Posted by admin on May 20, 2013

The genesis of risk management, frequently referred to as and synonymous with hedging, manifests itself in the heating oil industry sometime after the winter of 1985. The global financial and oil communities watched in shock as a relatively new commodity contract flushed the values of their inventory into a proverbial sinkhole.  What was valued at $36 per barrel in the blink of an eye (6 months) vaporized to just under $10 per barrel.  Ambiguity, secret meetings, and esoteric valuations gave way to a virtual public viewing of prices and became agonizingly transparent for all to see.  That’s if you were a producer (think Saudi Arabia, Exxon) or refiner.  Terminal operators (think Global, Wyatt, Northeast Petroleum…I’m dating myself here) also suffered large losses.  And so the oil industry embarked on the same journey that tulip merchants, farmers, and metal men traveled long ago.  Having no choice, they chose hedging to protect their investments.

The folks at O&E have asked me to use this occasion to look briefly into the industry’s rear view mirror at 20 years of risk management and, more interestingly, offer a futuristic peek at what’s to come.

As I sit here in Manhattan in the middle of a March snowstorm that was forecast as rain, there are certain ironies related to the timing to sit and write this. Twenty years ago the storm of the century, or “super-storm”, would drop a foot of snow on this very spot, but more notably wreak havoc across the largest ever swath of geography in the U.S.(go ahead, look it up. it’s true).  Kismet! Twenty years ago this month I began the un-nerving process of starting up a business. sri lanka .  Now, camped out in a hotel in Battery Park because I can’t get a flight out, I’m a stone’s throw from both the CME group and the former location of where THAT all started, the Butter and Cheese exchange.

The most compelling image of the past, no doubt, is the numbers.  In 1993, crude oil prices were $20/barrel and heating oil a paltry sixty cents per gallon. The decade of the 90’s would see crude oil prices reach a high of (gasp!) $41/barrel and dip briefly below $10/barrel for the second time in history.  Heating oil prices would trade below thirty cents per gallon in February (winter no less) 1999! Here’s a number to ponder; call option strips for a typical heating season were less than five cents per gallon! The party ended after Y2K.  Oil prices would embark on a decade of volatility that would make the 1990’s an outright yawn session by comparison.  In one period over 18 months (January 2007-July 2008)oil prices would rise $100 per barrel only to precipitously nosedive to $35 per barrel in a fraction of that time (6 months), traumatizing the consumers that locked in $4 per gallon, as well as the deliverer of bad news, the heating oil dealer.  (graphic:  heating oil chart)

It would be both arduous and autocratic of me to identify “the” game changer, or single iconic event or product that had the most pronounced effect on our industry over the past two decades, but a significant argument could be made for hedging and the resulting merchandise.  Prepay programs would lead the way with Caps to follow shortly after to become the rage to consumers and the tool of choice by heating oil dealers for retaining customers.  Hedging products and strategies as well as marketing collateral and software popped up to support growing demand.  Like so many other consumer driven offerings, these “programs” were seen as another arrow in the quiver to ward off the evil gas company that came knocking on the door every year.  However, soon enough the gimmicks emerged and it became a wishful customer acquisition tool.  And sure enough, misuse led to abuse which led to delinquency by a few which cast a cynical shadow on the majority.  That said, heating oil dealers are resilient, as well as stubborn.  Ultimately, these programs have proven to be valuable and have become embedded in the DNA of the industry business model.  Pricing programs have been coded into every back office software system.  They occupy prominent real estate on most dealers’ websites.  Hedging software is available that manage forward sales programs and forecast a forward looking P&L.  Identifying pricing program volumes, margin, and history is part of every Q&A on every merger and acquisition form now.

The price crash in 2008 was pivotal to the already increasing apathy toward forward pricing programs.  The data positively affirmed that consumers’ appetites for pre-buy programs were shrinking dramatically.  The recession was clearly impacting their ability to fork out large sums of cash, a requirement with most companies.  Many felt they got burned placing bets that prices would be higher when they took delivery for the oil.  Cap programs, managed primarily through budget payments, were also losing enrollments.  After multiple years on the program with low fee structures, they also experienced sticker shock when higher oil prices resulted in elevated cap fees.  They weren’t doing the math when it came to calculating huge cost savings over the alternative pre buy deals. Consumer fatigue was clearly setting in.  Huge volumes that were once harbored pre-season by these pricing programs were now migrating back to the rack to retail space, where margins have always been choppy and unpredictable.

Looking forward:

What does the future hold?  Volatility will no doubt maintain its considerable grip on the energy space.    It is well documented in consumer surveys that it is the constant change in the price that irritates consumers the most, more than the price level itself.  That irritant will repeatedly invoke a desire to remove that uncertainty.  Though fluid, the demand for pricing programs will always be there, albeit at different levels and dependent upon the actual prices, too.

What will continue to change at a considerable pace is the way you look at procurement, and ultimately your view of hedging.  Technology, supply, and price volatility contrastingly offer challenges and opportunity to improve how you buy oil every day.  The procurement of the oil, or cost of goods sold, is the last mile for improving profit margins.

You will learn how to use technology in the hedging space to actually obtain an advantage from rapid price changes over shorter time frames; days and weeks versus months.  Because you are facing a declining supplier portfolio with tougher credit terms you will need to use hedging to improve your cash flow.  Basis hedging, supplier index deals, and forward contracts are tools that will offer you an edge and the opportunity to reduce costs and improve margins.  Portal procurement, buying online from suppliers, will likely be the day to day buying method of choice in the future, superseding the rack method.  Buyer beware, however.  Like all cutting edge apparatus, misuse and abuse is bound to ensue.  Today, most buyers on portals are overpaying and don’t know how to use it properly.  Hedging over short windows of time will be commonplace within five years. Empirical evidence exists to prove what most of you know intuitively; that margins expand and contract in correlation with the movement in the commodity prices. That means you can hedge that exposure!

Companies will soon be offering bundled services that include hedging, procurement, and even billing services similar to what is currently offered in the deregulated natural gas space.  Understanding these concepts will be critical to your company’s future.  The single most interesting debate that I see emerging from all of the new technology, risk management strategies, and cutting edge procurement concepts will be who owns the customer!  The new offers that you will see in the near future will alter or challenge that concept.  Do you want to be a trucking company or do you want to be a marketer?  How much of your business do you want to outsource or partner with? The traditional business model is about to be challenged.  How you are advised on that and the decisions you ultimately make will have significant impact, both positive and negative, to the path forward for your business.  And that’s my version of the crystal ball!


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