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Hedging Today: What has Changed

By Keith Reid

Price volatility has always an issue with fuel, though starting in the mid-2000s and extending up to the last couple of years there was extraordinary volatility to go along with what had become ever-increasing prices.

The primary driver laid out in the national business media was a declining supply of conventional oil and increased demand in the developing world. Increased speculation was also credited to commodity deregulation at the end of the Clinton administration and a massive influx of non-commercial players.

But then, the breathtakingly sudden success of fracking technologies in just the past handful of years not only led to significant new supplies of natural gas but considerable new supplies of relatively inexpensive crude oil as well. Similarly, derivative reforms in The Dodd–Frank Wall Street Reform and Consumer Protection Act, passed in 2010, have driven many of the nontraditional players out of the market. Volatility settled down quickly, followed by prices that not only stabilized but collapsed when the Saudi’s kept up their production to ensure market share at the expense of price.

However, in the last six to nine months, volatility has returned, though not to the extremes that were once observed in the mid-2000s. Hedging has long been a useful, but hardly universal, tool among petroleum marketers and heating oil dealers to handle volatility.

“Dependent on individual needs within the sales and procurement process, hedging can be a helpful tool to allow distributors or marketers to secure their margins in a moving market,” said Holly DeVries, hedging manager at AMERIgreen Energy, Inc.  “Internally, it can allow distributors or marketers to buy and sell physical product at differentials to the traded market with more flexibility and security. When product is hedged it can remove the fear of market exposure if inventories are held or a time lapse occurs between purchase and sale of the physical product. In some instances, hedging with a sale can also allow for more flexibility with supply logistics and pricing arrangements.”

But, hedging does come at an added cost related to fees, and from a speculative angle it is more or less successful depending upon the nature of a market swing. The dealer business models also come into play.

“Hedging is not a one-size fits all solution,” said DeVries. There are similarities for application across the market, but it really comes down to what a distributor’s procurement and sales strategy is and what their individual goals are. It can be a helpful tool to provide market protection when partnered well with a distributor’s overall sales strategy. In regards to customer offerings, hedging can really equip distributors with a lot of helpful tools. Options, for example, can allow distributors to create cap or collar programs and even fixed-price programs without fixed supply in some procurement scenarios. These programs can help distributors to build their dedicated customer base by passing on tremendous price value and flexibility to the retail consumer.”

Hedging today

High prices have significant impact on the industry, but a dealer can get burned just as easily by $0.30 or $0.40 shift, whether the base price of fuel is $2 or $4 per gallon.

“If prices went up $0.03 per gallon per month for the next five years that would not necessarily be a volatile environment,” said Philip J. Baratz, president of Angus Energy and the managing member of Angus Partners, LLC. Angus began providing hedging services in 1991. “That might be normal and calm. As a matter of fact, if we go back to last June, nine months or so ago when prices really peaked and before they started cratering, volatility both actual and implied, which you measure when you’re figuring out what an option would cost for a price, were both at multi-year lows. The Nymex stayed in a fairly narrow range. When you have something that moves $0.10 or $0.15 either way, and it stays there for a long time, the actual volatility from that is maybe 5% of price.”

However, that has changed. And, it reinforces the traditional role of hedging but also some of the risks.

“The energy environment we’ve seen over the past year proves the value of protecting exposed product against price risk,” said DeVries. “We had been trading within a relative range from January 2011 until this heating season. This range had been dictating good buying values and creating some passivity to the need for protection on exposed productbut distributors who bought fixed priced product or contracts at what seemed like good values early last season took quite a hit as we broke that range and responded to the supply/demand fundamentals. This last year is evidence that volatility will always be present and with it can come significant risk if a dealer’s strategy includes exposed product without hedging protection.”

From a cost standpoint, this is also an excellent time to hedge.

“To my mind really nothing is changed except now you have better opportunity to offer people caps and other incentives to do business then you had before, because the cost of options has dropped so much,” said Alan Levine, CEO and chairman of the energy brokerage firm Powerhouse®. “You could recently hedge for $0.11 or $0.12 a gallon, and now you’re up to $0.17 or $0.18 range. But a few years ago you were talking $0.30.This is really a great gift to the industry but many will not take advantage of it.”

The customer

A dealer can offer a customer a range of fuel purchasing options. Each has advantages and disadvantages, depending upon how the market swings during the heating season. A dealer can look like a hero or a villain with any option if the market swings the wrong way and the customer looks for someone to blame other than himself or herself.

“The enemy is not the 1% each year that converts to gas, or the move-in/move-out, or when customers pass awaythe enemy is the other dealer that goes out and get your customer,” said Baratz. “And that then becomes you, because now to replace that customer you have to come out with a lowball price. The customer is willing to listen to other offers if he or she feels he or she is not been treated properly. And how do you make them feel they’ve been treated properly?”

Baratz noted that a dealer can typically offer three core programs: variable price (rack plus margin), fixed price or price cap. He favors a price cap program. While he readily admits that works in his favor selling options, he believes the argument easily stand so its own.

“With variable price, a customer might pay $3.80 gallon for one delivery and $2.30 a gallon on the next,” said Baratz. “There is no real risk there, but I look at risk a bit differently than conventional wisdom. You can rest assured that at some point somebody will go to that customer and say, ‘Do you really need that uncertainty? Why don’t you buy my ‘XYZ program?’ And the variable price is great when prices drop, but when they go up you do not look so good.”

The second option is a fixed price program.

“If prices go up the customer is happy, but no one is ever going to call the dealer and thank them,” he said. “But if prices go down, you have the winter of 2014/15 where the blame game starts. And somebody is going to go to the customer and say, ‘You locked in at $4 per gallon? Didn’t you read the news? Didn’t your dealer tell you that the U.S. just surpassed Saudi Arabia as the largest producer of crude oil? Didn’t he know? Buy from meI would never do that!”

While Baratz noted that the price cap option will never be the winner, it will never be the loser either. The dealer and the customer are protected if prices move higher as with a fixed price program. If prices plummet, the dealer can drop prices as with a variable price approach. The issue becomes selling the customer on supporting the fees by charging, say, $20 per month to cover the option costs.

Baratz stated this can be addressed successfully by the dealer though an open and honest discussion on what the fees are for and what they provide. The customer might spend $200 in fees, but they never end up leaving a huge sum on the table.

Affordable Fuels, based in Middleburg, Pa., takes advantage of hedging but so far, primarily uses it for fixed price contracts. And it faced limited blowback with the recent price collapse.

“We have not had the problems others have had, perhaps because we are very cautious with our customers,” said Arden Steiner, Affordable’s general manager. “We are careful not to oversell the benefits or make promises or even imply things that you cannot be certain about. As a result, we don’t really have any angry customers.”

As part of that cautious approach, Affordable is currently backing off of fixed price contracts with its customers because Stenier feels the market is not right today for the company’s and customer’s mutual benefit.

On the variable price side, Affordable Fuels offers “spot deals” on 10-day terms and the company has significantly expanded its supplier base to get the best deals at the rack on a given day. While there is notable market volatility, Steiner pointed out that that volatility can be even more severe at the rack. “This is the first time in 12 years that my spread on No. 2 heating oil at the rack is $0.18 between suppliers,” he said. “That’s more than the margin on some of my high-volume customers. If we didn’t diversify as much as we have we could really be in trouble.”

Additional information is available at www.amerigreen.com.

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