To Hedge or Not to Hedge
By Keith Reid
Hedging is a time-honored risk management solution that is applied to a broad range of commodities and financial instruments. It’s main purpose is to mitigate volatility and protect margin by providing some certainty in what are uncertain markets. In the airline industry, the practice offered some carriers, such as Southwest Airlines, significant advantages in the high volatility markets of recent years. Hedging is similarly commonplace for heating oil marketers, but it is certainly not a universal practice.
So, just who should be hedging, and under what circumstances? Fuel Oil News spoke with some hedging experts for their feedback on the subject.
“There is never a need to hedge,” said Phil Baratz, CTA, who he co-founded Angus Energy in 1991 and is the managing member of Angus Partners, LLC. “A hedge is always a choice. You are attempting to remain competitive.”
The point Baratz raised, and that were echoed generally by the others interviewed, is that the hedging decision should work as a component of an overall business model. It should be seen as a margin support tool and one that further allows a dealer to broaden pricing options to his or her customers.
“If you look in the airline industry there are some that do and some that don’t hedge it all,” said Mark Skaparas, owner of Aletheia Consulting Group. “There is no blanket answer that everyone should hedge all the time—I disagree with that. What it really comes down to is what are you trying to accomplish with your company, what type of emergency reserve you have to withstand a substantial move in the market against you and what type of programs you offer.”
Speculation: Hedging or not hedging?
While hedging in its pure form is a tool to reduce the impact of volatility in the markets some use it as a tool to speculate. And, some degree of speculation allows the markets to function. However, it can easily be argued that not hedging is just as open to speculation.
“You’re either hedging or speculating. There is no in between,” said Baratz. “I’m not saying it’s a bad idea to speculate—who am I to tell somebody what to do with their business? But the notion that hedging is good or bad is inaccurate. It comes back to the correct mindset of a business. In 25 years of business we’ve never told someone that they have to hedge. Because, if you don’t hedge and you’ve chosen to speculate that’s fine. You just have to understand it. You can choose to make a promise to your customer and you think prices are going to go down. You can choose to buy refurbished equipment instead of new equipment, but something might happen. You can choose to not buy a new truck as the old truck is starting to wear down. You can choose not to ensure your current truck for theft. You can choose a lot of things and I’m not saying they are good or bad.”
Baratz expanded on the insurance analogy. “When was the last time an oil truck was stolen? It does happen, but I’m going to save $500 per truck and on my 20 trucks I’m going to save $10,000 a year, which is good money for me.” He said. “How do you argue with that? Except that if it is stolen it’ll cost you $100,000 to replace.”
Rich Larkin, president of Hedge Solutions, discussed how using hedging as a tool for speculating not only misses the boat, but can be disastrous. “An interesting piece of data that came out last year from Cetane’s Steve Abbate, is that in talking to his colleagues in the industry the No. 1 reason companies were liquidating was poor hedging,” he said. “That was a mind blower to me, but I’ve seen it. Either they got caught buying too much and the price went down, or not buying enough and the price went up. It’s a tool for managing your margin, but it’s not a tool, in my view at least, to speculate. I always tell the clients if you think you’ve got it figured out there are a lot of folks out there that do this for a living every day, and they’re lucky if they squeeze 10% out of it.”
For all of the hysteria generated by the California Gold Rush—it generated the largest mass migration in U.S. history—it’s useful to remember where the real money was made. Some prospectors, speculating on making that big claim, did very well for themselves, some broke even but most busted out. The real fortunes were made far more traditionally by the merchants, including, most famously, Levi Strauss.
“The brain cells that are wasted relative to what the markets going to do relative to the brain cells that should be used to figure out how to run a business better is my pet peeve,” said Baratz.
Relative Risks
In general, the risk and margin factors that would drive a hedging decision are based upon the price program strategy a company offers its customers: rack plus, fixed price and price cap.
With rack plus, the necessity to hedge is reduced as long as that competitive issues are relatively equal.
“If you haven’t made any promises to your customers, and your customers aren’t going anywhere and you’re making your full margin you don’t really care that prices went up,” Baratz said. “But if it went up and you made a promise—if you didn’t back up that promise maybe it’s coming out your margin.”
Hedging is seen as an almost absolute requirement with flat price programs and price cap programs.
“If you offer up fixed-price or a price cap you absolutely have to hedge, because I’ve seen companies go out of business as the market moved against them and they didn’t have the ability to back up that offering to their customers,” said Skaparas. “In some states, if you offer pre-buy you have to have 75% of that bonded.”
While heating oil might be calming down somewhat compared to the sudden and significant moves common before fracking oil production gluts, the Saudi price war and the recent derivatives reforms, the same cannot be said for propane, noted Larkin. “The one place I do see the participation of hedging activity going up quite a bit is and propane,” he said. “Propane is more volatile than it’s ever been. It used to be nice and stable, and you would barely see the price move throughout the year. They are generally following the same path that oil did from the 1980s into the early 2000s when the Merc got introduced and oil became a commodity.”
Intimidation Factor
Some resistance to hedging, or exploring the options that might be available, undoubtedly involves how intimidating the commodities markets and the risk mitigation tools and strategies can be to those unfamiliar.
“I think smaller dealers sometimes get intimidated by the topic itself, but in reality it’s not that complicated,” Larkin said. “I always compare things to the farming industry—right down to the small farmer who hedges his crop every year.”
Larkin noted that there are a range of educational opportunities open to those in the industry to get a firmer grasp on hedging and how it can be applied to a company’s business model. “There are seminars out there—we put them on as well as others,” he said. “You can go online, you can get your feet wet fairly easy. Obviously I’m a bit biased, and I think hiring somebody like us as a consultant to walk through the process is a really good way to go about it.”
Larkin noted that when he started his business 20 years ago, he figured that once the customer learned the basics their need for a consultant would drop off. “In fact, it’s worked out quite the opposite—having somebody as an advocate all the time seems to be very helpful,” he said. “But I don’t believe the concepts are that hard to learn, and once somebody gets it it’s not than intimidating.”
Nor does a company have to fully commit to hedging right away to explore the concepts, and certainly not for 100% of its gallons at any point.
“You don’t have to hedge 100% of the gallons by any means—nobody does,” Larkin said. “And with today’s products you don’t have to work in those 42,000 gallon contract increments, which I think a lot of smaller dealers might be afraid of. We can hedge 20,000 gallons over a year. The volume component doesn’t kick someone out of the opportunity.”
Skaparas noted that a 100% rack plus company doing, say, 500,000 gallons of business might start with 5,000 gallons to see how it works. “I always tell people do some small trades so you get used to the paperwork and get comfortable,” he said. “You can go to all the seminars in the world but until you actually wire some money over and get confirmation—that is the real deal. It’s remarkable how quickly you learned in that environment when dollars are on the line.”
Integrating Hedging Into Company Operations
Al Levine, Powerhouse
Energy futures have been around since 1978. Since then, many oil companies have embraced energy price risk management through hedging. Hedging is a way to protect the value of inventory or take advantage of attractive prices in future months. Hedging is not a way to get rich quick. Many oil men understand this; many more do not.
One obstacle for those who do not understand hedging is how to integrate hedging into company operations. Before this question can be answered, however, the dealer has to determine his risk.
Identifying Risk
Risk to the dealer depends on how the business is done. If the dealer buys at the rack, marks the oil up and resells it, he has no price risk and no need to hedge. He also relies on the market for business; he is a passive market participant.
There are other risk profiles as well. Dealers may wish to sell oil at a fixed price. The dealer pre-buys oil from a supplier or using a futures contract. This assures that higher prices will not harm his position. If prices fall the customer remains obligated to pay the fixed price. If prices fall, there is a risk that customers could object to their deal. There is a hedging solution to meet this risk.
Those who store product face a different risk, which is prices falling before the oil is sold. This risk has historically dissuaded many dealers from using their storage.
Identifying Opportunity
These are three risk profiles that illustrate the basis question the dealer must answer: What is my risk of prices moving against my position? Once the direction of risk is known, it is possible to construct a risk management profile and identify new opportunities.
The passive market participant goes with the market. He accepts the status quo, but cannot take advantage of market change to grow the business. He foregoes the opportunity to sell at fixed or capped prices.
Selling at fixed price using futures instruments to protect against market weakness allows sales to be made with greater safety to the dealer.
In the current environment, the price of ULSD for (say) next February is about 23 cents higher than currently. A dealer who filled storage now could sell that oil at a future date and collect the difference as time passed.
Three different profiles offer different opportunities to grow volume or buy oil cheaply and sell at a high for future delivery. Identifying the opportunity allows a proper strategy to be developed.
Implementing the Hedge
The decision to use hedging as a tool of business growth and protection brings into play several important factors.
- Find competent advisory help
A hedger that uses futures or options on futures must establish a commodities account. The brokerage house should have energy industry specialists with the skills needed to establish a hedging strategy. Be aware that there are many brokers that do not specialize in energy. The energy specialization is in addition to the broker’s primary task of executing the order and ensuring it is reflected correctly on the company books.
- Determine how much is to be hedged
It’s important to match the actual market exposure with how much to hedge. If the dealer is offering a pre-paid or fixed price program, make sure the futures hedge is about the same as the dealer’s exposure. Similarly, oil in storage should be hedged as closely as possible. A mismatch between actual oil price exposure and futures could lead to losses. Here, too, your commodities advisor or broker can be very helpful.
- Establish an internal tracking system
Balancing wet barrel and futures positions is central for management control. The hedger needs a system to ensure this balance. Satisfactory commercial systems have not been easy to find. Most hedgers have relied on simple spread sheets to track their positions.
Dealers that adopt hedging often find that following the hedge yields benefits well beyond price risk management. For many, it is the first time they have dealt with inventory and forward commitments in any detail. For others, the ability to hedge allows them to expand marketing opportunities with financial safety.