Where Did All The Heating Oil Go?

by Adam Larkin

When New York State made the bold and relatively early move to replace traditional #2 heating oil with Ultra Low Sulfur Diesel, many thought it was the best news they ever heard.  Beyond the obvious environmental implications, most dealers in New England and beyond believed it would suddenly free up one third of all the heating oil used in the Northeast.  Yes, New York accounted for roughly one third of total #2 heating oil demand.  The result would be ample supply and lower cash market prices.  Not exactly.

 The dream of an oversupplied market has quickly been replaced by talk of outright product shortages and “basis blowout”.  The latter is a term on everyone’s lips this season and one that provokes awful memories of other years where stories of basis spikes were worthy of telling the grandchildren.  Thankfully, it is not an event that happens regularly in our industry but, in an odd way, this only adds to the mystery and fear.

 First, a quick refresher.  What exactly is basis?  Basis is simply the difference between the NYMEX price on any given day and the actual cash price at your supply point.  If the NYMEX is $2.98 and your local wholesaler rack posting is $3.08, then basis is $.10 per gallon.  Basis is also the most accurate and perhaps only remaining true indicator of supply and demand.  This is a crucial yet often overlooked fact in an industry obsessed with absolute product price which often decouples, quite literally, from fundamental supply and demand forces in lieu of pure trading related activity.  Hence, basis flexes constantly as supply adjusts for weather driven demand cycles, market conditions, and transportation logistics.

 So why does basis “blow out”?  The dynamics for this phenomenon are fairly simple at a high level.  Since basis is reflective of supply and demand, it blows out when supply is tight.  This happens when there is inadequate supply to meet normal demand or demand is excessive and outruns normal supply quantities.  A few examples would be extreme and enduring cold weather, harbors freezing over preventing barges from entering, or disruptions on a pipeline.  Basis blow outs can be localized, such as frozen harbors, where a specific market is affected.  Or, they can be systemic where there is a supply chain wide problem that impacts everyone.  Imagine a supply that is 40% (yes 40%!), below a 5 year average for instance, in a region historically dominated by heating oil for residential use.  Sound impossible?  Welcome to 2012-2013 in the Northeast.

 Where did all the heating oil go?  How can a region so entrenched in the use of heating oil suddenly find itself in a supply crunch of such significance?  After 60 years, we should have a good handle on how much we need right?  And what happened to all the oil that used to go to NY State?

 Ah, if answers were only simple.  Let’s start by stating that no one is to blame.  It really is a constellation of various factors converging in a moment in time, a couple of which are particularly noteworthy.  Refiners are in the business to make money and if NY wants to evaporate one third of the demand, then there are not compelling reasons to overproduce.  In addition, we are still dealing with the refinery issues, shut downs and retooling, that have plagued us for two years.  In short, supply was already tight to begin with last season and we were only “saved” by warm weather.  This led to us entering late summer 2012 already far behind the proverbial eight ball.  A tight supply outlook leads to a lovely condition called backwardation in which the near months are more expensive than future months in a domino pattern that tilts the entire curve downhill.  That is what we saw over the summer and fall.  Suppliers therefore have no reason to buy and store oil even for short periods.  Why should they take possession of a product that is a depreciating asset?

 This leaves dealers and consumers to fight for supply.  The result is spikes in basis that reflect conditions where supply cannot meet demand.  The ingredients are in place this year for a serious problem although probably not one of historic precedent.  Think more about basis being volatile in bursts than long duration.  But, if it is super cold, well, all bets are off.

 Dealers need to assess their dimensions of risk now.  First, if you used call options to cover cap programs, then you should certainly be investigating fixed diff wet product contracts to protect margins since calls do not account for real world basis.  Secondly, many dealers are buying these same fixed diff contracts for their rack to retail business in an effort to gain competitive advantage should basis blow out.  In theory, they will be locked low while others have to ride the basis up.  For all, the most crucial period to plan around will be January through March.

 Most importantly, don’t forget your customers.  Prepare your staff to deal with questions surrounding prices should basis spike and absolute NYMEX prices that a consumer can find remain static.  In the end, remember that consumers bear the burden of basis blow out since it flows right down the supply chain to their fill pipe and checkbook.

The information provided in this article is general market commentary provided solely for educational and informational purposes.  The information was obtained from sources believed to be reliable, but we do not guarantee its accuracy.  No statement within this article should be construed as a recommendation, solicitation or offer to buy or sell any futures or options on futures or to otherwise provide investment advice.  Any use of the information provided in this article is at your own risk.

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