EDITOR’S NOTE: This is the second installment of a two-part article.
Last month, I put forth some essentials of price risk management and hedging. It started with giving customers what they want and asserting that they want protection against significantly higher heating oil prices. I suggested that customers be made aware that a fixed price replaces risk of higher prices with risk of not benefiting from lower prices. They should be educated to understand that a cap price eliminates risk associated with both rising and falling prices and this clear value justifies a cap program fee.
Offering price protection to customers necessitates that the heating oil retailer protects himself with hedges. Fixed price programs are easy to hedge, but they have pitfalls. Are margins adequate? Are sold volumes and hedged volumes aligned? Are hedged volumes sold quickly? Will customers renege if prices fall drastically? Fortunately, there are ways to mitigate these pitfalls. Now, here are the remaining essentials of price risk management.
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.