Price volatility is typically regarded as a problem for heating oil retailers. When futures prices rise 7 cents in one day and there are two rack prices in that day, that’s a problem. When prices go up 12 cents in three days, that’s a problem. When prices increase 5 cents one day, fall 3 cents the next day and rise 6 cents the following day, that’s a problem.
So who would suspect that a heating oil retailer can use price volatility to their advantage, to enhance profitability?
Before describing how this works, it’s important to point out two relevant characteristics of price movements. When prices rise, wholesale prices increase faster than retail prices and margins deteriorate. When prices fall, wholesale prices decrease faster than retail prices and margins are enhanced. So let’s start with the latter of these scenarios and explore how to hold onto a margin spike.
Bulk Deal Strategy
Let’s say that a heating oil retailer has a target margin of 70 cents and his actual margin is 66 cents. Prices fall and the retailer’s margin increases to 76 cents. Eventually prices will go up again and the margin will deflate. What action can the heating oil retailer take to prolong an above-target margin?
One possibility is fixing his buying price by executing a wet barrel bulk deal with a wholesale supplier. Thereafter, if prices increase, retail will increase relative to the fixed buying price and margin expands. If prices decrease, retail should fall against the fixed buying price, adversely affecting margin.
In order to avoid the latter, the bulk deal strategy should only be employed if the retailer can fix the retail price for a few days in a weakening market. Accordingly, the bulk deal strategy should only be utilized for short periods, such as 3, 4 or 5 days.
Call Option Strategy
A more complete hedging strategy that can be implemented for longer periods is purchasing a short-term at-the-money call option. Recall that the retailer’s margin has spiked to 76 cents in a falling market. If he puts on a 10-day ATM call option, it will currently cost about 4 cents per gallon. So the net margin is 72 cents, which is still above the target.
Thereafter, if prices increase, the margin will contract, but this will be more than offset by the call option payout, with net margin exceeding 72 cents. If prices fall, the call option will expire worthless, but wholesale prices will decline faster than retail prices and margin could easily revisit 76 cents or higher.
Bulk Plus Put Option Strategy
Executing both a bulk deal and an at-the-money put option is another well-rounded hedging strategy suitable for longer periods. As with buying a call option, the retailer enjoys margin protection regardless of whether prices go up or down.
Specifically, if prices increase, the put option expires worthless, but margin increases due to a rising retail price and a fixed buying price. If prices decrease, the margin shrinks, due to a falling retail price and a fixed buying price, but this is more than offset by the put option payout.
Call options are simpler to execute than bulk + put, but the latter offers one notable advantage. If assurance of supply and/or basis blowout is a concern, the wet barrel portion of a bulk + put gives the retailer a product availability and basis commitment from a wholesale supplier, and a call option does not.
You may see some similarities between short-term hedging and retail price protection offerings. When a homeowner opts for a fixed heating oil price for the heating season, they are protected against rising prices, but they are vulnerable to (unable to take advantage of) lower prices. They are protected in only one direction, but there is no fee for this partial protection, and many find that irresistibly attractive.
When a retailer chooses a bulk strategy, similar to a homeowner, he is protected against rising prices, but not dropping prices, for no fee. However, unlike a retail customer, the retailer’s downside risk only lasts a few days that can likely be coped with, rather than an entire heating season.
Margin Spike is Key to Hedging
When homeowners select a capped price for the heating season, they are protected against both higher prices and lower prices, for a fee. The same is true for a retailer who uses an at-the-money option strategy. The bottom line is: If you go with partial protection, it won’t cost you, and if you go with full protection, it will cost you, i.e., you get what you pay for.
This relates to one of two reasons why the call option strategy and the bulk + put option strategy are employed when the heating oil retailer’s margin spikes. These reasons are (1) the retailer needs to make at least target margin and (2) the retailer needs to cover the cost of the short-term option. If both are accomplished, the hedge is solid and the margin spike is extended for a meaningful period of time (more than 3 to 5 days).
Hedging used to apply to off-season retail price protection program offerings only. It now has in-season relevance for retailers who are interested in prolonging margin spikes.