Is it Time To Consider Supply Contracts?

by Rich Larkin, Hedge Solutions

Learn from last year and resolve supply issues before they arise.

Last year, energy marketers were facing an oddity they hadn’t encountered for some time; the prospect of searching for their oil supply. Additionally, oil suppliers were asking for differentials on wet barrels that looked more like a retailer’s margin over rack! And that was if they were even quoting wet barrels. Some suppliers bowed out of any offerings altogether. By the end of October, early November rack postings were hitting insanely high basis levels at over $1.00 per gallon! Fear and anxiety became omnipresent, and it wasn’t even cold yet. The biggest source of anxiety came from the retailer imagining the prospect of having their customers run out of oil while they had no answer for them. Heating oil retailers lose sleep at night over a host of issues, but this one kept them up at night with an extra tick in the ticker!

The cause and effect of this phenomenon has been vetted, studied, and written about ad nauseum. Trust me, I’m likely one of the primary offenders. So, I won’t waste your time revisiting all of that. But it does beg a few questions. Can it happen again? Could it possibly get worse? Will the terminals run dry at some point? The answer is, likely yes.

So, what is the solution? Are supply contracts really the best fix? You’ve been shopping your supply needs to your posse of suppliers for years. And it’s a commodity, right? Of course, you’re supposed to shop for the best price. It’s a fundamental axiom to your business. Buy the best price every day. Yet this conflicts with another basic and fundamental principle. And one could argue that you won’t have a business if you fail at this. You must show up and deliver. You miss this one and your customers will run for the exits.

Last year’s experience should be compelling evidence that it makes sense to resolve supply concerns before there are supply concerns. If you think about it, you leverage your supplier day in and day out under normal conditions. Yet you lose your leverage in abnormal conditions. “You cannot negotiate with a tiger when your head is in its mouth” (Winston Churchill). Yet so many went out and entered deals at the worst possible moment last year. No wonder they turned ugly! Was this the supplier taking advantage of you? No. The suppliers had their own issues to deal with under tough conditions.

What should these supply contracts look like? There are a limited number of options for obtaining some assurance of supply through the heating season, depending on how much volume you’re willing to commit. You want to be sure the contract allows you access to competitive pricing. Transparency is critical. Both parties need to have access to the index to ensure credibility and to assess the performance, or competitiveness of the deal.

Three general rules to guide you through the process of sourcing a supply contract are:

• Only commit to a transparent and competitive index.
• Leverage your historical data! Stress this against the offer.
• Don’t over commit. Leave some volumes to access the rack markets.

“Knowledge is power!” and it couldn’t apply more than right here. Whatever the index (Platts, Argus, OPIS, etc.), you need to stress it and appraise past performance. If you’re still recording your rack price into a spiral notebook, you need to record these in a spreadsheet. If you’re not recording your rack prices every day, you want to start immediately.

When we look at a client’s offer from a supplier, we like to take that index plus the adder being offered and stress it in a variety of “looks” that tell us how good, or bad, the deal might be. Frequency waves, day counts, and correlation views are just some of the indicators. Back testing should be done over a minimum of two years. This will give you an indication, not a guarantee, of how the contract will perform. From there you can then assess how much of a commitment to make and enter the deal with confidence.

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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