Yes, It STILL Makes Sense to Hedge and Offer Price Protection

By Richard Larkin, Hedge Solutions

If this article looks familiar it’s because I am doing a bit of recycling from past columns. I decided it made sense to look backward a bit (about five years). I’m revisiting the questions you likely ask every year about this time. Do you need to offer your customers price protection and is all this hedging activity helpful to your business?

The hedging and trading of commodities harken way back to the tulip mania period in the 1600s in Europe when the Dutch would gather to speculate about the price that the annual tulip crop would fetch. From there exchanges emerged to offer soft commodities like corn and soybeans so that farmers and merchants could hedge. Then it was on 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 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. They would all eventually embrace the new era of price transparency.

It’s now 40 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 up “for no reason”). “It causes my margins to erode” (BUT 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 final frustration represents 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, which are open to anyone to attend, and we advertise them extensively. Yet 80% 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.

The past heating season is a perfect example of this dynamic. Prices declined precipitously after peaking in early October. Imagine that, a large price drop prior to the heating season kicking in. The price drop produced higher than normal margins right up to the end of the year. The hedge equation was obvious. If prices turned around and moved higher, margins would deteriorate back to normal or lower. Hedge and you could lock in the exceptional profits for weeks!

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. Prices controlled by the few have 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. 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 entirely, it can certainly smooth out its sharp edges and reduce the bite. Think about it: a dual benefit is attained by increasing margins while appeasing your customers.

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 rlarkin@hedgesolutions.com or call me at 800-709-2949.

The information provided in this market update 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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