Market Options
Feature Story
A look at the various tools a fuel oil marketer can apply to reduce fuel price risk
By Mike Corley
As I write this article, crude oil is trading around $72 and has traded as high as $78.70 in recent weeks. By the time you read this column, crude could very well be trading at $80 or $60 ‘ it’s pretty easy to make a strong argument for both higher and lower prices.� Will heating oil futures rise to $2.50 this winter, or will an economic downturn force prices back to the $1.50 range?� News and events that used to lead to a one or two cent move in heating oil can now cause prices to move 10 cents in a single day.�
As we approach another heating season, it’s a good time to review the various instruments, beginning with the basics, which are available to heating oil and diesel marketers. Regardless of market conditions, there is almost always a tool(s) that can be used to mitigate your exposure to volatile prices and stabilize, and in many cases increase, your margins.
Futures – A futures contract is an agreement to purchase or sell fuel for delivery in the future: (1) at a price that is determined at the time the contract is executed; (2) that obligates each party to the contract to fulfill the contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied by delivery or offset by selling the contract prior to expiration.� Energy futures are traded on the NYMEX and ICE.
In the heating oil and fuel business, futures are often used to hedge a fixed price sale to a customer(s).� As an example, let’s assume that ABC Oil has a customer that wants to fix the price of their anticipated heating oil and off-road diesel needs for the following six months, which happens to equal 42,000 gallons per month.� In order to mitigate the risk associated with selling the customer 42,000 gallons per month at a fixed price, ABC calls its futures broker and has the broker buy one heating oil contract (42,000 gallons) for each of the following six months.� If the price of the futures rise during the time the futures were purchased and the time the gallons are delivered, ABC will sell the futures contracts and its account will be credited with the amount of the gain, which will offset higher priced purchases at the rack and vice versa.
Forward contracts ‘ “Cash” transactions in which a buyer and seller agree upon delivery of a specified quality and quantity of fuel at a specified future date. Terms may be more “personalized” than is the case with standardized futures contracts (i.e., delivery time and amount are as determined between seller and buyer). A price may be agreed upon in advance, or there may be agreement that the price will be determined at the time of delivery.� Forward contracts are the most common fixed price contracts employed by suppliers and their retail and wholesale customers. �
As an example, let’s assume a similar situation as the futures example: ABC Oil has a customer that wants to lock in fix the price of their anticipated heating needs for the following six months, again 42,000 gallons per month.� However, this time ABC wants to use a forward contract to hedge this sale, so rather than calling the broker they call the supplier who quotes them a forward contract based on the NYMEX plus a differential.
Differentials – The premium or discount allowed for quality and/or locations of fuel, which is different than the par basis quality and location specified in the futures contact.� In the case of heating oil futures, the standard quality is greater than 500 PPM sulfur and the delivery location is New York Harbor.� As an example, let’s say Smith Oil is located in Albany and needs to hedge a year around fixed price heating oil sale, 42,000 gallons per month, to one of its customers. But none of its suppliers offer forward contracts so to hedge its exposure Smith buys a futures contract for each of the following twelve months and locks in the differential with its supplier, which is quoted as a basis to NYMEX heating oil futures ‘ let’s say five cents. This amount is essentially the cost of transportation from New York Harbor to Albany plus the supplier’s profit margin. In this case, Smith Oil has committed to lift 42,000 gallons from its supplier for each of the following twelve months, for which Smith will be invoiced based on the price of the prompt month NYMEX heating oil futures plus five cents.� Fixed differentials can also be used to protect against basis “blowouts” due to regional supply disruptions and/or price spikes.
Swaps ‘ Swaps involve the exchange of cash flows based on the changing prices of fuel, generally an exchange of a fixed price for a floating price or vice versa.� Swaps are generally financial transactions and do not involve the purchase or sale of physical fuel.� As an example, let’s assume that Johnson Oil makes a fixed price ULSD sale to one of its customers for the following three months. Let’s also assume that Johnson and its customer are located in Chicago, quite a distance from New York Harbor, which means a large potential for basis risk, not only because of the distance between Chicago and New York Harbor, but the basis risk between ULSD and heating oil.� Let’s also assume that Johnson can’t buy a forward contract from any of its suppliers. In this case, Johnson calls an over-the-counter broker and arranges to buy a ULSD swap, from a swap dealer, for the following three months based on the Chicago ULSD index.� If the price of the swap rises during the time the swap was purchased and the time the gallons are delivered (which will also be the time the swap expires), Johnson will receive a payment for the difference between the fixed price and the settlement price of the Chicago ULSD index, which will offset higher priced purchases at the rack. On the other hand, if prices decline during the time the swap was purchased and the time the gallons are delivered, Johnson will owe the dealer the difference the fixed price and the settlement price of the Chicago ULSD index, so while Johnson will be paying less at the rack, they will also be sending a payment to the swap dealer, which will offset the lower priced purchases at the rack.
Options – An option contract that gives the holder of the option the right, but not the obligation, to buy (or sell) a certain quantity of the underlying product from the seller of the option at a specified price (the strike price) up to a specified date (the expiration date).� As an example, let’s assume that Johnson Oil sold one of its customers a capped price on ULSD for the following month. In order to hedge its capped price sale, Johnson calls an over-the-counter broker and arranges to buy a ULSD call option for the following month based on the Chicago ULSD index and for this right; Johnson pays the option dealer an upfront premium.� If the Chicago ULSD index rises during the time the option was purchased and expiration, Johnson can call the swap dealer and exercise the option. Doing this will require the option dealer to send Johnson a payment for the difference between the strike price of the option and the current price of the Chicago ULSD index. This payment will offset Johnson’s higher priced purchases at the rack. If the Chicago ULSD index declines during the time that the option was purchased and expiration, Johnson will not receive a payment from the option dealer, but it will benefit from declining prices by being able to purchase the lower price product at the rack, which, in turn, will allow them to pass on the lower price to their customer.
As this article only covers the basics of the various hedging tools available to heating oil and diesel marketers, there are numerous hedging tools and strategies available to the industry that cannot only mitigate the marketer’s exposure to volatile energy prices, but just as, if not more, importantly, can stabilize and in some cases improve profit margins. Having said that, no two marketers are the same and significant due diligence must be performed before entering into any hedging positions, as employing a “cookie cutter” approach to hedging can prove to have as much of a negative impact on margins as pure speculation.
Mike Corley leads Asset Risk Management’s refined products risk management group. Prior to joining Asset Risk Management, Mike spent several years at Hedge Solutions where he served as an energy risk management consultant to refined product retailers and wholesalers.� Previously, he was an independent energy trader, during which time he traded crude oil, gasoline, heating oil and natural gas. Prior to becoming an independent trader, Mike was a natural gas derivatives broker with Cantor Fitzgerald. He began his career at El Paso Merchant Energy where he held various positions in trading, scheduling and quantitative analysis, covering crude oil, electricity, natural gas, natural gas liquids and refined products. For more information, please contact Mike Corley at 832-433-7289 or info@asset-risk.com.
