil fuels.

Aletheia: A sound hedging strategy does not need to worry about who is elected. There are many strategies that can be utilized when mitigating price risk. As to what strategies are best, that depends on many variables. For example: How many suppliers do you have? How many supply locations? What is your credit worthiness (to trade swaps, options and futures)? And which types of price protection programs do you offer?

There has been a lot of talk lately about bringing more biofuel into the Northeast’s heating oil pool. Obviously this poses a number of questions related not just to pricing, but also infrastructure and policy. As the industry and its allies work to address these latter concerns, how do you see wholesalers and retailers adapting financially? What kinds of financial instruments and strategies are already available to help the industry succeed with biofuel-blended heating oil, and how can these be incorporated into hedging practices?

Sprague: While biofuels have certainly established a place for themselves in the industry (and will continue to do so), there are still a number of questions that remain. Uncertainty around regulatory issues, and the difficulties in supplying biodiesel to the Northeast region in a reliable and economical manner, still exist. These questions will need to be addressed to ultimately determine the extent and timing of biofuels’ future place in the home heating oil industry. In terms of financial instruments, there are already federal programs in place, such as the Renewable Fuel Standard, which continue to be the key financial supports that enable biofuel-blended heating oil to succeed.

Angus: The industry is moving forward with a reasonably aggressive plan to make heating oil an environmentally acceptable fuel – despite the protestations of some. We are making great strides, but I don’t YET see the implications relative to hedging strategies. That may change in the future, but as hedges generally look no further than the upcoming heating season, it might be premature to look at changes to planning.

Hedge: There are a host of questions and uncertainties around this topic. I’m not really sure how wholesalers plan to adapt to the potential increase in the bio-blend mix. Heating oil dealers need to be prepared. The price dynamic will be significant and volatile. We are looking at a host of hedging strategies to mitigate risk while also allowing for our clients to hedge efficiently. Other areas we will be looking at are the biofuel credits and RINs [Renewable Identification Numbers]. Our clients will need to understand the methods for trading and hedging around these components, as they will impact their companies financially.

Aletheia: Some fuel dealers are taking advantage of Alternative Energy Certificates/Credits [AECs, available through the Massachusetts Alternative Energy Portfolio Standard].

Are you offering any new hedging products, programs or services in 2020?

Hedge: We are really excited about the launch of the new version of our hedging software, Hedge Insite. It has a host of new features and a new look. The application no longer requires the installation of software; it is now a web application and can be accessed from any device. Also, we are making Northland trading products available to all qualified heating oil and propane distributors. We have also made our consulting service more accessible than ever with significant new deliverables.

Visit our new website at hedgesolutions.com or call us. We promise a low-key, no-pressure approach to your inquiry about what a business relationship looks like at Hedge!

Sprague: The dramatic price slide this far in Q1 2020 has generated renewed interest in forward pricing. While these programs are certainly not new, we do see an increase in customer interest in programs with downside protection associated with them.  Price capped budget programs for homeowners are gaining popularity. While the addition of downside protection adds a layer of cost, those costs are now paired with dramatically lower outright product prices such that the total cost to the consumer is materially lower versus prior years.

Angus: As a Commodity Trading Advisor, we advise our clients on the best trading program and products for their distinct situation. All trading by our advisory clients is done either directly with our wholly-owned subsidiary, Angus Risk Management (Angus Trading), or with another counterparty of our clients’ choosing. As to recommendations, we do have some, but they need to be discussed directly with the client, as there is no cookie-cutter way for all.

Aletheia: Energy, weather and renewables are the markets that Aletheia trades in.


DISCLAIMERS

Aletheia: Aletheia is a renewable energy aggregator and is registered with the National Futures Association as a commodity trading advisory and swap firm.
Past performance is not necessarily indicative of future results. The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. In considering whether to trade or authorize someone else to trade for you, you should be aware that you could lose all of your investment and be liable for amounts above your initial investment.

This material has been prepared by a sales or trading employee or agent of Aletheia Consulting Group LLC and is, or is in the nature of, a solicitation.

Aletheia Consulting Group LLC does not guarantee or warrant that the contents contained herein are 100% accurate. We have made reasonable efforts to present accurate information and reasonable opinions as it relates to commodity market information, pricing, and statistics. Therefore, the information is provided “as is” without warranties of any kind. In no event shall Aletheia Consulting Group LLC and its related principals, agents or employees be liable for any damages whatsoever, arising out of or in connection with website, information, or other verbal and written communications.

Angus: PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable 
for you in light of your financial condition. In considering whether to trade or to authorize someone else to trade for you, you should be aware that you could lose all or substantially all of your investment and may be liable for amounts well above your initial investment.

Hedge: The information provided in this market update is general market commentary provided solely for educational and informational purposes. The information was obtained from sources believed to be reliable, but we do not guarantee its accuracy. No statement within the update should be construed as a recommendation, solicitation or offer to buy or sell any futures or options on futures or to otherwise provide investment advice. Any use of the information provided in this update is at your own risk.

Sprague: These responses above include forward looking statements that are inherently subjective and the responses are provided for general information only and are not intended as advice on any transaction nor is it a solicitation to buy or sell commodities. Sprague makes no representations or warranties with respect to the contents of such information, including, without limitation, its accuracy and completeness.


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