Hedging experts tackle 10 tough questions on the oil markets of today and tomorrow
The winter of 2017-2018 saw Brent and WTI crude oil prices increase by more than $10/barrel over the previous winter. Wholesale and retail heating oil prices also spiked significantly before settling closer to normal levels. Oil production and refinement records were broken. So too were temperature records, as the week of December 31, 2017 to January 6, 2018 was one of the coldest opening weeks in history for several population centers in the Northeast U.S.
And yet, degree days to date remain down from the annual average.
Meanwhile, as President Trump continues to wipe away federal regulations considered harmful to the domestic oil industry, a number of state and local governments appear to be moving in the opposite direction, debating and in some cases implementing new policies on carbon emissions. Still ahead, the ultra-low sulfur heating oil standard goes into effect for all six New England states this July, and other states across the Northeast and Mid-Atlantic regions are scrambling to keep pace.
Against this shifting and re-shifting backdrop, heating oil marketers look ahead for ways to benefit both their businesses and their customers.
Oil & Energy recently reached out to hedging providers who support the heating oil market for their thoughts about the current marketplace and prospects for 2018-2019. We’d like to thank the companies that took the time to participate: Hedge Solutions, Sprague Operating Resources, Angus Energy and Aletheia Consulting Group.
The cold spell of early 2018 drove cash market prices as high as $2.1285/gallon. Prices at the rack passed $2.20 in some spots, and we again saw consumer prices above $3.00. Most of the big oil companies’ stock prices fared very well during the first month of the year as well. How might these trends influence hedging strategies in 2018-2019?
Angus: The first thing we should recognize is that, as opposed to some cold snaps in the past, supply disruptions and jumps in “basis” were fairly rare during this cold snap. That is a good thing for our entire ecosystem. As to future strategies, what we have found is simply that customers on pricing programs have better retention rates than customers who are not on pricing programs, and capped-price customers generally stay longer than those who have fixed prices. There is a challenge and a tendency in our industry to overemphasize the most recent winter (cold/warm, high price/low price). I would guess that more companies might lean a little more towards fixed prices, in order to keep the price at a more attractive level, but I truly believe that year-by-year movement in program focus is not only speculative, but also sends a poor message to customers.
Aletheia: Basis risk can be minimized by fixing your basis with a supplier or via financial instruments. A big factor on what type of strategy should be implemented depends on how many physical suppliers an energy retailer has as well as looking at historical data on rack basis.
Hedge Solutions: I don’t believe your strategy should change based on the latest price trends. You never know what the oil price is going to do, and you cannot get complacent about hedging your risk. With oil prices dropping the past several years, it’s easy to get lulled into a false sense of security. I don’t believe your hedging strategy should change from best practice, which is to cover what you sell.
Sprague: While prices did indeed spike this season, from a wholesale perspective the spike was short-lived. While the weather around the holiday was sudden, unusually cold, and caught many off-guard, in the grand scheme of a heating season it was limited. February weather proved to be a non-event from a heating degree perspective, and markets are currently well supplied. Price and supply anomalies are not unusual in this industry, and nothing that transpired should change a fundamentally sound hedging strategy for a heating oil retailer.
How do you suggest heating oil marketers account for weather volatility when forecasting how many gallons to cover for winter? Do hedgers need to take a second look at their strategies from the past few years when winters were relatively mild?
Hedge Solutions: Though we review weather “insurance” every year to see if it makes sense to spend the premium and to embed it in the cost, we haven’t been able to justify it as a smart hedge for a cap or fixed price program. The heating oil distributor typically inherits the over/under risk that comes with the difficult task of forecasting exactly when those promised gallons tied to a price are going to be delivered and how much volume they will take. This debate rages on, and there are pros and cons to a weather insurance hedge. The challenge comes from trying to pass on the cost through either the cap fee or margin. Predicting oil prices going out 9-10 months is a tall task. Predicting what the weather will bring year-to-year is a much taller task. Which months will be colder than normal? Which months will be warmer than normal? This problem is analogous to predicting if oil prices will spike and when, which forces you to cover the entire span of risk. Therefore, purchasing weather insurance becomes cost prohibitive in our view. A more detailed focus on the option strategy itself will produce better results.
Angus: You need to look at weather history, both over the course of the season, and the individual months. If a company has no pricing program and readily available wholesale supply, the budgeting process (cash-flow, etc.) is far easier. Once you mix in the customer retention benefits of a pricing program, the weather becomes much more impactful to the budgeting and hedging process. There is not ample space for me to respond with all of the parameters, but you should start with a budget, add in some realistic possibilities for weather variance (10%? 15%?), and then build a hedging model around that to include weather-contingent hedges. Again, it is for a larger conversation, but if you want to “hit your number,” it might be the most important conversation you can have this spring.
Sprague: Again, weather and price anomalies will occur, but “normal” is normal for a reason. There is little point in trying to out-guess Mother Nature. Betting against “normal,” and when it may occur is a lower percentage bet than just planning around normal. A fundamentally sound hedging strategy based around the expectation of normal weather patterns is as good as anyone is going to do. At Sprague, our HeatCurve programs are built exactly around that concept and have proven to be a successful tool for heating oil retailers for many years.
Aletheia: Weather derivatives can play a role in mitigating weather volatility, but they can be difficult to understand (Max payout, Payout per gallon, HDD strike price, etc.). It all comes down to risk tolerance and actual value of the hedge. You can hedge every aspect of your business but then have no profit left over. The key is to evaluate what type of financial risk is at stake and what is the cost for that coverage.
We’ve heard from heating oil dealers that budget plan customers fared best this past January as they received priority delivery, and they were able to save big if they’d enrolled in cap price protection. With this in mind, what kind of consumer pricing programs do you expect fuel dealers and their customers to gravitate toward next season, and should dealers consider changing their offers based on consumer attitudes?
Sprague: That’s certainly true. Why? Because automatic-delivery cap-budget customers are wise enough to know that trying to out-guess weather and price patterns is a fool’s errand. Many, if not all, of the challenges and frustrations that retailers and homeowners faced this season are directly attributable to homeowners thinking they could do better than the long-established and time-proven degree-day based automatic delivery system. A “will-call” strategy may give homeowners a greater sense of control, but it comes with a higher degree of homeowner responsibility and risk. As a result, this year, many will-call customers experienced run-outs and higher prices than they would have using a cap-budget automatic delivery strategy, so retailers should devote more energy into developing and advertising these programs for the upcoming season.
Aletheia: The success or lack thereof for consumer pricing programs comes down to marketing, managing price protection programs and the goals of the energy retailer. Rack plus programs are the easiest to implement but risk losing market share if the price goes up substantially. Fixed price risks the retailer being stuck with the oil should the market fall precipitously (consumer doesn’t take the contracted oil). Capped price protection makes a great deal of sense for
the retailer as well as the consumer, but there is a cost to manage the program as well as a cost to participate in the program.
Hedge Solutions: Most full-service heating oil dealers have always given the highest priority to their automatic delivery and budget customers (and this includes the cap and pre-buy customers, since automatic delivery and budget plans are typically prerequisites to participating in price protection). However, I do believe that due to all the media attention focused on consumers running out of oil this year — some reports showed homeowners seeking shelter because they ran out and the discount company was unable to deliver on time — this was a year that significantly accentuated the advantage of enrollment in the budget or automatic delivery programs as well as acquiring price protection. It makes sense to make sure that these customers are aware of the advantages they enjoyed, as well as that safety net; whether it was peace of mind knowing they never had to check the tank level and/or that they didn’t need to be stressed about price. This experience alone will likely bring them back to the price protection offers and keep them enrolled as a budget account; which we all know is the gold standard customer. Additionally, the consumers who had a bad experience stressing over an oil delivery and what they were going to pay will rethink and revisit their choices.
Angus: I can’t comment on whether budget customers received priority deliveries, but if they did (and that is company policy), that should be conveyed to customers as part of a push to get more people on the budget plan. The exact same thing can be said about price caps. Frankly, if you can push customers to be on a budget, with a cap, and a service contract, you have customers most likely to stay. Convincing customers of the value of those programs is best discussed with marketing consultants — but should not only be kept as an internal metric.
EIA predicts U.S. oil production will hit new records in 2018 and 2019. We’ve already seen record monthly production in January 2018. Exports are also increasing like never before. What do these factors mean for hedging objectives and strategies, in 2019?
Sprague: What we are currently seeing, with the U.S. becoming a major producer and exporter, has so far had very little effect on hedging programs, other than adding some liquidity to derivative markets, which is, of course, a good thing. There may be some unforeseen consequences, but the markets are mature enough to manage the changing landscape.
Aletheia: Record production in the U.S. will greatly reduce the risk of basis blowouts. As a result, the retailer will have the flexibility to shop the lowest rack prices while utilizing a higher percentage of paper hedges. This will allow them to take advantage of competition daily at the rack instead of locking in fixed differentials that most likely have a premium above the normal historical rack basis.
Hedge Solutions: I think that the “song remains the same.” Many analysts have predicted tightening oil markets for 2018. Indeed, the significant surplus in crude supplies that drove oil prices lower in 2016 has now vaporized to near nothing. Yet, this phenomenon develops as we speak, and predictions are now emerging that oil production will likely exceed demand once again in the coming months. If that is the case, then we are likely heading for lower prices. Of course, other variables will come into play. The usual factors — OPEC, geopolitical events, global economics — will all have some level of influence. Our view is the same. Hedge what you sell, and don’t speculate. Use the tools in the marketplace to ascertain your margin and eliminate your risk.
Angus: I don’t know that they necessarily impact hedging (crude oil still has to be refined, and wherever it comes from, we haven’t had shortages of crude oil in decades). Bear in mind that while production has increased to the point where the U.S. is actively exporting crude (Go USA!), there are MANY factors that influence price, the most obvious one being the increasing world demand for oil that is being predicted as well.
The current administration has struck a stance that’s generally viewed as favorable to businesses and supportive of deregulation. On the other hand, President Trump has a penchant for the unpredictable. How do you see the administration’s positions and policy moves affecting market conditions?
Hedge Solutions: You have to chuckle here. “Unpredictable” is an understatement. I never imagined that in New Hampshire there would be meetings with federal officials regarding offshore drilling. Yet, that is exactly what happened on March 5. Trump also surprised everyone with the steel and aluminum tariffs, and I suspect there will be more surprises. Less regulation is good for our industry, I think all would agree. The lifting of the crude oil export ban has contributed to lower oil prices — a positive for our industry. In the end, however, U.S. policy is one factor of many that will play on oil prices. Also, local policy by the states has had significant, if not more influence on our industry’s business environment than the federal policies.
Aletheia: Based on the action the Trump administration has taken thus far, it is clear that promoting business, and in particular the domestic energy industry, is of utmost importance. Perception plays a vital role in the pricing of commodities around the world, so if the world views the United States as a competitor for market share, then consumers should benefit from lower prices.
Sprague: Although the President has a tendency to throw a spanner in the works, his approach to the markets, and in particular U.S. markets, has been one of allowing them to operate as unhindered by regulation and government interference as possible. Therefore, one would expect market conditions to be unaffected for the most part by the actions of the current administration.
What effect have OPEC production cuts had on hedging plays to date, and moving forward, how do you see OPEC’s continued compliance (or lack thereof) affecting the market and hedging strategies?
Aletheia: The OPEC production cut pushed prices higher. When this occurred, many of the energy producers in the United States hedged their forward production, thus locking in profits. Once these hedges are placed, it gives domestic producers the green light to go after market share.
Hedge Solutions: OPEC (and non-OPEC Russia) have been surprisingly disciplined in keeping to their policy. It’s a large part of the erosion of excess supply over the past 12 months. The antithesis to this policy has been the reemergence of shale production, now reaching over 10 million bpd. Again, there are multiple influences on oil prices besides OPEC. That said, it always bears watching. Any slippage in the compliance regimen by OPEC or Russia would likely put downward pressure on prices. OPEC does not have an admirable track record in sticking with their agreements, particularly in the face of weakening demand for oil.
Sprague: The OPEC production cuts should remain in place until at least the end of 2018, and these combined with the counter balance of increasing U.S. oil production should make for a relatively stable oil price, with probably no more than a $10 trading range for crude oil. As a result, hedging should be relatively straightforward, with relatively few wild swings to manage.
Angus: Similar to the question about U.S. production – not all that much. I don’t correlate hedging strategies with potential price swings (and there are many reasons that we might anticipate changes in prices and swings in volatility). If you are truly hedging — and not speculating — I don’t put much weight into OPEC strategy. Find a plan, execute, and the rest should be just static.
What are your expectations regarding volatility over the next 12 months?
Hedge Solutions: Though I see volatility increasing in the global arena around issues like Trump activities, global developments (Middle East, China’s economy, European economies, North Korea), oil prices appear to be mired in congestion. You’ll always have small breakouts both up and down. But large moves don’t seem likely. That said, accurate forecasting is difficult.
Sprague: With the current outlook of either global supply or demand only marginally outpacing one another for the balance of 2018, volatility on fundamentals alone should remain low. Obviously, global political events can change this quickly.
Aletheia: Until alternative energy sources gain prominence in the energy mix, volatility will be here for the foreseeable future.
Angus: I don’t have an opinion on volatility. We are nearer to historical lows than historical highs, but I don’t know what will happen beyond today.
This July, the uniform 15ppm sulfur standard for heating oil goes into effect throughout New England. Does this add any new considerations into the mix, or has the phase-in already accounted for those?
Sprague: From a retailer perspective, the industry-wide return to a single distillate pool can only be viewed as a good thing. Multiple grades of heating oil have historically resulted in logistical supply challenges as well as grade-specific price anomalies. A single distillate pool improves re-supply logistics, increases effective industry storage capacity, and lessens the likelihood of product “basis spikes.” In addition, the cleaner burning ultra-low sulfur heating oil provides retailers with a product that can compete effectively with natural gas on multiple dimensions. From a wholesaler perspective, there will likely be some tank-conversion challenges during the transition, but with the number of product grade changes the industry has gone through since the early ‘90s (LSD, ULSD, LSHO, ULSHO, Conventional, RFG, MTBE, Ethanol), there is nothing about this latest challenge that cannot be handled in stride.
Hedge Solutions: The change in sulfur content increases fungibility, which is good for supply logistics, which helps reduce volatility. It is the essence of a commodity. States such as Maine and New Hampshire (currently on high sulfur) will see a slight increase in basis.
Angus: Despite the challenges over the past decade during the move from 2,000 ppm to 15 ppm (in most places), that is mostly water under the bridge, and suppliers are certainly acting like they are prepared.
Aletheia: Refiners have historically done an incredible job with meeting changing specification standards. There typically is a phase-in period allowing wholesalers to price accordingly.
Last year saw some huge changes in biofuel-related policy; stagnated RFS volumes, New York’s downstate B5 standard, the Massachusetts APS program, and the antidumping and countervailing duties on Argentina all come to mind. How might any of these changes impact oil prices in 2018, if at all?
Hedge Solutions: All these factors will impact biofuel costs and availability. It likely won’t have a huge impact on the oil price.
Aletheia: Any increase of volume by renewable energy resources will lead to lower prices.
Angus: I think that I wish politicians spent more time talking to businesses and assessing the impact of their decisions/legislation. Everything sounds good when a consumer advocate stands in front of a podium to complain about how businesses take advantage of everyone. However, it is all too often forgotten that those same businesses are run by local families, staffed by local employees and supporting local economies.
What do you see as the single most significant risk factor for heating oil prices in 2018?
Angus: Since you are not asking about the single biggest risk to running a profitable heating oil business, but only the risk factor for heating oil prices, I would have to say a breakdown in the Russian-OPEC alliance.
Hedge Solutions: You can’t really single out one element. If forced to pick, it would have to be Saudi Arabia and OPEC’s compliance rate. The Saudis are the “beef” in the agreement. If demand should decline even marginally at this point, it will present a challenge to OPEC’s discipline. Shale producers are well hedged throughout 2018, so it is highly unlikely you will see them retreat from current rates. That places the challenge of balancing supply and demand squarely in OPEC’s camp.
Aletheia: The correlation of the U.S. dollar to crude oil.
Sprague: Once we get through this final sulfur transition, there should be very few. Barring unforeseen international or economic crises, there is as good a reason to expect relative stability as we have had in quite some time.
Aletheia: Aletheia Consulting Group LLC does not guarantee or warrant that the contents 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 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 article 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 article is at your own risk.
Sprague: The 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 or completeness.