How to Hedge for Next Season

If you’re like a lot of oil companies out there, you’ve spent the past three months watching oil prices plummet while wondering whether you should be hedging now in anticipation of your cap or fixed price offerings, writes Richard Larkin. You may even have entertained just buying some product at a fixed price from your wholesaler since prices look so darn low!

“That’s called speculating and is a really bad idea,” Larkin says. Read on for Larkin’s advice on how to hedge for next season:

History is littered with stories of failed heating oil companies that thought they could predict oil prices and laid down big bets. This fact should prove to be an adequate deterrent for betting your company on oil price direction. I’ve often lamented that we probably spend more time and effort talking a client out of jumping into the market than we do getting in. 

At my company we prefer to be opportunistic over short windows that capture great margins with no risk. But that’s an article for another time. Here I want to focus on hedging for next heating season.

Structure and discipline are critical to hedging successfully. I have preached this ad nauseum. It never ceases to surprise me when I interview with a potential new client to find out they have absolutely no plan or process in place for hedging the cap or pre-buy program they’re about to launch. Sticking one’s finger into the air and checking which way the wind is blowing does not constitute a plan. Yet that’s how many companies go about it. What is frustrating to an advocate for structure like me is that most of the time they get away with it. This encourages bad practices. That’s because the averages usually will cover most of the mistakes, particularly when buying over a period of several months. That doesn’t mean you’ve done well. Most cover their mistakes by blending in an ugly purchase and burying it in the rack-to-retail pool.

Making these decisions is lonely. And if you don’t have a plan you typically are not going to do well. Having a process will dramatically increase your chances to be successful. I define success as getting your program launched and sold at the target margin you need to make a profit.  

Here are four key elements that you should incorporate right away:

  • Timing: When are you going to make the offer to your customers?
  • Price: Is the market price allowing you to make the offer at the desired margin?
  • Strategy: How are you going to hedge? Are you going to buy wet barrels? Options? Both?
  • Execution: When, how much, and how often?

Timingand price don’t always cooperate with each other. Sometimes the price is right but it’s too early to make the offer. Alternatively, you might be under pressure to get an offer in place but the price is not giving you the margin you want. If you don’t work this out you can get into trouble.

Strategy is where lots of money gets left on the table. In other words, your margin could be a lot better if you understood how strategy impacts your cost. This subtle but really important component can have a huge impact on not only the price itself, but the premiums spent on hedging.

The execution is where so many fall short and have problems. And it’s always the same cause; a lack of planning and discipline.

We use a program called Lodestar. It’s a fancy name for the mapping out of how we are going to execute. Lodestar breaks down our buying decisions into weekly increments and instructs us on what exactly the hedge is for that week. It also maps the pattern for scaling in and updates our cost of sales as we execute. This discipline keeps us focused on the goal of hedging what we sell and reaching our target margin.

Finally, you should have a forward-looking profit and loss that accounts for how the program performs. I’m not talking about your internal financial report that shows how you did after the fact. You want to view your sales as they apply to your hedging before you deliver a single gallon. We use a program called Hedge Insite. We simply enter our sales and hedges and the software produces a graph showing exactly where our margin is, based on multiple iterations of price movement. Importantly, this is before you deliver the oil. – Richard Larkin

Richard Larkin, founder and president of Hedge Solutions, Inc., can be emailed at rlarkin@hedgesolutions.com. Hedge Solutions’ website is www.hedgesolutions.com. Larkin also founded Northland Energy Trading, which provides customized hedging products, and he created Hedge Insite, hedging software for fuel oil and propane companies.

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