Working the Margins
Hedging experts offer advice on managing multiple uncertainties regarding price, weather and a patchwork of sulfur specifications
Each heating season brings its share of surprises that alter market conditions and increase the challenge of running a profitable fuel sales operation. The 2014-15 heating season has been wilder than most, with a price decline of epic proportions that began in June and didn’t stop until prices had fallen by 40 percent or more.
Cap programs and budget cap programs proved their value this winter, rewarding customers who paid a premium for two-way price protection. Fixed price programs, on the other hand, were a disappointment. As Angus Energy wrote, “Fixed-price customers feel (correctly so) that there is a party going on, and they are not only not invited, but are standing outside the party watching through the windows.”
Against this backdrop of heightened uncertainty, seven hedging experts who serve fuel retailers have fielded questions about hedging for 2015 and the next heating season and provided many thought-provoking observations. We’d like to thank the companies that took the time to participate: Global Companies, Hedge Solutions, Sprague Operating Resources, Angus Energy, Aletheia Consulting Group, Irving and Powerhouse.
QUESTION: Given the rapid decrease in crude oil prices in the last nine months, what are your expectations regarding heating oil price volatility in 2015 and into 2016?
Angus: By all current measures, we are looking at sustained high volatility for at least the next few months as the marketplace tries to absorb the many planned, actual and realized changes in the production and supply landscape. We saw very low volatility through the end of the second quarter of 2014, and that is making the current levels of volatility seem even higher, but the Saudi decision to “defend market share” may well go down as the biggest impactful news to hit the oil markets since the second Gulf War.
Global: Three things you can count on; taxes, death and price volatility. I see no difference in the next twelve months either. Unfortunately, volatility is here to stay with us. With that being said, we are still in the middle of a “new crude price environment.” The dust will settle eventually, but I think we’re still months away, if not years away, from the new normal for crude prices.
Hedge Solutions: Prior to the recent plummet in prices, volatility levels in 2012 and 2013 ranged between a low of 15 percent to a high of 25 percent. These are relatively low numbers when you compare them to the 2009 to 2011 period, when volatility ranged from 55 percent to 35 percent. It’s difficult to predict just how volatile crude and heating prices will be over the next year, but I don’t think we will maintain our recent levels that are in the 20 percent range
Irving: Heating oil price volatility is going to continue going forward, especially in the winter months. Whether we see crude oil prices decrease, increase, or stay stable going forward heating oil prices are going to move. As we have seen this year the prices and moves do not always go hand in hand with crude oil, and the basis (cash price minus the paper) can move quickly based on supply issues and perception of future supply issues. Since there are so many players in the game (both hedgers and speculators) and so many methods of forecasting for trades such as computers using different technical trading algorithms, I think the volatility is here to stay.
Powerhouse: The decline in prices in the past nine months represents a fundamental change in the locus of global crude oil production. The United States has become the marginal producer and price maker. Change as dramatic as this will require market participants to become accustomed to the changing circumstances. Accordingly, Powerhouse expects the next several months to be a time of heightened volatility.
Sprague: It seems likely that volatility will remain a feature of the petroleum complex for the remainder of 2015 and into 2016 for a few reasons. First, we already have a clue from crude oil futures prices that are characterized with an expanding carry or contango, a premium placed on future months rather than the current or front month. For example, if we look at the front April 2015 Nymex (WTI) Crude futures contract as compared to the April 2016 Nymex (WTI) Crude contract, there is an $11.50 carry or premium. The futures market is currently projecting that WTI Crude will cost $11.50 more in a year. This difference represents a 23 percent increase. Second, we are witnessing an extraordinary period of technological advances for North American oil producers, as they have figured out how to extract oil from regions and oil wells thought once unrecoverable. The North American shale oil boom has created a paradigm shift in world oil markets where OPEC’s ability to set and influence world oil prices seems to be diminishing, and geo-political events have had less of a “spike” factor despite the rise of Islamic terrorist groups (ISIS, al-Qaeda, Boko Haram) across the globe and renewed regional threats from Russia, North Korea, and Iran. Third, the practice of investors using crude oil and other commodities as a currency proxy has become more prevalent, which contributes to underlying market volatility. Ironically, we would assert that U.S. oil production has helped to return oil markets to a more fundamental dynamic of supply and demand. Until the current oversupply of global oil is balanced with global demand, charting this new course will likely remain volatile, at least in the short to medium term.
Aletheia: With capital expenditures declining for drilling and exploration, the volatility will continue to be elevated. Since OPEC decided to not cut production back in November 2014 this initiated a game of chess between United States producers and OPEC. No longer was OPEC (more specifically Saudi Arabia) going to be the one to lose market share while the price of oil stabilized. Instead OPEC’s decision was to let the market correct itself. As a result the weekly Baker Hughes’ Rig Count report has been declining for many weeks in a row.
QUESTION: Is the range of wholesale price outcomes larger than usual? And how does this affect hedging strategy?
Global: What is “usual”? I don’t think we’ve had a usual for over a decade. Prices have been unbelievably volatile for quite some time now. As far as affecting hedging, no one should be buying wet gallons and NOT hedging them, if they are, they are just speculating, which is an extremely dangerous game. Global Partners has virtually an unlimited amount of hedging options and products that are custom designed to reduce risk for each one of our customers needs.
Hedge Solutions: Yes. The effect of this comes from two variables. There are fewer wholesalers competing in the marketplace today for our seasonal business. The other factor comes from the patch quilt of the various fuel specifications required by each state that range from 15ppm to 3,000ppm, depending on location. This makes the logistics of supplying the Northeast difficult, due to the lack of a fungible product.
Irving: The range of pricing has been wide and moving quickly. This leaves dealers making more—or at times less—than planned margins. With the big drop in the market over this winter season some dealers had contract gallons that were priced much higher than current wholesale prices. Fortunately for most dealers the street prices do not fall as much as the wholesale prices, and this gives good opportunity for needed healthy margins on a portion of their business. One of the hedging strategies that dealers can use is the availability to buy prompt gallons in small quantities to lock in margins for their weekly non pre-buy customers. They can also buy some prompt gallons to blend in with their higher priced product to help ease any price pain on unsold or undeliverable fixed business. Also, with the quickly moving market prices dealers should be buying online and putting in limit orders for the amounts they are going to be lifting each day so that they can take advantage of the drops in the market at virtually no risk. The risk only applies (as some have found out) if you are buying unsold gallons for future deliveries.
Powerhouse: Higher volatility will translate into expanded price ranges for wholesalers. This should not affect hedging strategies, tied as they are to the hedger’s internal expectations for gross margin.
Sprague: A more volatile oil market would likely be one reason why wholesale prices would be volatile. If the purpose of a hedging strategy is to reduce price risk, we believe the best way to reduce price risk is for a retailer to have robust product offerings to their customers that have made a contractual and/or financial commitment to the dealer. For example, in the absence of not knowing what the markets are going to do, a good program to help mitigate risk is a two-way capped program where a known never-to-exceed price per gallon establishes “the cap” and if prices go lower, the program offers downside participation. Add a budget program to the capped program and we believe that a “Capped Budget” program is one of the smartest hedging strategies a retailer can use. The “Capped Budget” program implements a strategy that dealers can use to reduce volatility for their customers by offering equal monthly payments (and perhaps a credit on the account if prices went lower) even if oil markets themselves are volatile.
Aletheia: Backwardation is a market situation in which futures prices are lower in succeeding delivery months. This forces the wholesale supplier to rely more on just in time inventory. As a result basis spikes are more prevalent since inventories are kept at a minimum in order to keep retail and commercial customers supplied during times of backwardation. When extreme cold weather occurs then suppliers are forced to increase their basis in order to fulfill contract requirements foremost while also reducing the volume sold to non-contract customers until resupply arrives. Contango is a market situation in which prices are higher in the succeeding delivery months than in the nearest delivery month. This provides an opportune time to lock in profits by buying low and locking in those profits by selling swaps or futures. As a result the wholesaler would want to fill their storage to take advantage of this carry in the market. From a retailer’s perspective this will greatly reduce basis concerns.
Angus: Suppliers are scurrying about trying to figure out how their supply logistics and costing will be impacted by the higher levels of uncertainty. That is leading (in general) to higher “diffs”, but there are still a sufficient number of suppliers who are not swinging their pricing pendulums too far to the “other side”. Fixed-diffs are still best for predictable margins, whether or not you are offering a pricing program. Lacking that offer, we strongly recommend fixed-diff “paper swaps”.
QUESTION: Can dealers leverage current low pricing to improve margins in the 2015-16 heating season? What strategies should they consider?
Hedge Solutions: Heating dealers should not speculate, even in what may appear to be bargain prices. Recall just 5 years ago that heating oil was trading at $1.20. They should consider rolling their budget cap customers into next heating season early.
Irving: Low pricing is relative. What seems low today may or may not be low next season. If you can lock in fixed sales for next winter now using an improved suitable margin then lock them in and buy a forward contract from your supplier. I would caution however that if you are just buying thinking you could sell them higher at a later time you are only speculating. It seems like the prices today would have to be lower than next season but there are still analysts forecasting that crude oil prices could drop to $20 per barrel before it hits bottom. That is a long way down from where we currently are. If crude oil did drop that low heating oil prices would be significantly lower than they are today. Do I think the price will get that low? Probably not – but I wouldn’t bet my life that it will not go that low, and you shouldn’t bet your business on it either.
Powerhouse: Margins are a function of internal efficiencies and competitive advantage. Dealers should act rapidly to offer fixed price and capped sales sooner than in the past in order to lock in a higher margin. With delay, one can assume that wider margins will be eroded by competition.
Sprague: We believe that dealers should only leverage lower pricing if they have a committed retail sale on the other side and can hedge that risk. Today’s low price may not look so attractive if tomorrow’s price is lower. We believe that locking in fixed price contracts now because a dealer “has a hunch” that the bottom has been reached but does not have any of those gallons sold (and contracts and monies collected) is speculation, and runs contrary to prudent margin or risk management strategy. For dealers with inventory storage, there is an incentive to look at using physical gallons for program gallons with a spring/summer storage fill, as we feel that the carry is becoming sufficient to justify risks associated with such a strategy. As always, for all dealers, because we don’t know what Mother Nature is going to do, having some basis and physical supply contract protection in the colder, higher heating demand months of December through March (perhaps April even) is recommended.
Aletheia: That depends on the goals and timeline of the individual company. If you want to offer your current customers a lower budget payment for next year then one approach might be to lower their current budget payment by recalculating a new payment based on the current lower pricing thus giving them extended protection throughout the 2015/2016 season. Another benefit of lower pricing allows energy marketers to apply balance credits to next season’s price protection program.
Angus: It depends upon the reference point, but generally the answer is yes. You do need to consider that the 2014-15 margins – for rack-plus and for cap customers – should be the best in years. Certainly the best since 2008-09. Fixed-price customers feel (correctly so) that there is a party going on, and they are not only not invited, but are standing outside the party watching through the windows. Strategies for consideration need to revolve around not only gross margins, but around customer retention. Offering capped pricing – preferably not during August and September, with everyone else – may well lead to a more stable and profitable customer base.
QUESTION: Is it safe to buy next year’s oil now without hedging downside risk?
Irving: This answer lines up with the last question about low prices. It is never “safe” (without taking a speculative risk) to buy oil for a future delivery time before you have sold it. You can buy small amounts to sell forward, but buying a large amount without hedging it is risky. It can be hedged by either selling the product (the sold product is your natural hedge) or by buying options to protect you in case the market drops further. There are so many factors to look at, and each dealer has a different risk tolerance, view of the future and financial situation to work with.
Powerhouse: It is rarely safe to buy oil without hedging downside risk. If you were absolutely sure prices would only go up from this point, then yes. But of course it’s not possible to know that. The purpose of hedging is to help decision-makers deal with this uncertainty. Successful businesses hedge on a regular basis.
Sprague: We believe that it is never “safe” to buy next year’s oil without hedging it. We consider this to be speculation. We do not promote speculation with regards to future oil prices.
Aletheia: The first question that needs to be asked is why to hedge the downside in the first place. The goal of hedging is to reduce the risk of an adverse price movement. If the price protection offer to the customer includes the possibility of lower pricing then a lower price is an adverse occurrence that needs to be hedged against. For example if you offer a pre-buy fixed price then there is no need to hedge the downside risk since you only promised your customer a set price. If it is a cap price then you must hedge your downside risk since this type of program promises a lower price.
Angus: No. It is never “safe” to buy without hedging – unless you have a customer who is paying you a fixed price for that product.
Global: Absolutely not. Dealers should always have a hedge against physical gallons they purchase whenever they decide to buy them. As I mentioned earlier, Global Companies have multiple tools to help dealers manage their risk.
Hedge Solutions: Absolutely not. If they’re hedging a fixed price sale to their customers, then they should go out and hedge that. If they’re offering a cap price to their customers, then they should hedge the downside risk.
QUESTION: Pre-buying did not work out for customers this past winter, and yet this seems like a great time to pre-buy. What do you expect in terms of customer interest for 2015-16?
Powerhouse: More precisely, pre-buying at a fixed price did not work (i.e., was at a loss.) If customers bought caps, far the better alternative, they did just fine. They were happy, and they were happy with their dealer. Fixed price sales are a recipe for conflict between dealer and customer. Caps assure a good deal for both sides. Cap programs put the dealer on the same side as the customer.
Sprague: Pre-buying any type of fuel at a fixed price only provides price protection in one direction – if prices go higher than the fixed price. The customer will never get to participate if prices go lower, and herein lays the fundamental concern with any type of fixed-price program, whether that is pre-paid up front, or is set up as a fixed budget program: Will customers walk away from their obligation if prices go below their set fixed price? We saw this happen in 2008 when prices came off their highs and customers walked away from their fixed-price obligations. Since that time more dealers have insisted that if a customer wants a fixed priced program, customers will have to pay up front. We have also seen some dealers refuse to offer a fixed price program due to state regulations regarding pre-paying fuel. We believe that pre-paying a fixed price program with a clear, signed contract is the better way for a dealer to collect the whole fixed price obligation. In this light, the “best” time to buy a fixed-price program would be when the market hits the bottom. However, does anyone truly know when the bottom hits and it’s the “best” time to buy? Because we don’t know what markets are going to do, we believe the best solution is to offer two-way price protection with a capped program to protect both the customer and dealer from the pitfalls of a one-way, “speculative” strategy. With regard to timing, we have seen success in offering a capped program typically before the customer gets their last delivery in the season and before summer vacation. Interest for capped programs continues to grow, and customers who participated in capped programs this season reaped the benefits of a lower price. We expect that customer interest will continue to grow for capped programs and particularly after this season, we expect that fewer customers will want to do a fixed-price program.
Aletheia: Pre-buy offers are both rewarding and challenging. On one hand they can be beneficial by allowing you to compete with other companies due to a relatively similar cost basis. On the other hand they add downside risk to the equation. It is a 50/50 proposition: 50 percent of the time the pre-buy works out well, and 50 percent of the time the market drops below the pre-buy, making the program look bad in comparison to a floating price program. A good rule of thumb is if you must or want to offer a pre-buy then by all means offer a budget cap alongside of it. This gives your customers the best of both worlds and also insulates you from taking the blame when the pre-buy prices are significantly higher than the market price during the heating season. Point out to your customer that instead of paying for a full year of deliveries up front at a fixed cost they could spread out their payments as well as add a more complete form of price protection in the form of a cap.
Angus: Why would it seem to be a “great time to pre-buy”, unless you embrace speculation? There are many who say—we do not opine on market direction—that prices still can fall significantly. If they do fall, the answer would be that it clearly was not a great time to pre-buy. Our expectations, and we are starting to see it already, is that fixed price customers will be either converting to cap prices with their existing companies, leaving their existing company as they feel (usually incorrectly) that they company “did them wrong”, or just hanging around with their head in the sand.
Global: I believe dealers will see a similar number of customers still wanting to pre-buy. The numbers, in general, have shrunken from their heyday some 10 years ago but I believe they’ve since leveled off.
Hedge Solutions: I think you will see some interest in pre-buying with the prices at these levels. This has been a tough year for heating dealers who have pre-buy programs, dealing with their customers’ buyer’s remorse. This is not new to the industry. Lots of concessions are made, which usually means the dealer is losing money on the program. I think this is a great time to convert disappointed customers from what is typically a low-margin, low-retention program to the higher-margin, higher-retention budget cap.
Irving: The pre-buying for this season was obviously at a higher price than where the market dropped this winter season. It is looking like the pre-buy prices offered this year (for next winter) will be much lower than last year’s offerings. That being the case I see customers being very interested in locking in for next year—as they will be thinking the price is most likely to climb. If customers can lock in close to current street prices, they will lock in. There has been a much earlier interest in locking in for next season by dealers who are servicing commercial accounts since many of those customers can currently lock in below their budget levels. Many buyers chase the market, and like all chasing of markets you end up losing. If you pre-buy because prices jumped the prior year and don’t pre-buy because they were lower you will almost always end up on the wrong side of the trade each year. Over the years it is amazing how many do chase what happened the prior year—similar to buying the hot stock after it has already climbed and selling the loser after it has already dropped.
QUESTION: Extreme cold has been a factor in each of the last two heating seasons, but recent history suggests it’s not a sure thing. How can dealers best prepare for such a broad range of possible degree-day counts?
Sprague: Dealers should keep track of gallons sold in each month for the past five years to determine how many more gallons they deliver in the colder months between December and March/April. These are the months that pose the greatest threat if there are extreme cold temperatures. Having some form of a contract with a supplier to guarantee supply for at least 25 percent to 50 percent of supply needs (based on their 5-year average from December to April) would typically ensure contracted or guaranteed supply in the event of a supply disruption. We believe relying on rack-only fuel purchases is no longer an adequate strategy. Currently, there are a variety of supply contract choices, so dealers should not assume that a supply contract simply means “locking in” or “fixing” the entire price. At Sprague, we offer a program to allow customers to lock in the basis (differential) only and float the market price portion of the supply price with a product we call an Unpriced Guaranteed Differential (UGD). Customers can purchase these contracts in advance of the season, in the months they want additional supply security, without locking in the market price portion until a time closer to delivery.
Aletheia: The answer is closer than you think. All that needs to be done is to look at your in-house computer software. You have valuable information at your fingertips. Utilize yearly usage to incorporate into your hedging strategy. A good reference point is three years average usage per account.
Angus: Price, while being a major component of profitability, often pales in comparison to the volumetric (weather) risk that dealers need to consider. If you spend time, effort and money hedging the price of oil, the same consideration should be paid to the weather—and hedging that risk. Weather hedging products have evolved and can now be tailored to the specific situation of each individual dealer, regardless of size.
Global: Relying on S.T.M. (short term memory) is the worst thing a dealer can do. Dealers should be looking at their business plan as a three-year average, better yet, a five-year average of HDDs. Getting caught up with what happened last year is a sure-fire way to seriously harm your business. After going through this past really challenging season, dealers need to make sure they are buying from a reliable supplier (like Global Partners) with multiple loading locations so they can be assured of supply even in the most demanding heating oil seasons.
Hedge Solutions: This is another issue with the pre buy programs. The dealer carries all of the over/under risk. If it’s warm, the customer base takes less oil. If the price falls, then the heating oil dealer ends up having to blend the higher priced product into his rack to retail volume, reducing their margins. A cap budget, which should be hedged with a blend of call options and put options (with wet barrels), tends to dilute most of the over/under risk. And because the program carries a higher margin the dealer eliminates most, if not all, of any potential margin erosion.
Irving: Recent history suggests it’s not a sure thing? The only sure thing is that there is no sure thing when it comes to predicting next season’s heating degree days! One way to prepare for the varying temperatures is to buy a percentage of what you are selling at fixed prices (maybe 90 percent) and then using options (out of the money for a lower cost) for the rest of the volume (10 percent). You can spread the price of the options over all the gallons sold. You will then be protected on what you sold for fixed forward gallons while at the same time not having extra gallons to move if the HDD are up to 10 percent lower than your plan. You also need to be sure your customers understand that they are only able to get the number of gallons they fixed at the pre-buy price and that once those gallons are gone they are purchasing at the then-current market prices. Another tool that can be used to assist with the unsure temperatures is weather derivatives that can pay you if the temperatures are either warmer or colder than what you are planning on.
Powerhouse: Dealers concerned about HDD variation should consider buying weather insurance, which is tied into volumetric exposure.
QUESTION: Heating oil specifications became more of a patchwork one year ago with multiple sulfur requirements that vary by state. Are the shifting sulfur specifications an important factor for retailers? If so, what do they need to consider?
Aletheia: One consideration is how many wholesale suppliers are available to you. If you have less than three then you might want to take a harder look at securing some forward gallons ahead of time (ex. fixed differential unpriced). Until 15 ppm is the norm then various states will be susceptible to supply disruptions resulting in basis spikes.
Angus: The market is trending in the right direction of 15 ppm. The 500-ppm states are moving in that direction and the few holdout 2,000-ppm states will eventually follow suit. There were likely a few more weather-related supply disruptions in February due to the fact that the marketplace is supplying different specs, but we didn’t see much that much that screamed out that there were specific “ppm issues.” Dealers need to have a better grasp of their local diff, and seek out suppliers that can assist in limiting or eliminating the swings in the diffs.
Global: While our industry is going through the transition from high sulfur to lower sulfur fuels, there have been growing pains, mainly due to the fact the Federal Government left it up to each state to determine when to switch their sulfur contents and to what levels. As all dealers know (and suppliers for that matter) this caused confusion along with multiple products to try and navigate daily and affecting forward markets. In the end, I believe calm will return when all states finish the conversion process. Really nothing for the retailers to consider at this point. Dealers need to buy what is required in the state(s) they operate.
Hedge Solutions: As I mentioned earlier in the survey, this presents some challenges. The biggest issue they need to consider is how they assess basis and basis risk when hedging.
Irving: The heating oil specifications are going to continue to be an issue between states that are selling Ultra Low Sulfur Heating Oil (ULSHO 15 PPM), Low Sulfur Heating Oil (LSHO 500 PPM), and High Sulfur Heating Oil (HSHO greater than 500 PPM but less than required state maximum sulfur). In New England the same factors that dealers had to consider this year will continue next season. The logistics of selling in both an LSHO state and in an HSHO state can be complicated and costly. Also the difference between the cost of HSHO and LSHO can be significant. As this is being written the spread between them in New York Harbor spot pricing has been as much as a whopping 36 cents per gallon over the past week. Of course that is higher than it has been during the winter, but it shows that the difference can be significant enough to pay the costs of being able to deliver both if you live and deliver in bordering states. In a couple of more years (most states slated to go to ULSHO in July 2018) the variations between states will go away but until then the logistics and pricing issues will remain. Of course if the pricing spread between the products is close, the LSHO can be delivered to either the LSHO or HSHO delivery areas.
Sprague: Until all of the Northeast states move to a standard ultra-low sulfur heating oil of 15 ppm of sulfur (ULSHO) by July 1, 2018 to match the state of New York, there are still several heating seasons where this multi-heating fuel “patchwork” will require some strategies. First, heating oil dealers that deliver across multiple states with different sulfur specifications need to determine if they have enough delivery truck and/or storage capacity to offer different fuels in the first place. If not, the dealer may have to default to the lower sulfur fuel to be in compliance in all delivered states. The cost for low sulfur (500 ppm) and ultra-low sulfur (15 ppm) is more expensive than the traditional #2 high sulfur heating oil. Costs will be higher, and we recommend marketing the lower sulfur benefits to customers. Second, dealers who border a state with a higher sulfur specification may be at a price and potentially supply-distribution disadvantage. Dealers will need to check with their suppliers to ensure that they will be able to load the appropriate type sulfur fuels for the appropriate locations. Bottom line: Additional marketing and planning will be essential as we get through the next several years of the heating oil patchwork.
EDITOR’S NOTE: Sprague asked that the following disclaimer run with the survey.
These responses are provided for informational purposes only and are not intended as advice on any transaction nor is it a solicitation to buy or sell commodities. Sprague makes no representations or warranties with respect to the contents of such information, including, without limitation, its accuracy and completeness, and Sprague shall not be responsible for the consequence of reliance upon any opinions, statements, projections and analyses presented herein or for any omission or error in fact.
Contacting the Contributors
Aletheia Consulting Group
Phone: (954) 564-7500
Toll free: (800) 440-0472
Fax: (954) 564-7045
Wholesale Risk Manager
Cell phone: 603-785-2321
Fax: (603) 559-8793
Alan Levine, Chairman
Elaine Levin, President
David Thompson, CMT Executive Vice President
Phone: (202) 333-5380
Sprague Operating Resources LLC
Manager, Program Development
Toll Free: 800-225-1560 x205367
Yahoo! IM: krismagnusson