Recently, at the Atlantic Region Energy Expo, I ran into an acquaintance who inquired about Hedge Solutions and the services that we provide to our clients. He lamented that price risk management is complex enough to occasionally set his head to spinning. He suspects that peripheral issues are muddying the waters, and he asked me to focus him on the core issues, the essentials of price risk management and hedging. It is worthwhile to share my thoughts on this topic with Oil & Energy readers as well.
Giving Customers What They Want
It is essential for a business to, within reason, give customers what they want. If you won’t, someone else will. I believe that consumers want protection against the possibility that high heating oil prices will soar even higher. Heating oil retailers who offer this protection provide value and fulfill a customer need, especially if they educate consumers in the process.
For instance, people are attracted to fixed price programs because there is no fee charged to participate. Frequently they don’t understand that rather than eliminating price risk, they are simply swapping one type of price risk for another. That is, a variable price is vulnerable to price increases, while a fixed price prevents the participant from benefiting from price decreases.
Customers should be made to understand that cap price programs are the vehicles that actually eliminate price risk, providing both protection against rising prices and access to falling prices. In that caps provide real value, people shouldn’t be shocked that there is cost involved, not unlike an insurance premium. The last couple of years, these costs (option premiums) have moderated, and cap fees are currently tolerable. Cap versus fixed: what you pay is what you get.
Protect Yourself: Fixed Price
If you price-protect your accounts, it is essential that you cover yourself. If you don’t hedge your programs and the market goes against you, you may sink your company, and then how will you give customers what they want? Fixed price programs are very straightforward to hedge. You simply back your fixed price volume up with fixed price wet gallon contracts purchased from wholesale heating oil suppliers.
There are pitfalls, however. Is the margin between wholesale and retail fixed prices adequate? Is your hedged volume more or less than your fixed price retail volume? How best to minimize the time lag between buying hedges and selling fixed price gallons? If prices fall drastically, how do you combat the threat of customers reneging on their commitments to buy fixed price (now very high price) gallons?
Let’s drill down on a couple of these concerns. If you purchase fixed wholesale gallons and it takes a couple of weeks to get a program solicitation letter out to your accounts and you give them another month to respond, you are asking for trouble. What if the market tanks during that six-week period? Who’s going to want to buy your program gallons and pay your high fixed price? At a minimum, tighten that period up drastically. Perhaps cut the hedged volume, offer a short-term price “while supplies last” and offer a second and third tier, perhaps at a different price, when initial hedged volume is depleted. Some retailers have computerized their program sales, hedging volume sold on a daily basis.
Regarding fixed price customer defaults in a falling market, collect as much of their fuel payment money as possible before the season is in full swing, tighten the legalese in your fixed price program agreement as much as possible and seek out inexpensive and creative ways to hedge a small portion of your fixed price sales against downside risk, i.e., the modest population who will bail out on you.
Protect Yourself: Cap Price
As with fixed price, if you offer a cap price program, it is essential that you hedge yourself. There are two primary ways to cover a cap offering: (1) Buy call options or (2) purchase fixed price wet gallon contracts from a wholesale supplier and also buy put options. If you cap your selling price and acquire call options, in a rising market your rack price will go up, your selling price won’t and your margin will be squeezed. However, your call options will pay out and compensate for lost margin. In a falling market, the option does not pay out, but that’s OK, because both rack price and selling price are dropping and you are maintaining (perhaps increasing) margin.
If you cap your selling price and hedge with wet gallons plus puts, in a rising market the option does not pay out (again, no problem), your fuel buying price is fixed, your selling price is capped and your margin is not compromised. In a falling market, your wet gallon price is fixed, your selling price is dropping and your margin is shrinking. However, your put options will pay out and offset lost margin.
When you purchase options, a premium is charged. It is too large to bury in the selling price, so, as mentioned previously, it must be passed on to the consumer, usually in the form of a program participation fee. An option premium is a per gallon charge. Therefore, I highly recommend that the participation fee be calculated on a per gallon basis and then levied as a single charge, perhaps at the front end of budget payments. Don’t recoil from cap fees; they’re currently reasonable and your customers receive value, i.e., the only “full spectrum” price protection.
Cap programs are subject to pitfalls as well. If the hedged volume is more than your cap price retail volume, a portion of your option premiums won’t be passed on. Again, it’s essential to minimize the time lag between buying hedges and selling cap price gallons. Lastly, because options are involved, you must take care to prevent your hedge from being compromised by basis risk.
Protect Yourself: Basis Risk
It is essential to understand and properly manage basis. The basis I am referring to is the difference between the NYMEX price and the rack price. When options are part of a hedge, it is important that this spread (also basis or diff) be preserved. Unfortunately, there are occasions when it “blows out” (widens), sometimes drastically. I previously discussed hedging cap prices with call options. I advised that in a rising market your rack price will go up, your selling price won’t, your margin will be squeezed and your call options will pay out, which will offset lost margin. But what if the NYMEX price increases 10 cents and rack price increases 25 cents – a 15-cent spread increase or blowout? In this case, your margin will contract 25 cents and the call will only pay out 10 cents, leaving you with 15 cents less margin.
The simple approach to protecting against possible basis blowout is to hedge caps with wet barrels plus puts in months where basis risk is highest: January through April. In this case, the options are irrelevant in a rising market. Your wet gallon price is fixed, your selling price is capped and your margin is preserved. There are other ways to protect against basis blowout and I will not address them in this article; you should discuss this with your hedging advisor.
What are the essentials of price risk management? Satisfy your customers and don’t drain the bank account doing it. Price protection is a valuable and workable concept, but you must understand how it works (and/or get help), educate your customers and avoid the pitfalls.