By Rich Larkin, Hedge Solutions
And so it began. From tulip mania in the 1600s in Europe to soft commodities like corn and soybeans to hard commodities like gold and silver, and of course the financials: bonds and interest rates. It was only a matter of time before the markets discovered the promise in energy trading.
Oil futures didn’t surface until the late 1970s, more than a century after the hard commodity was first discovered and commercialized (the first documented oil well was in Oil Creek, PA in 1859). One has to wonder what took so long, considering prices were manipulated and controlled by barons and major corporations for over 50 years!
The emergence of the first heating oil contract, borne out of necessity after the infamous “potato trading scandal” on the then obscure New York Mercantile Exchange in lower Manhattan, changed all of that. This fledgling financial enterprise brought transparency to what had been up to that point, very dark markets. The major oil companies, refineries, and large wholesalers treated this little contract and the exchange that introduced it with contempt at first. It was sort of like Serpico showing up at the annual NYPD ball. Nevertheless, eventually everyone went out and built a trading room to deal with it.
The Debate Rages
I started my career in the wholesale business in 1986 with a company called Wyatt Energy, shortly after crude oil prices went from $32/barrel to $9/barrel in four months’ time! I thought my job was to take heating oil dealers to lunch and then to play golf; next thing you know I’m sitting in front of a quote screen selling bulks, and they were taking away my expense account because the Wall Streeters had sucked the margins and certainty of profits out of the business. Charlie Burkhardt once told me that this was the best job to have in the industry! Sure.
Now it’s 28 years later and the debate rages on: Is the treatment of oil as a commodity good for our industry and its business model? I say yes, absolutely.
I understand the frustrations: “Prices are often volatile.” (Not lately, actually.) “It’s speculative.” (Yes, if you decide to speculate.) “The futures market causes prices to spike for no reason.” (Sometimes, it seems. But prices go down as well as they go up “for no reason.”) “It causes my margins to erode.” (Not if you learn to hedge!) In my 20 years of teaching heating oil dealers how to use the futures market as a tool to improve – not erode – margins, this is the most common misperception. Demystifying the hedging process has always forged a path to a greater appreciation for the advantages that it brings to the table.
I’ve seen hard evidence of this. We run Hedging College sessions every year that are open to anyone to attend, and we advertise it extensively. Yet 80 percent of the attendees are our own clients! Why? They want a better understanding of what it is we are instructing them to do. Clients that attend Hedging College stay longer and reap greater benefits because they incorporate our advice to a much higher degree.
Cap-budget programs have proven to be an effective retention tool, often preventing conversion to gas or other fuels. Fixed price programs, though I’m not crazy about them, are appreciated by large end users and small consumers alike. Yet most heating oil dealers are still afraid of or simply adverse to the practice. Farmers have been hedging their crops for centuries. They do this to protect their profits, or incomes! Cattle ranchers do the same. They hedge in long cycles and short cycles. Heating oil distributors should do the same.
Hedging is about leverage. When profits are healthy or substantial, it makes sense to use the tools in the futures market to “insure” or safeguard that ideal condition for as long as possible, particularly since we all know that great margins are difficult to sustain in a volatile commodity environment. Exceptional margins in our business are elusive when rack prices are knee jerking to the tune of the Nymex. It’s also a short season that we work with – another parallel to the farmer’s business model. That’s why they embrace hedging!
Transparency is always good. A few controlling the prices has never proven to be a positive for any commodity-based industry. Thanks to that transparency we enjoyed a competitive edge over other fuels for well over two decades. But now we find ourselves on the flip side of that competitive edge and are challenged by a declining footprint.
Two for One
Ironically, consumer frustration is bred more from the actual volatility in the oil prices than the oil price itself. Though hedging cannot eliminate market volatility, it can smooth out its sharp edges and reduce the bite. Think about it! A dual benefit is attained by increasing margins while appeasing your customers!
Markets need oversight. Looking at the history of any commodity that has been around for a while, one will discover quickly that all of them have experienced a “traumatic” or “black swan” type of event at one time. Oil prices endured such an event in 2008. Since then, thanks to the hard work of some folks in our industry, action has been taken to prevent manipulation and abuse. Improvements in regulatory oversight, like the Dodd-Frank bill, will go a long way toward restoring order and normalcy.
So the fact remains that the futures market for oil prices – the core product of our industry and its business model – is not going away and will be here for years, if not centuries to come. Hedging is not going away. It makes sense to ply another tool of the trade that will advance your business interests.
At a minimum you should investigate its capabilities and discover what you may be missing. I have yet to meet a farmer that doesn’t hedge.
Comments? You can reach me at firstname.lastname@example.org or call me at 800-709-2949.