Think You Know Your Margins?

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By Rich Larkin, Hedge Solutions

 

What are you doing with all that data you are mining these days? Modeling your data can tell you quickly and efficiently how to increase profits and spot areas where you are leaving money on the table! Specific to hedging and buying oil, let’s look at this area as the new heating season approaches and find ways to improve the most important business metric: your profit margins!

We recently got a call from a company based in London, referencing a white paper from our website. His company was parent to a Chicago-based company that contracts out school busing services to cities around the United States and the world – with enough under contract in the U.S. to burn well over 25 million gallons of USLD every year. Fuel costs being a large part of their budget, they hedge the prices up to three years forward. What drove the analyst to research hedging was last year fuel costs, which were not in line with expectations based on the hedge they had in place. They asked us for help. After researching their data and hedge program, we found several problems with the assumptions they were making and with the index they chose to as base for their swap. A quick fix, really.

What surprised me most was that here was a company with significant resources that ultimately sought advice and bought the hedge product from a major vendor who missed the most fundamental integrant to hedging. The primary component that failed them was the basis. Their “swap” hedge got blown out. These folks did more modeling than a barn full of quants, but they were modeling the wrong data – and it cost them a lot of money.

Where am I going here? Best practices.

To properly forecast margins on forward sales programs (cap, prebuys, fixed price), you want to make sure you have solid data integrity. How are you forecasting your customers’ demand next season? By last year’s data? Not a good idea. Back-to-back heating seasons are rarely the same. You might want to use a 3-year average or some kind of degree day data. And what about those portals your customers are logging into and ordering on their own? Make sure you check the data for accuracy.

Next, how are you going to hedge your exposure on these promises you’re making? Did you get “blown out” last year? You thought you had your margin covered with all those calls you bought but forgot to factor in the basis risk? It’s a rude awakening when you learn the hard way what a .30 rack basis for three weeks straight at the height of seasonal demand does to your margins hedged on paper. A little modeling of historical data would have alerted you to the impact on your margins if the basis were to inflate beyond expectations.

New Specs Increase the Difficulty

The new sulfur regulations are making it harder to forecast where the rack basis is going to be next year. You should be modeling your program and stressing it against best and worst case scenarios. Hedge Insite, the tool we use to manage our clients’ programs, stresses every possible variable that can impact the margin it is forecasting. You can do this in a spreadsheet environment also. Just make sure the data is reliable. The modeling tells you where your risks are and points to the variables that can potentially blow your forecasts out of the water.

Let’s talk about another important segment of your business: the delta between retail price and the price you pay for oil, better known as your rack-to-retail margin. We have preached ad nauseam the importance of tracking this number every day! And I’m proud to admit it. It’s the most important quantifier in your business. We built a software program just for this metric alone! Clients tell me all the time that they’ve increased their margins just by being aware of this number every day.

Now I know what you’re thinking. “Is this guy an idiot? I’m in the retail heating oil business. Of course I know what my margins are every day!” Really? What’s your target margin? How many days were you at or above your target margin? How many days below it? What is your actual selling price today? After the senior citizen discount, the new customer discount, the referral discount, the quantity discount, and the “your best friend’s second cousin to your favorite uncle discount”? The reality is that most of you do not know what your weighted average selling price is, net of all the deals. If I had five dollars for every client or prospect that told me they were certain of where their margin was all the time, only to prove them wrong once they entered three months of data into MarginTrak, well, I couldn’t retire (I spend too much), but I could certainly have a good time.

Control Product Costs

Your next question should be, “what the heck does one do with this information?” Now, I’ve been in this business long enough to know that the answer is not “raise your price, dummy.” It just isn’t that easy, for all of the obvious reasons. But what you can do is control your cost of sales. The price of oil! Most of you try very hard every day to do just that but are simply going about it the wrong way. You jump on those supplier portals like day traders. The portals are a great tool, but only when you use them correctly.

What a good modeling program would likely reveal to you is several important metrics that are costing you money or efficiency in managing your costs. You would see clearly when you are overpaying for basis on the portals, for example. You could take this savings and use it to hedge in short windows more efficiently. It would also reveal patterns in the ebb and flow of those margins that can and should be hedged around.

The good news right now is that the volatility in the ULSD futures contract is at historical lows. What does that mean? Hedging costs are cheap. Instead of locking in those bulks only to watch prices fall further, which ultimately scares you away from the next opportunity, you can hedge that risk at a fairly cheap rate, relative to your margin.

I’m not encouraging you to trade in the futures market or take risk. I am suggesting that if prices fall for a period of time during peak demand and your margins widen out as a result, you have a clear hedging equation. Because I am certain that if prices spike following this windfall, you will not recover from it. Your margins will shrink. So doing nothing is where the real risk is, if you think about it.

Don’t take my word for it, enter the data and model it. The historical pattern will emerge and reveal in stark reality where the true risk is. You can then take a proactive approach with the data from your model driving your decisions. The results will be much better than day trading!

Please feel free to send comments or contact me at rlarkin@hedgesolutions.com.

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