Price Protection: Have We Learned Our Lesson?

I hope after the experiences of the last few years we are all better schooled on price protection programs. But the big question that must be asked is ‘Do petroleum marketers need to offer price protection programs?”

Price protection programs were originally conceived to protect the customer from price spikes, while at the same time insuring a profitable margin for marketers.  Unfortunately for most customers and petroleum marketers, they have done neither. There is now a track record of cases where marketers have lost their business because they could not resist the temptation of speculation.  Other marketers thought they were protected, but never saw their expected results because of unexpected market fluctuations and weather variances. 

The typical answer from petroleum marketers is ‘Everyone else has a program, so I need one, too.” I can tell you from first-hand experience that not everyone else has price protection programs, and you don’t need to have one.  Let me give you two examples in two different marketing areas.  The first company is Seaboard Oil Co. in New Haven, Conn. The Bussmann family decided that they would not offer price protection programs.  The company thrived in the heart of an area where everyone else was doing it.  When the family made the decision to sell Seaboard, the company’s value was dramatically increased because it was not strapped to very competitive pricing as a result of price protection.  The other example is Kelley Energy in Philadelphia.  The Duffey family, who owned Kelley, chose not to offer price protection.  They decided instead to concentrate on their HVAC business.  They grew the oil business without price programs and expanded the company to include non-oil related customers.

I have had the unique experience of interacting with hundreds of fuel companies.  I can tell in the first minute of a conversation if a company is involved in price protection programs because the first subjects that come up are the price of oil, frustration over the market and rationalization that the future may be better if something happens and something else doesn’t happen, etc.  Some examples of what I hear:

‘The market fundamentals aren’t working.”
‘China is driving demand.” 
‘There is an OPEC meeting this week; I hope they don’t cut production.” 
‘They say if the economy continues to slow in the fourth quarter that we may see a softer market, but we may not see the level of price reductions because there may be a firming up of the refinery margins because the crack spreads are too low on gasoline even though foreign diesel demand is keeping the distillate market up”
‘My competition does not know what they are doing, their fix price program is so much lower than mine.” 

If you talk like this, then you are a market junkie.  Your focus is on the market because the market drives your business and can drive you half crazy.

I spoke with a company recently and the owner told me that service contract revenue was off because people are short on money and are canceling service contracts.  He went on to tell me how he has tightened up on credit terms to reduce bad debt, changed credit card vendors to get a better rate and is considering flat rate billing for service. He never spoke about the market, so I asked him how it was going with his price protected customers.  He told me that he tried that once and got burned so he stopped doing it.  I asked if he lost customers when he stopped, and he said ‘Sure, but who needs those customers?”  He said that he has grown his business by over 5 percent a year for the last three years without price protection programs.  It’s obvious to me why.  His focus is on his business and not the market.  He was all over it.  His drivers were productive, he was making money on service and he took time to talk with his customers about what is truly important to them’good quality service of their homes’ heating and cooling systems.

So far I have not encountered one company that makes a larger profit margin on a price protected customer than they do on a non-price protected customer.  As a matter of fact, the non-price protected customer typically foots the bill for the price protected customer.  This is particularly true with a capped program in a down market.  Something has to make up for that 40 cent call option or the 50 cents out of the money put that was purchased to cover the cap.  Just look at your competitors in a down market.  February 2007 and December 2008 were both great examples.  Rack to retail (posted price) margins were very strong due to falling prices.  In most cases they needed to be in order to make up for losses on price protected gallons. 

Hedging companies that have programs to help petroleum marketers cover price protection programs will tell you that if you do not hedge your price protected sales, then you are speculating.  While I agree with the concept, I contend that you cannot hedge perfectly, it is impossible, so if you sell price protection programs, to some degree, you are gambling.  All hedging programs I have seen are based on a customer’s projected usage based on the weather.  What happens if January is 30 percent colder than normal or 30 percent warmer than normal?  In these circumstances, you are under covered or over covered, and thus, you are exposed to unexpected losses. Weather insurance or derivatives can reduce this risk, but it is expensive and still will not provide you with complete protection.

In April of 2007 I debated the subject at the Atlantic Region Energy Expo.  My opponent made a comment to the audience saying that we had to think about our customers.  He asked the audience what would happen to our customers if they had to pay $4 a gallon.  How could we expect our customers to pay for fuel at those levels he asked?  Little did anyone at the conference know that this seemingly outrageous statement would become a reality?  Now we have the answer to the question.  The customer was not protected against the high costs and when the costs came down, many wanted out of their contracts, leaving the petroleum marketer with upset customers, lower profits and a public relations nightmare.  Even the customers on cap prices who saw their prices go down are questioning why many other companies are charging substantially less than they are paying. After all, they were told that they had the best of both worlds and if the market came down, their price would come down with the market.  But they forgot to ask by how much.

So what can a petroleum marketer do to get away from price protection programs?  I think there are two possibilities.  Either stop offering programs completely or gradually move customers away from them.  With both approaches the first step is to talk to your employees and explain why you are changing your approach.  The next step is to focus on the value your company offers to your customers (Your Value Proposition). Customers are not all price shoppers.  Past focus groups have found that the customer values:

Reliability of Service
Assured Supply
Pleasant Employees
Quick Response Time
Easy Billing
Financially Stable Company
Price of Fuel and Services

If you just cannot bring yourself to cut programs out completely, then let me make some recommendations.  First, if you have a sales person or persons, pay them less for a price-protected customer.  You make less on price protected customers, so those customers are not worth as much and your sales person should make less.  The results will be astonishing.

The other effective method is to make the customer default decision to be on a market price. In other words, if the customer does not actively ask to be on a price protected program, leave them on a market price.  If they want a program, have them call the office to discuss it.  Train your staff on the reasons why it is better in the long run for the customer to be on a floating price.  Train your employees to explain why a cap program is not always in their best interest.  Explain how competitors have a proven track record of not coming down equally with the market.  Another suggestion would be to incentivize your employees.  Set a company goal in reducing the number of customers on price protection.  Give prizes or monetary compensation if the company makes its goals.

Price protection was a great thought when it was introduced to our industry, offering insurance against price spikes to the customer and a fair margin to the retailer, but now that we have a track record on the adverse effects on both margin and risk, I encourage you to refocus your business and our industry on providing quality service to your customers at a reasonable price.  That is what customers really want.