The Four Key Metrics of Your Hedging Strategy

by Richard M. Larkin, Hedge Solutions

It’s a good time to look back before looking forward!

As we approach the end of the heating season, it makes sense to review the performance of your forward sales programs. Basically, this means looking at how your hedging strategy did with locking up the best possible margins. This exercise does not take a lot of work and will teach you really valuable lessons to use in the next season, which is just around the corner!

There are four key metrics you should be tracking:

• Basis
• Gallons delivered vs gallons forecasted
• Options spend and returns
• P&L tracking

Basis: By now we are all familiar with the term basis. Simply put it’s the delta between the NYMEX spot price and the price at the rack or on the portal. Basis is one of the most important elements to a successful hedge program. It is also the most difficult component to predict. In the 22-23 season, basis fluctuated over $1.50 per gallon. So far this season it’s relatively benign at 25 cents in most markets. Still, it’s worth noting that if you locked in a wet barrel at NYMEX plus 10 and you can access rack gallons today at NYMEX minus 5 you essentially are overpaying by a whopping 15 cents per gallon. This dynamic works both ways, however, so it makes sense to have a balanced hedging strategy when it comes to managing basis. There is a simple exercise you can deploy in order to track basis. Fire up one those spreadsheets near and dear to your heart and log just 3 data points every day:

• NYMEX spot settlement price.
• Low Rack Price.
• The difference between the two (simple excel formula here).

An additional benefit here, which I won’t go into detail at this time, is that you will be able to back test future offers for an index-based supply contract. Hugely valuable!

Gallons delivered vs gallons forecasted: This metric is often overlooked. I call it the over-and-under risk. As you aggregate orders for your cap or prebuy programs, you are required to best guess how they will be delivered. We know that it will take the shape of a bell curve, or what we like to call the “heat curve.” However, weather is a significant impactor that can change the shape and, hence, the actual gallons delivered. It’s impossible to know in advance exactly how each customer is going to consume the product you have allocated to them. So, it makes sense to review this metric in hindsight. We call this the “actuals” process. Most back-office software systems make it easy to run a report that will show you how many gallons you delivered to a specific pricing program. When you run this report each month, you will be able to compare how many gallons you actually delivered to what your forecast was. This is of critical importance in a couple of ways, depending on which program you are analyzing.

In the prebuy program, you get a measure of the remaining gallons. This will allow you to make adjustments to your hedges in the forward months. For example, if you look like you underestimated some of the forward months, you may be able to still put on additional hedges ahead of time and thus eliminate the risk.

In the cap program, after reviewing a couple of months’ data, you might need to adjust going forward also. Likely, the most consequential benefit will be longer term. After reviewing the before and after data over a couple of years you will undoubtedly tighten up that over-and-under risk, regardless of the weather factor. In other words, the heat curve will start to take on a more reliable shape for predicting when the gallons will be delivered each month. It’s just one more factor that will increase the efficiency, and your profit margins, of those forward sales.

Options spend and returns: There are three factors to this important measure: the returns, the type of option deployed, and the allocations. The obvious is the return that you get from the options. Regardless of how you record premium and returns on your books, you should calculate the returns in cents per gallon and apply it to the wet barrel cost that month, inventory, or rack. This can be a simple back of the napkin quick summary, or a more detailed calculation. The idea is to get a granular view of how the option returns are impacting your cost of goods sold (COGS).

The other two factors are option deployment and allocation. Reviewing the impact that the options returns have on your COGS will add long-term benefits and efficiencies to the “spend” on your hedging activities. Tracking your options spend and returns will help you decide on allocations in the future.

A simple example: After observing basis in October at NYMEX minus 5 cents versus the wet barrel purchase you made at NYMEX plus 10 cents, you realize that you are better off using the premium spend on call options because the calls allow you to access the rack at minus 10 cents. Conversely, if you observe higher basis in other months you may want to allocate more premium to put options that match up with your wet barrel purchases.

Tracking P&L: This is the most important metric to track for obvious reasons: it’s your bottom line. It is critically important to look at this monthly so that you have an opportunity to make adjustments to your hedging strategy going forward. Also, it makes sense to view how you did, based on the choices you made regarding strategy and implementation so that you can learn from it.

I’ve said over and over again, in seminars and articles and consultations with clients, that a successful hedging program requires you to take a long-term view, five-years minimum. Each year will teach you a bit more about your approach to hedging, which in turn will add significant value to the efficiency of your hedging strategy. This ultimately will reduce both your risk and costs!

Rich Larkin is President of risk management consultancy Hedge Solutions. He can be reached at rlarkin@hedgesolutions.com or 800-709-2949. www.hedgesolutions.com

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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