All Eyes on Margins
by By Rachel Luc, Hedge Solutions
Another hedging season (and summer) is about to end, and another heating season (and winter) is right around the corner. How will you keep track of your margins, specifically the margins on the gallons in your cap and fixed price programs, to make sure they are at the levels you forecasted for the end of heating season? An accounting of your hedge programs after deliveries are made is critical to determining the effectiveness of your hedging strategy.
During a hedging season, which typically occurs over the summer, customers enroll in various forward pricing programs that fuel companies offer. The two most common programs are cap price and pre-buy, or fixed price. Based on customer sales commitments, various strategies are deployed to ensure your company’s profit margins on these sales. The purchase of wet barrels, put options, and call options are all common “hedging” tools for locking in margins.
Fast-forward to winter months when the actual deliveries take place: your company now transitions from theory to reality as you purchase oil supply at what will likely be a very different price level from when you hedged. It could be higher or lower, and the local markets will reflect the difference. Other variables will also impact the predicted outcome. The weather variance can be significantly warmer or colder, thereby altering the amount of oil the participants use. Basis — the difference between the NYMEX and the local rack price — might be substantially off from your predictions. To complicate matters further, cost of goods sold might change depending on the type of oil supplies companies use to service customers, such as oil from local racks or from wet barrels. Additionally, returns from paper hedges are marked to the futures market on a daily basis, which will then be reconciled after each month. These factors can alter your projected profit margins significantly at times.
It makes sense to track the actual margins and compare them with the planned numbers for each month so that you are aware of deviations from your plan. You’ll know if any mid-season corrections are needed while also gaining critical insight for making improvements to next season’s strategies!
So how does this accounting process work? After each delivery month, you’ll need to extract the sales volumes for each program and the revenue derived from each. This should be an easy back-office report to run off of your software. Then you’ll want to run cost of sales. This will likely be a blend of the monthly rack purchases and any assigned wet barrels for that month. Any gains or losses from your paper hedges, such as call options and put options, should be debited or credited against the physical purchases. Don’t forget to expense the premiums while adding in any fee income to the revenue side.
Although most back-office software solutions produce a profit and loss (P&L) statement, they don’t have the capability to simulate a forward looking P&L marked to the futures market. They also don’t isolate the forward sales programs from the variable rack to retail sales so that one can see the hedging result as discussed here. So, most dealers’ accounting, if done at all, happens in an Excel spreadsheet. Though an effective tool, spreadsheets are prone to errors and require a lot of maintenance. In recent years, cloud technologies have gained popularity and can potentially offer a better solution for fuel companies when it comes to generating an accurate picture of their P&L. There are multiple online software solutions that will handle this task. Some can be integrated with your back-office accounting systems. Hedge Insite is one such program. See the snapshots on this page (full disclosure: Hedge Insite is owned by my employer, Hedge Solutions).
With new technologies, data are safely stored on the cloud and therefore, accessible at any point in time. The good old days of legacy desktop software will soon be replaced by a new era of cloud-based solutions, which allow customers to have instant access to their risk portfolios just by logging in using their mobile phones without the hassle of having to install software. What does this mean for your business accounting? It means that keeping track of your profit margins has never been faster or easier.
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.