Hedging…It’s not just for Price Protection Programs

Since early December there has been a flurry of activity with companies still reeling from the price spikes and drops of the past two years.  In January 2010 I have consulted for six companies who are involved in the purchase, sale or reorganization of fuel businesses because they are in various stages of bankruptcy, pre-bankruptcy or liquidation to avoid bankruptcy.  The catalyst or in some instances, direct cause, has been improper hedging of price protection programs. The consequences of mismanaging the hedging of your forward sales programs cannot be understated.  Some of these companies were second and third generation businesses that had endured some of this industry’s most cataclysmic events, only to come undone by an avoidable situation.

I’m probably not telling you anything new.  The virtues of properly covering price protection programs are obvious. In addition, making sure customers have liquidated damages clauses in their contracts has also been a tough lesson for our industry. You, the marketer, simply cannot afford to take on all the risk.

I have never been a fan of price protection programs; however, I understand that they have become a part of our industry. Regardless if you offer price protection programs or not, a well managed hedge program can be a valuable and profitable tool for all fuel marketers.

Many fuel marketers have learned that variable priced customer gallons can also be hedged and additional profits can be made with little or no risk.  Not only is there little risk to hedging these gallons, but you can actually reduce the volatility while simultaneously locking in higher margins.

The futures market offers multiple opportunities and strategies that marketers can employ to enhance their margins. Recognizing which ones best suit your strategic goals is critical to capitalizing on these opportunities.  If you have a sizeable amount of storage, for example, the correct hedging strategy will allow you to lock in a significant profit that wouldn’t be there without that storage.   Let me give you an example.    The March 2010 NYMEX opened at $1.9130 on Monday, February 1 and the February 2011 NYMEX opened at $2.1122.  If you round it up 8 points for simple math, there is a 20 cent difference.  The market is in what is called a ‘carry,” or ‘contango” (higher prices in the future).

What many smart marketers will do when there is a carry in the market is buy the fuel at the rack for delivery into their bulk storage and simultaneously sell the equivalent volume on paper for delivery in the future.  In this example, the future is February 2011.  This strategy effectively locks in a minimum profit of 20 cents per gallon before their normal delivery margin.  There are some costs involved in doing this.  They need to pay for the fuel and store it until next year.  They will probably have interest expense as well.  Most banks will lend 75 ‘ 80 percent of the cost of the inventory at favorable rates.  Other financing sources will lend close to 100 percent at higher rates. Some fuel suppliers will make you a deal to use your storage.  This is the simplest method, but it typically carries the least profit.  These ‘Storage Plays” are very popular in the late spring and summer when you can borrow funds for shorter time periods.  This past year has seen the carry spread as high as 30 cents a gallon, within a period of as little as six months.

One major fuel wholesaler I spoke with told me that in some years they make more money on the carry in the market than they do selling the fuel.  This is a tool that is available to all fuel marketers who have bulk storage.  If you have bulk storage, you should be talking with someone about how you can leverage that storage and benefit when there is a carry in the market. Maintaining a bulk plant can be a large operational expense. Hedging, under the right circumstances, allows you to convert an operational expense into a revenue generating profit center.

Many fuel marketers with bulk storage prefer to have a several day supply on hand, especially in the winter months.  There is a comfort level knowing that you have fuel available to service your customers, especially if the weather makes it difficult to re-supply your bulk facility.  Having several days of supply on hand makes good sense from an operational prospective, but it can be disastrous from a financial prospective. Unhedged inventory can be incredibly costly in a volatile market.

Here’s a real life example that drives home my point. A marketer I know had a 10,000 gallon kerosene tank.  They sold 30,000 gallons a year.  They took an 8,000 gallon bulk delivery into their tank at $4.25 per gallon, the market dropped and they ended up with a $3.25 per gallon average selling price to the customers.  They lost $8,000 dollars plus the cost to deliver, defeating the purpose of having storage to begin with. It should be noted that many of the hedging companies servicing our industry can protect you from this type of situation. Having un-hedged fuel in your storage tank is a risk that can easily be covered.  You can have both product supply and security of protection from market fluctuations with a proper hedging strategy.

You don’t have to have storage to lock in better profit margins.  Most fuel marketers who have variable priced customers know that in a rising market margins get squeezed and in a falling market, margins rebound and can exceed projections.  These market fluctuations can be hedged to limit your margin squeeze and to enhance and prolong your margin expansion.

The process of locking in expanded margins while removing damaging market volatility requires a marketer to create a strategic plan to address these opportunities.  You will need to make projections for how many gallons you expect to deliver in the next few days and you need to know what your overall margin goal is at the end of the year. This is your ‘target margin” or the ‘ball” that you want to keep your eye on all season long. 

Let’s say that you are targeting 68 cents residential heating oil margins for the year.  This may mean 45 cents in September and October and 70 cents in January and February.  At some point, this past January for example, the market saw a significant price dip and the result was expanded margins well above the target margin.  If you’re keeping your eye on the ball and don’t get too greedy, you can lock in the resulting expanded margin for multiple days or weeks at a time.  This in turn will give you time to reap the extra benefits without having to adjust prices to meet competition.  Companies with automatic delivery customers will typically have a longer time to react than price sensitive COD fuel marketers, but it works for both.  This strategy helps you achieve and exceed your margin objectives.

Hedging companies servicing our industry have become so sophisticated that they can offer you hedged positions for as little as 500 gallons.  You no longer need to purchase 42,000 gallon positions.  These companies become your partner in maximizing your margins and the fees you pay are typically a small part of the benefits you receive.  Some companies will actually help you negotiate better wholesale pricing from your suppliers. There are also online tools that can track your margin trends and your hedging results with some minor data input from you. If you can’t measure it, you can’t manage it!  These programs allow you to measure the results and properly manage your margins.

Having worked with hundreds of fuel marketers, I am still not an advocate of price protection programs, but I am a huge advocate of proper hedging practices.  Our industry has become more complex in many ways. Fuel purchasing in today’s volatile markets can be risky and complicated. Many marketers think they can figure it out on their own, but I recommend that they seek professional help from companies serving our industry who specialize in hedging.  Let them help you focus on hedging so you can spend more time focusing on your customer and the other aspects of running your business.