Tuesday, April 7, 2020


Change and Adaptation

Heating oil marketers are emerging from another challenging heating season that saw OPEC try to control oil production, while volatility dissipated and prices settled in at an intermediate level between the notable highs and lows of recent winters. U.S. politics have taken a dramatic turn with the election of President Trump, who could implement new energy policies and global strategies that significantly affect oil markets in unforeseeable ways.

The Northeast experienced its second consecutive warm winter, with degree day counts that were 10 to 25 percent off the annual average, continuing a warming pattern that has reduced sales volumes in every heating oil market and forced marketers to adapt.

Meanwhile, the heating oil market is one year closer to the ultra-low-sulfur transition that will replace the current patchwork of product specifications. As of mid-2018, heating oil throughout the Northeast will match the on-road diesel specification of 15 parts per million sulfur.

Oil & Energy recently reached out to hedging providers who support the heating oil market for their thoughts about the current marketplace and the prospects for 2017. We’d like to thank the companies that took the time to participate: Hedge Solutions, Sprague Operating Resources, Angus Energy, Aletheia Consulting Group, Irving and Powerhouse.

1. Oil & Energy: As suppliers prepare to implement a uniform 15ppm sulfur heating oil standard in 2018, how will hedging strategies change for heating oil marketers?

Aletheia: This will potentially provide heating oil marketers an opportunity to expand their margins. More suppliers will market heating oil again since separate storage will no longer be needed. An added benefit will be reduced risk of basis blowouts. As a result, heating oil retailers will be able to buy from more suppliers, which will create more stable supply and negate the necessity of high priced wet barrel differentials. As was the case this past winter, racks were at a discount to the Nymex, nowhere near the premium charged by wholesalers back in the spring and summer. Better pricing and more secure supply will allow heating oil marketers to hedge more on paper rather than having to rely on wet barrels from one of their suppliers.

Angus: It is the standard with the Merc contract, so if anything, there may be a lesser need for certain types of basis-swaps (such as the 2000 ppm vs. the 15 ppm). If there was one good thing about the awful weather this winter, it is that the “surprises” on the supply side were kept to a minimum.

Hedge Solutions: The CME/Nymex contract is actually a 15ppm Ultra Low Sulfur contract. So nothing on the “paper” side will change. What will change is the basis relationship if you are currently in a market that is not Ultra Low Sulfur. For example, if you are in a market that still has a high sulfur spec and will go low sulfur in 2018 then you need to adjust your basis (the difference between the Nymex contract and your rack price each day) to account for the spec change. That will likely mean a higher basis. The same applies if your marketplace is going from 500ppm to Ultra Low Sulfur.

Irving: Hedging strategies should not really change since the NYMEX contract has been referencing ultra-low sulfur product since 2013. The change will be to overall logistics with storage, piping, and transportation issues made easier without having to be concerned with contamination of ultra-low sulfur product by higher than 15 ppm product. It will also simplify distribution with the whole Northeast area having similar product specifications.

Powerhouse: NYMEX ULSD futures and options will continue to be the primary hedging tool for heating oil marketers. With the move to the 15ppm standard in the physical markets, the issue of basis differences will be simplified. This should bring greater transparency to pricing and more efficiency to hedging.

Sprague: If nothing else, the change to a single sulfur pool should bring some clarity back to the market with regard to forward differentials for heating oil marketers. For a few years now, the NYMEX contract has been 15 ppm ULSD. However, with the exception of New York, home heating oil markets have been supplied with 500 ppm sulfur (or higher) fuels. As a result, wholesale forward quotes in states other than New York have necessitated that wholesalers make forward “basis” assumptions regarding the expected price spread variances between the various sulfur grades of heating fuels. Since each supplier is likely to see things differently, retailers in non-15 ppm states could see fairly dramatic differences in forward quotes from the wholesale suppliers – based largely on how those suppliers viewed the forward sulfur spreads. The return to a single sulfur pool for the 2018-2019 season should largely eliminate those sulfur spread variances.

2. Oil & Energy: Oil prices have increased from the 10-year lows seen in 2016. How have hedging objectives and strategies shifted in the last 12 months to reflect the change, if at all?

Aletheia: It is a reminder to have a plan in place and always be ready in season and out of season to initiate one’s hedging strategy. There have been many opportunities in the past for heating oil retailers to buy at advantageous prices in the middle of winter or at the tail end, but unfortunately, they have been missed due to the normal busyness of the energy retailer. Have an adviser watch the market for you so that you don’t miss out on a good time to buy.

Angus: There are many “objectives” of hedging, but that is not where it should start. Hedging is meant to be the effective response to market and marketing conditions. So, while objectives – managing margins, controlling basis risk, offering pricing programs – may not have changed at all, a winter like this does change a couple of things. There is a lower amount of “churn”, so some hedged volumes might be different than last year. In addition, thanks to the tight range of prices over the past couple of months, we are seeing two things that we are not used to. The first thing is that early indicators of supply “diffs” are lower than one might expect with so much uncertainty in the marketplace. The lower diffs are likely a result of the warm winter, and suppliers looking to be sure that supply will be sold next winter, if not this winter. The second thing we are seeing is that with the tight price ranges, we have lower price volatility. With lower volatility, we are seeing lower “Implied volatility” – a major component in the price of options (for hedging). So, the bottom line is that options are less expensive than they would be if the market that had bigger price swings, and that should be considered as you determine the appropriate mix for you to hedge your pricing and volumetric exposures.

Hedge Solutions: The prices are not that much higher relatively speaking. Current prices are half of what they were just 2 1/2 years ago. We like to look at the impact that the price change has on the customer’s budget payment based on the change in the cap price from year to year. It’s still a really good value.

Irving: Hedging objectives are still the same. The objective of risk management hedging is to minimize the probability of loss because of fluctuations in oil prices. Strategies can change with different price levels and volatility in the market such as increasing or decreasing the volumes hedged and what hedging instruments are used. Higher prices increase the possibility that prices could be lower in the future and therefore hedged volumes for inventory may be increased. But changing strategies can really border on speculation when used to try to maximize profits rather than minimize losses. By maximize profits I mean using hedging as a profit tool rather than risk management. There is nothing wrong with that as long as you are aware of what you are doing and realize that speculation actually increases your risk of loss.

Powerhouse: In periods of low price and/or low volatility, some distributors abandon pricing programs like caps or fixed prices. We believe this is a mistake. Pricing programs were originally developed as a marketing tool. These programs benefit the marketers by securing the customer’s business. There is also benefit for the customer, who can now budget with certainty through the heating season.

At writing, prices have been in a trading range, supported by a recent OPEC/non-OPEC deal, but capped by growing U.S. production. As a result, option volatility and pricing is relatively low, making cap premiums attractive. The cap allows marketers to lower the price to the end user if prices fall, putting the distributor and customer on the same side of the table.

Sprague: As a result of the dramatic decline in prices that occurred during the 2008-2009 heating season, retailer forward hedging programs have become a much smaller part of their marketing strategies. Even the “lows” of 2016 did little to change that fact. Lower prices, which one might think would incentivize homeowners to “lock-in” winter prices to protect against future price spikes, actually seems to have the opposite effect: The lower prices appear to generate a degree of price complacency amongst buyers. The attitude seems to become “prices aren’t too bad, so I’m not too worried about it,” making them less interested in locking in their winter price. Conversely, it is an environment of rising prices that seems to generate a degree of urgency among forward buyers. The attitude then becomes “OMG! How much worse might it get?” In short, the relatively small price rise from 2016 to 2017 has done very little to change things.

3. Oil & Energy: How have degree day expectations and projections shifted in light of the relative warmth of most recent winters?

Aletheia: We are starting to see more and more retailers expanding their marketing territories as a way to combat alternative fuels, more efficient equipment and lack of HDDs. This is a prime reason why hedging should be looked at once again, even if price protection programs are not being offered. If you don’t offer anything unique then the consumer focuses more on just the price. Rack plus (non-price protected) and weather hedging are two examples of how hedging can make up for lost margin and HDDs.

Angus: The marketplace for “weather projections” pretty much keeps with the most recent 10-year average. So, by definition any winter will have a 10% impact on the following 10-year average. However, if a warm winter happens, and the winter being replaced (from 11 years ago) was also a warm winter, there might not be a sizable impact. That is the math side of things. On the psychological front, while many are saying “It’s going to be warm every year”, just because we had two warm winters in a row, there are also those who feel that we are “due” to have a really cold winter. Only the Man Upstairs knows what we have in store – and he is not speculating on weather derivatives!

Hedge Solutions: When it comes to hedging any forward price programs, that forecast does have consequences. The heating oil dealer in almost all cases will inherit the over and under risk related to the customer offtake of that volume. So, if it’s warm and the customer takes less oil, the heating oil dealer has likely over hedged, or has bought more cover than was needed. Conversely, if it is colder than normal and the customer takes more oil it is likely that the dealer did not have enough cover. This is why it is important to have the proper balance between your wet barrel purchases and the paper hedges.

Irving: When looking at degree day expectations, a couple of warm winters do not change future expectation too much. If you look at a 10-year or even a 30-year history as I often do, a change in one year will only slightly shift the average. For instance, if a year ended at 20% warmer than normal and you were averaging the last 10 years, you would only see a difference of 2% which is minimal. I would also point out that even though last winter (2015/2016) and this winter (2016/2017) were warmer than normal, the prior two winters (2013/2014 and 2014/2015) were actually normal to colder than normal. Therefore, placing too much weight on a couple of warm years might leave you in the cold.

Powerhouse: Weather is the one of the biggest uncertainties heating oil marketers face. Analysis shows a warmer trend over the last 10-15 years. That said, every year is different. We suggest heating oil marketers add weather insurance to their risk management program. Powerhouse now has online tools that dealers can use to see historical weather patterns in their markets, as well as design a weather hedging strategy.

Sprague: For a variety of reasons (conservation, efficiency) homeowners (in aggregate) consume less heating fuel per degree day than they did in the past. So, for the retailer, the same number of degree days in 2017 won’t generate the same level of sales volume they did even a decade ago. This trend isn’t likely to change, so both retailers and wholesalers need to take this into consideration in their sales projections. The unfortunate reality is that if margins don’t improve as volume declines, sales revenues (holding commodity prices constant) will continue to move lower if the trend of lower volumes per degree day continues.

4. Oil & Energy: Is it good business for Oilheat dealers to commit to Bioheat marketing in 2017, given the uncertainty surrounding the Biodiesel Tax Credit?

Aletheia: 15 PPM heating oil with bio is a great marketing tool for oilheat dealers. It is a clean product with good lubricity. Although we don’t know what the future holds, it is safe to say that all types of alternative fuels will play a critical role in the global energy economy.

Angus: That is truly a marketing question, and I don’t think I am any better positioned to answer than anyone else with an opinion/guess.

Hedge Solutions: This tax credit does introduce significant volatility to the margin scenario of a cap or fixed price program for sure. Not so much the daily retail margin, though if the credit isn’t there or the price of biofuel changes
dramatically, then it becomes decision time on the blend and ultimately the margin. I’m not so sure it’s a good idea to change your marketing strategy year to year. If you commit to the bio component at any time, it becomes difficult to suddenly pull back.

Powerhouse: Marketing surveys show that homeowners have positive attitudes toward a greener heating oil. Bioheat makes good sense from a marketing standpoint. That said, building a business solely around a subsidy does not. With the uncertainty surrounding the Bioheat Tax Credit, dealers need to make sure their Bioheat program is sound before taking into account any tax credits.

Sprague: There is so much uncertainty around bio these days that this is a very difficult question to answer. Far more than the tax credit, the biggest concern for the home heating oil industry is the role of bio in it. Many retailers and resellers appear to be blending bio with little to no regard for the regulations surrounding the practice or the very real operational issues involved with doing it correctly — not to mention the widely differing product qualities that the generic term “bio” seems to encompass. Huge bio discounts in the market in 2016 resulted a dramatic rise in blending activity to include retailer bulk plants, where often-times improper blending practices have resulted in less-than-favorable outcomes. Whether or not the Biodiesel Tax Credit gets renewed is up for debate. However, one thing is certain; without the tax credit, biofuel producers cannot compete on price with traditional fuels, and retailers should keep that in mind going forward.

5. Oil & Energy: What are your expectations regarding volatility over the next 12 months?

Aletheia: The tug of war between US production and OPEC/Non-OPEC cuts is going to be the main driver of volatility. The new administration has an aggressive agenda to rebuild the United States’ infrastructure and this will increase oil demand substantially.

Angus: My take is less so what will happen than what will not happen. I have a hard time believing that prices for crude oil will stay mired in the $50-$55/bbl range that we have seen since early December. Once prices break out – above or below – I would expect that the marketplace will start to factor in an increase in volatility. So, to me, the question is not “if” volatility will return, but more so a question of “when.”

Hedge Solutions: Lots of it is my guess, although this winter there is no doubt that we’ve experienced the least amount of volatility in both crude and heating oil prices in recent memory. I don’t see that continuing. Too many extraneous factors come into play here. Will the OPEC agreement unravel? Highly likely. Where will shale production be this year? Then there’s Trump and politics along with the global factors. I can’t really see the market maintaining its calm.

Irving: Volatility is difficult to forecast, just as overall prices are, but my expectations are for volatility to be lower than it has been in recent years. In fact. the latest EIA Short-Term Energy Outlook (March 7th) points out that implied volatility for crude oil is significantly lower now than a year ago. If you look at the chart in the EIA report, you can see how volatility has steadily decreased. But also, as soon as that report was published, volatility took a jump over several days, as crude oil prices had the largest drop of the year and are continuing to drop as I am writing this. The volatility will take jumps at times but the reason I think it will not be as bad is that with increased North American production, fears of short supply are lower. Over the next 12 months, the OPEC production cuts and their success or failure to bring the current global oversupply down will play a large part in how volatile oil prices are. Prices will have a harder time jumping back up over $100 again or even to $80 like they have in the past, and as we have seen this year, the highs and lows have remained in a fairly tight range. Of course, if there is some major disruption to supply in any year, volatility will increase.

Powerhouse: Oil markets are historically volatile. However, volatility is rarely uniform. Periods of quiet, like we have been in recently, are often punctuated by dramatic increases in volatility. It is important to remember that volatility can drive prices lower as easily as it can propel them higher. While we will never know with certainty when the next shock will be, we do know that a volatility shock will inevitably hit the market again in the future. This may sound trite but it contains insight that market participants often overlook. Some people make the mistake of believing a period of tranquil markets will continue indefinitely into the future. Wise business owners acknowledge that they can never know exactly when a volatility spike will occur, but they position their companies and their customers to be in a position to benefit when it does. The unknowable question around volatility is when, not if. A good hedging advisor can offer guidance to provide benefit in any scenario.

Sprague: We believe that WTI crude prices will bounce between $40 and $60/bbl over the next year. OPEC countries can’t support their own economies below $40/bbl, and anything in the neighborhood of $60/bbl will bring US production roaring back.

6. Oil & Energy: Please describe any products or services you have introduced to help marketers buy fuel more effectively and the advantages that marketers can gain.

Aletheia: Our online platform provides real-time pricing and quotes for hedging. This gives our clients the most up to date and transparent pricing available. No minimum volume provides complete flexibility to only hedge what is needed. This latest technology allows fuel dealers to capture the full amount that the market is down immediately. Program gallons and non-program gallons can be hedged to protect against price swings.

Angus: As a solutions-based company, it is hard to know exactly what product or service that we have might be beneficial to them. On the pure hedging side, we have a trading subsidiary with a full-time trading desk that is competitively priced, understands the needs of dealers, and offers products to cover fuel price and weather hedging needs. Our advisory groups spend a lot of time helping dealers set their budgets, margins, price-plan offerings and the marketing of those offerings. Without a plan, you won’t be in a position to pivot and make necessary changes. Our offerings in the Business Intelligence and Predictive Analytics sectors act as the linchpin between planning and successful operations. Lastly, our remote monitors and customer apps bring together operating efficiencies with technological advancements that customers not only want, but demand. All bundled together, our offerings run the gamut of oil operations, leading to more predictable and efficiently profitable companies.

Hedge Solutions: Hedge Solutions is a 24-year-old consulting firm that has always approached the client relationship as their advocate in solving problems and dealing with the challenges in the purchasing and hedging space. We use tools like HedgeInsite, MarginTrak, and various worksheets that keep the focus on the client’s profit margins, not trading. Like the farmer that’s been hedging for generations, the heating oil distributor has likely been engaged in some form of hedging activity for at least a generation now. I believe it’s time to think outside the box and review how you purchase and hedge differently than traditional means in order to increase profit margins. Our clients have increasingly demanded this from us and we truly enjoy the challenge! The spec of the oil is changing. The supplier approach to selling oil is evolving, something we forecasted five years ago. We now find ourselves spending more and more of our time advising the client on best practices for using the portals and on how to evaluate basis opportunities, contract offers and storage plays. There are many subtle nuances in the purchasing and hedging process today that can cost a lot of money if you’re not aware of them. Hedge Solutions’ core value proposition is our commitment to our clients as their full-time advocate for hedging and purchasing. We are a fully registered CTA firm and compliant with all regulatory requirements.

Irving: We have continued to enhance our offerings to meet marketers’ needs. Our customers can access their accounts online at the customer self-service site to check their invoices and account balances. Purchases can be done online at eNavDesk from 3 a.m. until 5 p.m., which gives the ability to take advantage of the live NYMEX-based pricing. They can purchase with no minimum volume required for their prompt purchases. Forward contracts can also be purchased from 9 a.m. until 2:30 p.m. with volumes split over a degree day curve in quantities as small as 1,000 gallons for the winter season. The flexibility now allows dealers to back their sales and minimize risks of having to buy a large quantity at one time. We work with individual customers to help meet any specific needs they may have.

Powerhouse: Powerhouse now offers a user-friendly online tool to help marketers quickly price out risk-management tools, including options, in any gallon size per month. You can use this tool any time of day, and Powerhouse staff is available to guide you through it. We believe it will be worth marketers’ time to check out our pricing. Please call Powerhouse at (202) 333-5380 for a no obligation demo.

Sprague: At Sprague, we feel that our product and price risk management programs are among the best in the industry. All of our programs can be tailored to fit small and large retailers alike. With hours from 4 a.m. to 7 p.m., our online platform (the Sprague Real-Time® pricing platform) is available around your schedule, and unlike other online sellers, our forward pricing is always available online. Our HeatCurve programs have become the standard in the industry for retailers to use to hedge their homeowner offerings.

Notice from 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.

Notice from Hedge Solutions: The information provided in this article 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.

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