‘In traffic engineering, guardrails prevent vehicles from veering off the roadway into oncoming traffic, crashing against solid objects or falling into a ravine.” Wikipedia Reference
Don’t you wish you could build guardrails that keep your company’s profits from crashing and falling? In the heating oil business the number one threat to your sales volume and profits is weather.
The standard deviation from one heating season to the next is about 10 percent, but more importantly the deviations from month to month within the heating season are in the 22 percent range. This means that warm weather in one month has the potential to materially reduce your sales and profits, especially if that month is January.
Like the traffic engineers, many dealers are now building their own ‘guardrails” to protect sales volumes and profits from veering off the company’s financial plan and crashing and falling into red ink. These dealers are implementing weather risk management programs that lock in levels of earnings that allow their companies to meet financial objectives regardless of how warm it gets.
How do they do this and why is this becoming more necessary?
Let’s start with the why. Volatility is the enemy of a fuel dealer. We all know what volatile heating oil prices have done to margins over recent heating seasons, and when you couple this with warm weather like we had in March, it spells trouble.
Swings in profitability were part and parcel of being in the heating oil business. However, bring on the recent banking crisis and the recession and dealers now see that there is very little tolerance from banks and suppliers for poor financial performance. Not a week goes by in which I am contacted by a dealer who has just learned that the bank and/or supplier has reduced credit because of swings in financial performance. The main reason is poor and inconsistent profitability.
The need for a heating oil dealer to generate a steady stream of earnings regardless of weather and commodity price volatility is now the new reality of the heating oil business. This is why more dealers are locking in a range of profitability that meets bank covenants, supplier requirements and other objectives.
Now let’s see how dealers do this. First we must be clear that protecting your company’s earnings from weather volatility is different from hedging your commodity costs (which also have a weather component if done properly). What we are protecting is a level of profitability that is at risk because warm weather results in lost sales.
This is where the analogy of roadside guardrails comes in. A proper earnings protection program establishes a limit to how bad things can get. We will work with a dealer to determine how much profit is directly related to a heating degree day. Then we will look at the company’s cost structure to determine what level of costs is fixed and variable. We can then calculate the impact variances in heating degree days will have on the company’s profitability.
Now that we know how much profit levels can fluctuate due to weather, we then work with the dealer to determine the objective for the earnings protection program. For example, a company may have financial covenants tied to a bank loan and we must insure that regardless of the weather the company maintains a level of cash flow sufficient to satisfy the covenants.
Another example is the owner of a company is doing estate planning. The owner has to make recurring payments into various investments. We can match these payment requirements to a level of earnings. The owner can now execute the estate plan free from worry knowing the payments will be made regardless of the weather impact on the company’s earnings.
Earnings protection programs establish a minimum level of profitability by assigning a profit value to a heating degree day and then establish a ‘strike” if heating degree days falls below a certain number. That number or ‘strike” is determined by the objective of the program. Using the first example mentioned earlier, it was determined that weather would have to be 12 percent warmer than normal for the loan covenants to be tripped.
So the ‘strike” was set to equal the number of heating degree days that was 12 percent warmer than normal. In this way the company’s earnings and cash flow would always be at levels in compliance with covenants.
While this structure requires an upfront fee, another common method eliminates the fee but does limit the amount of profits when weather is cold. This approach commonly called a ‘collar” and protects the company’s earnings when weather is warm but limits profits when weather is cold.
A common collar structure, using the case described above, protects the company when weather is warm but requires the company to give back incremental profits when weather is 10 percent colder than normal. So just like the guardrails on the highway, this company’s profits will always fall within the range between 12 percent warmer and 10 percent colder than normal. This achieves the level of consistency that the owner, supplier and bank are looking for.
There still are many uncertainties and risks to your heating oil business but weather and its impact on your company’s profits can be now be managed affordably though these earnings protection programs. I would encourage you to learn more about your options to deliver more consistent profits.
About the Author:
Matthew Ide is the managing director of the Energy Advisory & Finance Group at RenRe Energy Advisors Ltd. (REAL). REAL engages in a variety of non-insurance businesses centered on the weather and financial markets, with a particular focus on weather-centric commodity price risk. The company supports the fuel distribution industry with an array of products, including risk management solutions and customized financial advisory and capital solutions directed to the retail fuel distribution industry. REAL is a wholly-owned subsidiary of RenaissanceRe Holding Ltd. (NYSE: RNR), a global provider of reinsurance and insurance.