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Thursday, February 22, 2024

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2023 Hedging Survey


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There hasn’t been a “normal” year for our annual Hedging Survey in quite some time

There hasn’t been a “normal” year for our annual Hedging Survey in quite some time. In 2020, surveys went out in early January and were returned a few weeks later. By the time that issue went press in March, the pandemic had effectively shut down the entire world. The following year we were crawling back from negative crude oil prices, upside-down usage patterns thanks to a year of country-wide work-from-home, and broken supply chains that shattered every industry and every product. We thought we were looking at a somewhat “normal” year in 2022. Then, once again just as we were going to print, Russia invaded Ukraine and all bets were off!

That brings us to this, the 2023 Hedging Survey. At the start of the heating season, we were looking at severe backwardation in the market and distillate stock levels so far below the previous five-year range that industry leaders feared shortages not seen since the 1973 oil embargo. In November 2022, wholesale heating oil reached a record $5.227 per gallon, $2.652 higher than the previous year, and more than $4.00 per gallon higher than November 2020. As survey questions were being asked and answered, sanctions on Russian crude and petroleum products were coming into play.

It was in this environment that Oil & Energy again reached out to hedging providers who support the heating fuels market about their thoughts on the current marketplace and prospects for 2023-2024. We would like to thank each of the companies that took the time to participate: Aletheia Consulting Group, Angus Energy and Hedge Solutions.


Oil & Energy: In the last few years we experienced a worldwide shutdown from the pandemic, record lows and highs, the outbreak of war, sanctions on Russian oil, an uncertain national and global economy and the strengthening of the electrify everything movement. What do you see as the next big crisis looming out there that would have a significant impact on oil prices? (Potential issues over the next 6-12 months only. We will address some of the recent issues in other questions.)

Angus Energy: I think that predicting a crisis is best left for those who have a deep understanding of geopolitics or those who love to speculate. At present, we have enough to worry about before starting to guess what unforeseen challenges lie ahead of us.

Hedge Solutions: It always seems to be the event that no one could have predicted: e.g. Covid, Russia invasion, etc. I think the economy will be the next big price mover. It may seem obvious, but the markets and pundits alike have never been more uncertain, it seems. Are we headed for a global recession? Will China emerge from so called “zero covid” policy with a roar or a whimper? It will significantly impact whether we have enough distillates or too much. I don’t think there will be a middle ground.

Aletheia Consulting: The next challenge I see is how the overall economy responds to the Federal Reserve’s continuous rate hikes. If the economy cools down, then petroleum demand will also take a hit. In addition, if Russia and Ukraine can make peace, we could see a black swan event for oil.


Oil & Energy: This winter, so far, has been warmer than normal, despite a few deep freezes at the beginning and end. How do anomalous weather patterns change your recommendations for dealers?

Hedge Solutions: It doesn’t, because you can’t predict weather out that far. So, you have to “hedge” what I always call the over and under factor. You do your best to allocate your customers’ usage over the winter and apply a balanced hedging strategy.

Aletheia Consulting: Look at 5 years of degree day data. Use this information when deciding how much product needs to be hedged when compared to previous sales. Another way would be through weather insurance. Weather insurance (buying a put option on degree days) is available to mitigate risk. Keep in mind it is critical to dig deep into what the cost is in comparison to what the payout will be. Is there a max payout? What is the probability of the hedge being in the money?

Angus Energy: This might be a bit controversial, but in some ways our clients and their customers might have been saved economically by the warm winter. Understandably, no dealer wants to have trucks and drivers sitting around without deliveries to make in January, but considering the pricing, basis, and inventory situations that we were facing in the fall, this winter might have been a “lesser of evils.” Relative to the weather, we have some specific plans for clients, including simple weather hedging (protection against lower-than-normal HDD’s), as well as some that have varying volumes based upon the daily weather.


Oil & Energy: On the economic front, what do the inflation rate, rising interest rates and the potential for a recession mean for prices and supplies going forward?

Aletheia Consulting: The 2015 fracking bust saw over 50,000 job losses, which was detrimental for the oil industry, but lower energy prices became a catalyst for a massive stock market rally. In 2023 we are seeing Fortune 500 tech companies laying off thousands of workers plus higher interest rates are putting significant pressure on real estate. The tech bubble of the early 2000’s and housing crisis in 2008 are eerily similar to a lesser extent here in 2023. In addition, the current administration seems to want higher prices for petroleum as a way to speed up the transition to “green energy” leaving supply more vulnerable.

Angus Energy: It is all a very mixed bag, but with the plethora of information that floods our daily lives – inflation, Russia-Ukraine, interest rates, inventory levels, shifting political winds, tension with China, etc. – prices have ALREADY factored in the “known and assumed” factors that impact prices. What will happen to prices from this point forward will be based upon changes as compared with what is forecast today.

Hedge Solutions: Distillate consumption is primarily in transportation and manufacturing. If we go into even a moderate recession, it will likely mean distillate consumption will shrink. It doesn’t necessarily foretell price direction, however, as we are already behind in the inventory department and there’s not enough refining capacity. We need PADD 1 inventories to recover this spring and summer in order to build a cushion for next heating season. The suppliers need contango in the futures market in order to build inventory without a lot of risk. Here’s hoping.


Oil & Energy: Distillate inventories are still at low levels heading into spring. Global constraints on Russian oil aren’t likely to be lifted anytime soon. The market continues to maintain a significant level of backwardation in the ULSD forward curve. What can dealers do to mitigate the issues of higher supplier differentials and hedging costs?

Angus Energy: Basis differentials were a sleeping giant for a number of years. Although the Russian incursion into Ukraine was what finally snapped the basis market, the focus on transitioning away from fossil fuels and the severe drop in capital investment to keep supply up with global demand was a big contributor to the ability for the basis to blow out as badly as it did. As mentioned earlier, in some ways we got lucky with the mild weather. Imagine how wide basis diffs might have been with further shrinking of distillate inventories and how high retail prices would have gone in order for dealers to retain their full margin (not to mention collection risks and stressing of receivable lines of credit). Will the basis blow out next year? That is not a question that can be answered at this moment. However, the marketplace has shown that it CAN blow out and if it does, it can blow out by a lot. It is a risk and companies need to decide how seriously to take the risk. We had a lot of clients hedge their basis through one of several basis-risk offerings by our trading division.

Aletheia Consulting: For a portion of your gallons, it would be prudent to lock in supply agreements such as Argus, Platts, and OPIS. Supplement those agreements with call options to offer capped pricing programs to customers. Aletheia has invested heavily in technical analysis research to understand which indicators provide the best probabilities for buy and sell opportunities. In the age of instant news and “factually incorrect, i.e., fake news” you need to be careful of letting the headlines dictate your purchasing decisions. Instead look at the technicals to determine the best entry points.

Hedge Solutions: There’s not a lot one can control here. I like supply contracts based on transparent indexes. However, it is critical to back test any contract offerings before signing off. Not all contracts are created equal. We’ve been advocating for supply contracts long before the recent issues emerged. It’s not so much the backwardation as it is the anemic supplier mix these days. Most markets in New England have few terminal and supply point options. It’s important to have the right mix in your hedge programs.


Oil & Energy: Last year, the market was in such flux that many dealers eschewed offering price protection programs such as price cap programs. Do you anticipate that those who offered price caps in the past will bring them back again this year? Why?

Hedge Solutions: Not really sure. I believe those who did put an offer out last year will follow up this year with one. There are two “camps” on this issue in the industry. Those who prefer to go without a program offer and those who wouldn’t think about pulling it off the table. I’m an advocate for offering a cap. I believe it makes the customer (particularly budget customers) “sticky”– more likely to retain. My view is why not offer it? You risk losing customers if you don’t offer them peace of mind.

Aletheia Consulting: Consumers understand fixed rate mortgages, less so for oil and propane caps. This lack of prevalence outside our industry leads to a lukewarm participation in cap price protection unless proper marketing is done. In combination with solid marketing and sound hedging principles, these programs will potentially provide margins substantially better than fixed price. As an additional benefit the energy retailer benefits from a cap because the consumer is essentially subsidizing most if not all of the hedging cost, which in turn protects your margin.

Angus Energy: While we are aware that some did choose to not offer caps, our experience at Angus was that almost 100% of our clients who offer caps did offer caps for this past winter – and in most cases they had full (often much higher than budgeted) per unit profit margins. The costs to hedge (generally in the form of an options premium and/or a basis hedge) were expensive and had to be collected – up front or as part of a sales price – from the customer. So, I would anticipate a very active price capping year. One sidenote: Think of the customers who lost their ability to cap and were forced to buy a fixed price offering (if they wanted price certainty/protection), only to find that they are paying a dollar or two more per gallon than their next-door neighbors!


Oil & Energy: How does the electrification/anti-liquid fuels movement play into your calculations for 2023-2034?

Aletheia Consulting: In a recent interview, former Secretary of State Mike Pompeo stated that he did not envision an M1 Abrams tank being green anytime soon. Even Elon Musk says that hydrocarbons are going to be around for a very long time (think Space X). Musk also stated that if all gasoline and diesel-powered vehicle production was stopped immediately it still would take 20-30 years to replace all those vehicles with electric. Most major vehicle manufacturers are still manufacturing gasoline and diesel-powered cars every day in 2023. Our global economy needs energy wherever we can get it. Let’s not forget lower energy prices are good for economic growth, thus any energy that we can get that is economically viable is a benefit to the world.

Angus Energy: Frankly, it is likely nothing more (for the next year, per your question) than a distraction. It has become more of a political lightning rod than an operational or economic concern, but at some point, there will be some changes made. Hopefully those changes will consider the needs of affordable and reliable energy, instead of the “burn the witch (fossil fuels)” rhetoric.

Hedge Solutions: We’re definitely heading down that road. Though there’s yet to be any significant impact yet, there seems to be some play. Specifically, if you have a lot of heat pumps out there in the customer base, you’re more likely to see the gallons per degree day falling off.


Oil & Energy: Even as states attempt to legislate liquid fuels out of use, the Inflation Reduction Act (IRA) expanded the funding available through the Higher Blends Infrastructure Incentive Program (HBIIP). What do these programs mean for supply outlooks?

Angus Energy: It makes the notion of investing in exploration, production, pipeline infrastructure or large storage projects quite speculative. Should our elected officials learn to understand that fossil fuels do 100x more good than bad, perhaps those infrastructure investments will return. If not, supply might be “iffy,” and basis and price hedges become that much more of a requisite part of an oil dealer’s life.

Aletheia Consulting: Incentive programs would make supply more abundant because it allows for suppliers to offset capital expenditures.


Oil & Energy: As renewable fuels, Bioheat® fuel, etc., continue to increase market share both voluntarily and mandated, how will this impact hedging strategies for next year?

Hedge Solutions: Again, not here yet in a significant manner but likely coming. As we shift to a higher biofuels blend in the coming years, the hedging strategies will need to adapt to cover a variety of variables such as feedstock prices (think soybeans, cooking oil, etc.), RINS, and Tax Credits. We are currently adapting our hedging software, Hedge Insite, to incorporate these variables.

Angus Energy: The market seems to have managed this fairly well. We have worked with some non-Merc indexes for hedging, but while you can customize a lot of things, customization comes with
a cost and the dealer needs to assess the difference between the two.

Aletheia Consulting: As long as the underlying derivative correlates closely with the product you are selling, then hedging strategies would be similar to what have been used in the past.


Oil & Energy: RINS have increased in volatility every year and can impact both diesel and heating oil prices. Will energy marketers need to incorporate hedging RINS pricing as the volume of sales in
biofuels continues to grow? As the trading volumes in RINS grows, will this add or decrease volatility in fuel prices?

Aletheia Consulting: The more moving pieces, the more there is a price risk.

Hedge Solutions: Yes, we will definitely have to incorporate the RINS factor. I’m fairly certain that as RINS trading increases, so will its volatility.

Angus Energy: RINS are an important part of our lives, but generally are not considered to be minute-to-minute or day-to-day risks. They are more often considered to be an annual “reality” that, by default of the mechanisms, impact rack and contracted “diffs.” In general, trading volumes SHOULD decrease volatility – more participants, tighter bid/ask spreads, etc. However, this is oil, so who knows!


Oil & Energy: Is there any one market metric that you anticipate weighing more heavily than others in the next few months?

Angus Energy: There are not that many individual metrics for hedging and they haven’t changed in a while – price, basis, volume, volatility, availability of storage. So, on the supply side and the pricing side, the variables are known – the risks have to be either accepted or hedged. With that said, the challenges in our industry are much more so on the operational side of things – driver shortages, excess capacity – trucks and drivers – for most of the year, generations’-old consumption and delivery planning, changing consumer behavior, lack of the use of data and technology to optimize operations (“that isn’t the way that dad did it…), etc. The biggest opportunities are related to some ignored metrics: gallons/delivery (by month of year), gallons/truck/year, optimal delivery size (same year-round? Same regardless of K?), shifting delivery planning around by will-call/auto mix, etc. Data is available and you should understand what you can, should and MUST do with it.

Hedge Solutions: Basis for sure. Refining is in decline. The supplier mix is declining. Storage is in decline. All of these factors will contribute to the volatility in basis.

Aletheia Consulting: Technical analysis always plays a key role in determining when to buy. Aletheia invested heavily in research as to what technical indicators perform the best. These indicators play a pivotal role in guiding clients’ short-, medium- and long-term purchasing decisions. The wide swings in the market make active monitoring necessary.


Oil & Energy: Do you have any parting advice for next heating season? Are you offering any new products or services for 2023-24?

Hedge Solutions: Don’t make assumptions about price direction regardless of the daily “noise.” Use hedging to mitigate risk, not amplify it. We are constantly tweaking, evolving, and developing improvements to both our product lines and our software management tools, Hedge Insite and MarginTrak.

Angus Energy: This is a marathon, not a sprint. What happened in one year is not necessarily a precursor for what will happen in the next year. You need to decide what is most important to you – customer count, reducing losses, maximizing profits/EBIDTA? We believe that you need to have a plan to maximize profits and it must incorporate the “top line” Gross Margin AND the bottom line – the impacts of operating expenses. We offer several items that can be “the most important thing,” but as each company is different, you would have to have a conversation with us to best understand your particular needs.

Aletheia Consulting: Utilize advanced technical analysis instead of relying on questionable news headlines. There are times when options are cost prohibitive due to high implied volatility, in this case retailers need to be more creative in their program offers or hedging strategies implemented. Aletheia offers hedging services for heating oil, diesel fuel, and propane.


Disclaimers:

Aletheia Consulting Group: Aletheia is registered with the National Futures Association as a commodity trading advisory and swap firm.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. In considering whether to trade or to authorize someone else to trade for you, you should be aware that you could lose all or substantially all of your investment and be liable for amounts well above your initial investment.

Aletheia Consulting Group LLC does not guarantee or warrant that the contents contained herein are 100% accurate. We have made reasonable effort to present accurate information, pricing, and statistics. Therefore, the information is provided “as is” without warranties of any kind.

In no event shall Aletheia Consulting Group LLC and its related principals, agents or employees be liable for any damages whatsoever, arising out of or in connection with website, information, or other verbal and written communications.

Information contained herein was obtained from sources believed to be reliable or is a reasonable assessment of that information, but is not guaranteed as to its accuracy.

Angus Energy: PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. In considering whether to trade or to authorize someone else to trade for you, you should be aware that you could lose all or substantially all of your investment and may be liable for amounts well above your initial investment.

Hedge Solutions: 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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