Short-Term Options Can Provide an Edge

Short-Term Options Can Provide an Edge

By Jarrod Robinson, Hedge Solutions

It’s finally that time of year, the time we wait all summer for, when the weather gets cold and the days get short. Now is the time to take advantage, and make as much money as possible.

Yet this is also that time of year that we get so busy wearing those multiple “hats” (managing personnel; keeping the trucks on the road; responding to needy customers) that we often miss opportunities staring us directly in our face. The vehicle delivering those opportunities is actually the nemesis that we complain most about, market volatility. By focusing so much on the daily movements of the NYMEX we often miss that other important price mover, basis.

When making purchasing decisions, the old crystal ball is not enough anymore. Instead, shift your attention to basis, or the difference between your price and the New York Mercantile Exchange (NYMEX), to guide your procurement strategies.

 

Find the Starting Point

 

Basis is much more predictable, and is a better representation of the physical markets. To get a good gauge, compare your rack price to the NYMEX for a period of time. If over that period, rack prices are 10 cents higher than the NYMEX close, you can use that as a starting point. Buyer be aware! Due to the contract specification change on the NYMEX, differentials have been quite volatile, so be sure to adjust your forecasts often.

Now that you’ve decided on a good filter to identify potential opportunities, what is the best system? It depends on a couple of things, but most importantly, how does the basis on your bulk offer compare to the forecasted number? Regardless of your “deal of choice,” always compare your offer to what your basis has been the past several days.

Know your options! Short-term options are an important tool, and can be optimized to minimize associated costs while maximizing value. Short-term options are significantly cheaper than long-term options – those used to hedge cap programs. Options for a week or less can cost approximately 3 cents. Below I am going to go over a few scenarios that warrant the use of short-term options.

 

Bulk Offerings vs. Rack

 

As we’ve seen lately, bulk offerings have been generous, often beating rack basis by several cents. When this anomaly occurs, you might consider getting long physical gallons. However, consider the downside risk if prices fall. You may be beating your rack basis by 3 cents on a given day, but what happens if the market drops by 10 cents over the next couple of days? Here the dealer will forfeit any expansion in margin received – assuming the rack basis reverts back to the mean.

Let’s look at an example for this scenario: ‘Company A’ receives their evening fax, and the rack price is $3.10, as the NYMEX closed at $3.00 on that day; thus, having a 10 cent rack differential. The next day the market plunges 7 cents to $2.93, and the decision is made it’s an optimal time to get a bulk quote. To their surprise they receive a quote for $3.00. This gives them a differential of 7 cents – 3 cents below what they typically pay. They decide to go ahead, and make the commitment. On that day, the market finishes down 7 cents, and their new rack price is $3.03. They have effectively beaten the rack by 3 cents. All is fine, except the next day the market settles down 5 more cents- giving them a new rack price of $2.88. Their slick deal from the day before is now above rack!

Meanwhile, “Company B” used the 3 cents “discount” off the rack and used it to finance an ATM put option. Their cost would still be $3.03 – the same as the rack. However, on the 2nd day, when the market settled down 5 cents, their cost would be $2.98 – their rack cost ($3.03) less 5 cents from the put option. Still the same price as the rack! Now, should the market bounce higher, they will be locked in no higher than $3.03. Obviously, if they didn’t purchase the put option, the cost would be $3.00, but they wouldn’t have had downside protection.

 

If Bulk Basis Is Higher

 

Now, let’s review an example of when the bulk basis is higher than the forecasted rack basis. We’ll use the same starting figures of $3.00 for the NYMEX, and a 10 cent differential. The market drops 7 cents, from $3.00 to $2.93, but in this case they only see a 4 cent cheaper bulk offer of $3.06 ($3.10-$0.04). Since margins are really strong, and they are keen to lock them in, a decision is made to purchase the bulk anyway. Assuming the market settles down 7 cents, the rack price for the following day would be $3.03 and the bulk price would be at $3.06! They effectively paid 3 cents extra, or a 13 cent differential, to get a fixed price.

Let’s review an alternative strategy: Purchase a call option for 3 cents/gallon and buy oil at the rack price every day. When the rack price is $3.03, assuming a 10 cent basis, they will be paying that plus the 3 cents they spent on the option ($3.06). The net cost will be the same as the prompt ($3.06). Now let’s review what happens if the market drops 5 cents the next day. With the call option they will be able to log on to the portals, and take advantage of the cheaper rack. In this case, if the market drops 5 cents, they are able to purchase bulks for that day 5 cents cheaper their cost would be $3.01 ($2.98+$0.03); effectively beating the bulk price by 5 cents. If the market rebounded the following day they would still be capped at $3.06, as with the bulk strategy.

So while short-term hedging may come off as the old “buy low, sell high” method, you can see there’s more to it. The use of short-term options can turn the odds in your favor, and give you the competitive advantage you’ve been seeking – without taking on significant risk! There’s more than one way to skin a cat! Know your options.

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