by Richard Larkin, President, Hedge Solutions
There has been, appropriately, much discussion about the recent, so-called Black Swan event, the coronavirus. I’ve witnessed the term Black Swan often inserted where it doesn’t belong. The term is not listed in the Merriam Webster Dictionary, but Investopedia defines it as this: an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, their severe impact, and the practice of explaining widespread failure to predict them as simple folly in hindsight.
OK, though we’ve had pandemics in the past, this one is shaping up to be a doozy! The “severe consequences” are obvious. The virus is killing people at a significant rate, which is tragic. But since the term Black Swan is aimed more at the financial community, let’s take a look at it. The theory behind the virus’s impact to global economics is that it is compelling humans around the globe to become shut in, thereby stunting economic activity. Besides the required two-week quarantine for those who become infected, the contagion anxiety is driving people out of the public square. That means they’re not flying, shopping, traveling, or going to any kind of public events or gatherings. Money is not being spent! That’s bad for the economy. But the most significant effect at this point of writing is fear. Fear of the unknown. How quickly and how extreme will the virus become? Whenever fear and the unknown come together, there is usually an over-reaction.
The virus has rocked financial and commodity markets. That’s where the Black Swan label is applied here. The markets rely heavily on data, particularly historical data, to make assumptions about price. And though the global financial community has other pandemics to look back on, the coronavirus has been lopped into a class of its own apparently. Until there is more data and more information in general, the markets will continue its march through a highly volatile alleyway.
What does this mean for your hedging and purchasing of the oil? Whenever there is “panic” in the markets, it makes sense to step back and get some perspective, lest we make decisions that cause regret and, worse, harmful consequences. When prices fall precipitously, our first instinct is to search for a bottom. We’re terrified that we are going to miss a fortuitous “chance.” In our advisory capacity at Hedge, we often spend more time and effort talking the client out of getting into the market than we do convincing them to hedge. Speculating is always a really bad idea. If I had a dollar for every time I heard a so-called guru advising my clients (and the industry in general) to go long oil last summer in anticipation of an IMO 2020 price spike, I could buy a really nice set of new golf clubs!
The timing of this price plummet does present a challenge, though. It’s late February (as of this writing) and prices traded on the Nymex next winter are already well below what you locked in last year. Additionally we’ve had a warm winter, which is causing a substantial credit balance on the budget accounts. For many of you, this equates to an extraordinary opportunity to offer your customers a lower budget payment next season. Whenever you can deliver good news to the consumer in this business, it usually makes sense to act on it. Unfortunately, timing and opportunity don’t always cooperate with each other. If you don’t have the option to go out early to your customers, it means you are taking on risk if you hedge in February for a program offer that isn’t going to happen until late spring or summer. This delta, the length of time between your commitment to price and the commitment from your customer, is loaded with risk. Your business model cannot sustain a bad decision. In other words, you can’t sell $2.00 oil in a $1.00 market; all things being equal in the comparison.
That’s why it is critical to have structure and discipline when hedging. Sticking your finger in the wind and making a buying decision will usually end poorly. It’s important to have a process in place. We use a system 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.
Admittedly I’m biased. (Full disclosure: I own a consulting company that advises on hedging and procurement.) But going it alone here can be daunting. In these conditions there is way too much noise and confusion. It makes sense to have an advisor or team to bounce your views and ideas off of.
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?
We’re always happy to help. Please feel free to contact me with any questions at firstname.lastname@example.org. You can also visit our new website at hedgesolutions.com.
The information provided in this market update 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 the update 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 update is at your own risk.