Take Control of Product Costs

Hedge

By Rich Larkin, President, Hedge Solutions

When John “Mac” MacKenna, the impetuous and enthusiastic editor of Oil & Energy, ordered me to write an article in accordance with the theme of Cost of Sales for this issue, I was quite excited, as I felt that this was right in our wheelhouse.

The fuel delivery business model is centered on logistics and cash flow and requires continual improvement in efficiencies in order to compete and gain an edge. However, legacy constraints and a heavy cottage industry effect (think discounters popping up due to the low barrier to entry) have in many ways delayed the acquisition and acceptance of technology to drive costs down and productivity up. In other words, either “Dad” won’t spend the money, or you’re not making enough profit to afford the advancements.

Both cost controls and productivity enhancements can increase margins. The level of sophistication we find around these pursuits covers quite a range. At one end you find fax machines that still use thermal paper and computer screens the size of mini refrigerators. At the other end, the advancements are remarkable: tablets with POS billing and invoice delivery, and large flat-screen monitors on the walls with the latest CRM software populated with enough customer data that it almost feels like NSA headquarters. The constant evolution of technology is good and necessary, and all should strive toward it, as it can drive up efficiencies that will improve logistics.

Areas of Opportunity
However, there is another area that I am certain has not seen much improvement over time: procurement and hedging. We’re still chasing the low rack as if it’s the Holy Grail to higher margins, all the while ignoring—or simply oblivious to—the opportunities in front of us.

I never thought I would look at hedging as an “old” practice or art form. But here we are, nearly 30 years since the industry first embraced the concept of a future price offer to their customers and hence the hedging that allowed them to make that offer. Budget caps are a staple at most companies now. Much like the farmers who have been hedging their crop for generations, hedging has become a ubiquitous practice in our industry. And it should be. Yet I still find oil companies that have resisted participating or even learning why it is such a popular tool for customer retention and a popular offering. Selfishly, I’ve embraced this opportunity and continue to seek these folks out.

Meanwhile, we continuously work with our clients to advance both their hedging and procurement practices. Like technology, both hedging and purchasing methods have evolved into a variety of strategic tools, products and protocols that can lower the oil companies’ cost of sales. At the risk of overstating my supposition, I believe that changing the way you look at the procurement of the oil is the last frontier for margin improvement and acquiring an edge on the competition.

Many ideas are simple and can be implemented quickly and on your own. For example, using a spreadsheet, start logging your selling price every day along with your supplier’s pricing. And when you chart it, you will see the same picture that I see across the 150-plus clients we service every day. This is standard in our business model. Very few—less than 1 percent of companies by my estimates—can show a graph that does not have the same characteristics. I call it the accordion effect. When prices go down, margins expand. And when your cost of oil goes up, the margins contract. I call it the lag effect, and it is demonstrated in the first chart below. This is also an obvious hedging equation that can improve your margins considerably by hedging this risk effectively.

Day-Counting Margins
Additionally, with this same data you can create a histogram that provides a great visual that tracks your margins. You are day-counting your margin levels. If you think about it, most of you have less than 150 days in a year to make a profit or create enough cash flow to get through the quiet months. Sixty percent of the degree-days are condensed to about an 80-day period. So it makes sense to track where your margins are at the peak periods. We use the graph in MarginTrak (second chart below) to track this statistic. You can also compare one period to another. This graph provides a hugely impactful picture of where you are as you go through the winter. It also will prompt you to hedge your risk on margin deterioration. Clients tell us all the time that the visual alone motivates them to either move their retail price sooner when prices are going up or hold their price longer when prices come down. By day-counting margin levels you are elevating the impact that every day has. Both instances will improve margins significantly.

When I created my consulting model and prospected on it 24 years ago, I had built into my pro forma a considerable turnover ratio. I did not, and still do not, believe that hedging is rocket science or some mysterious practice that no one ever quite gets clarity on. However, much like the way technology evolves into multiple versions of its original self, hedging and the procurement of the oil also evolves from a strategic perspective and by looking at different methods. Providing this service has clearly proven its value.

Index and Basis
Several years ago I wrote an article in this magazine advising readers of the eventuality of buying oil on the portals as well as predicting that they would see a supply contract offer based on some index such as Platts. I’m not calling myself a prophet; I already had a handful of clients utilizing this tool in their procurement apparatus. And it worked quite well. Significantly more clients now utilize some index or basis structure to improve their cost of sales and hence their margins. This trend will continue. What is critical, however, is knowing which index works best for your location and having the capability to back-test any offer. Currently, every client on a contract is realizing lower fuel costs than what is offered at their rack. This isn’t by accident; it is the result of due diligence. The client had historical data to compare against the offer. (Again, see the idea in the previous paragraph suggesting you keep a log of your rack data in a workable environment like a spreadsheet).

Recently I checked a folder we have on our server called Client Tools. There are over 35 “worksheets” in there that cover everything from short-term hedging models, to temperature correction calculators, to storage fill cost-of-sales illustrators. We use these worksheets as both teaching tools and as stressors to quickly view a specific purchasing or hedging strategy. The charts on Page 26 show an example of the short-term hedging model graphing the margin as well as the cost of sales.

Many farmers, no matter their size, have evolved their hedging practices over the years after they had become more comfortable with their traditional methods. This has led to more advanced structures, resulting in better profit margins or lowering risk. Our clients have traveled a similar pathway that farmers have, also furthering their procurement and hedging methods such as short-window hedging, basis management, and buying on an index structure.

I believe for certain that, as with technology, if you are not advancing your knowledge and skill sets around both hedging and the procurement of the product, you are leaving profits on the table. Hedging has become embedded in the DNA of the heating oil industry. It is here to stay as long as the oil remains a commodity traded on an exchange. It makes sense to not only learn about it, but to embrace it.

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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