Hedging Guidance Adds Valuable Perspective

MeetingWide

By Rick Trout, Account Executive, Hedge Solutions

When Mobil Oil transferred me to New England in the early ‘90s to work in the Distillates Department, price protection programs offered by heating oil retailers to consumers were in their infancy. As with a lot of start-up programs, the offerings were not complex and the hedges that backed up these offers were likewise simple.
Mobil promoted three programs: fixed price, cap price and collar price. Collars were rare, perhaps because it was perceived as not simple enough and an unnecessary middle road between fixed and cap. Basis risk existed, but not if you used supplier wet barrels in your hedges.

Supplier diffs (amount over the NYMEX price) were 3 cents and option premiums (for downside protection) were 4 to 5 cents. Programs ran from October through March, and almost everyone hedged to a projected sales volume. Retailers were typically not hesitant to carry their own water when it came to crafting their price protection programs and purchasing hedges to cover these offerings.

Harder Than You Thought
Then a not so funny thing happened over time. Unforeseen risks appeared and lessons were learned the hard way. Occasionally hedges were purchased, and the market tanked before much of the volume was sold to consumers or after the program was well sold, the market plunged and consumers reneged on their commitments or capped gallons were hedged with call options and rack prices blew out so that option gains only partially covered rack price increases. It was not rare for retailers to take substantial financial hits.

Concurrently, the futures market evolved in unhelpful ways. In the late ’90s, a series of equity and commodity market bubbles commenced: first the technology bubble, then the housing bubble and now the Fed bubble. Bullish sentiment and speculation drove futures prices and option premiums to unrealistically high levels, followed by catastrophic crashes when the bubbles burst.

Now supplier diffs above 10 cents are not rare and option premiums in the area of 20 cents are considered attractive. The latter must be passed on to consumers, which dissuades many from opting for capped price protection (they’re protected against price increases and participate in price decreases), the very program that they and heating oil retailers sorely need in today’s market environment.

Help Is Available
Given current complexities, risks and costs, it’s no wonder retailers are apprehensive and disgruntled about retail price protection. Many probably wish that it would go away, but they know that, done skillfully, it can be of great benefit to their customers, and exceptional customer service is a hallmark of successful heating oil dealers (and something foreign to natural gas suppliers).

Fortunately, price protection and hedging are not an all (do it all yourself) or nothing (don’t do it at all) proposition. Consultants, with considerable price protection and hedging expertise, are available to help retailers navigate the complexities and minimize the risks and costs.

Much to Offer
You have many responsibilities, while hedging consultants have a singular focus. They have encountered a myriad of price protection and hedging issues, learning the best ways to deal with these issues in the process. For example, they offer clients recommendations such as what months price protection programs should cover, what months should be incorporated into budget payment plans, how and when to layer-in hedges, when to protect against basis blowout, whether you should hedge to sales projections or actual sales or a combination of the two, and this barely scratches the surface of available advice. Learning from the experience of others can be far less painful than learning on your own, through trial and error.

One of the signs of a skilled consultant is utilization of a sophisticated, computerized modeling tool. While basic hedging concepts may be intuitive, the degree of impact that a contemplated hedge will have on profitability is most effectively determined via modeling. If that impact falls short of objectives, the hedge can be adjusted and re-modeled, until the desired result is nearly or fully achieved. A tool such as this can also be used to model unorthodox scenarios, such as, hedging caps with only wet barrels or hedging fixed price sales that may experience considerable consumer defaults in the event of severely falling prices.

A good consultant has the tools and experience to analyze a wide range of variables.
A competent consultant is familiar with concepts other than price protection program hedging, such as how to identify in-season margin spikes, then devising and implementing short-term hedges for extending these lucrative margins. The core of the heating season is only about 110 days, so extending particularly high margins a few times during the winter, totaling 15 to 20 days, has a significant positive effect on profitability. Ironically, this short-term hedging takes advantage of market volatility, the very nemesis that makes price protection program hedging a challenge.
Another consulting benefit is abundant communications. Most importantly, you should be advised, in real time, regarding the direction and magnitude of NYMEX price moves and what is causing them. Daily market recaps and market advisories that you can send to your commercial customers are also helpful.

No Hidden Agenda
A crucial consideration is the consultant’s commitment to look after your best interests. When a wet barrel supplier advises you, they are most interested in selling you heating oil. When an options merchant counsels you, they are biased towards advice that causes you to purchase options. On the other hand, a consultant recommends what is most beneficial for you, with no hidden agenda. The consultant is fixated on your success, your profitability and your peace of mind.

Pin It

Leave a Reply

Your email address will not be published.