Page 39 - Oil and Energy January 2013

January 2013 • 39
Market Stance
By Mark Stillman, Hedge Solutions
WHEN NEW YORK STATE MADE THE BOLD
and relatively early move to replace tradi-
tional No. 2 heating oil with ULSD, many
thought it was the best news ever. Beyond
the obvious environmental implications,
most dealers believed it would free up
one third of all the heating oil used in
the Northeast. The result would be ample
supply and lower cash market prices.
Not exactly.
The dream of oversupply has quickly
been replaced by talk of outright product
shortages and “basis blowout.” The latter
is a term on everyone’s lips this season and
one that provokes awful memories of other
tough years. Thankfully, it is not a regular
event, but in an odd way this only adds to
the mystery and fear.
WHY BASIS BLOWS OUT
First, a quick refresher. Basis is simply
the difference between the NYMEX price on
any given day and the actual cash price at
your supply point. If the NYMEX is $2.98
and your local wholesaler rack posting is
$3.08, then basis is $.10 per gallon. Basis
is also the most accurate and perhaps
only remaining true indicator of supply
and demand. This is a crucial yet often
overlooked fact in an industry obsessed
with absolute product price that often
decouples, quite literally, from fundamental
supply and demand forces in lieu of pure
trading-related activity. Hence, basis flexes
l l dj f h constant y as supp y a usts or weat er-
driven demand cycles, market conditions,
and transportation logistics.
So why does basis “blow out”? The
dynamics for this phenomenon are fairly
simple at a high level. Since basis is reflective
of supply and demand, it blows out when
supply is tight. This happens in extreme
and enduring cold weather, when harbors
freeze and prevent barges from entering,
or when pipeline supply is disrupted. Basis
blowouts can be localized, or they can be
systemic in the event of a supply-chain-wide
problem. Imagine a supply that is 40% (yes
40%!), below a five-year average in Oilheat
country. Sound impossible? Welcome to
2012-2013 in the Northeast.
Where did all the heating oil go? How
can a region so acquainted with heating oil
suddenly find itself in such a huge crunch?
And what happened to all the oil that used
to go to NY State?
CONVERGENCE OF FACTORS
Let’s start by stating that no one is to
blame. It is a constellation of factors, some
noteworthy, converging at once. Refiners
are in the business to make money, and
if NY wants to evaporate one third of the
demand, why overproduce? In addition,
we are still dealing with the refinery issues,
shutdowns and retoolings that have plagued
us for two years.
Supply was tight to begin last season
too, and we were only “saved” by warm
weather, and then we entered late summer
2012 far behind the proverbial eight ball. A
tight supply outlook leads to a lovely condi-
tion called backwardation in which the near
months are more expensive than future
months in a domino pattern that tilts the
i d hill Th i h ent re curve own . at s w at we saw
over the summer and fall. Suppliers there-
fore have no reason to buy and store oil,
even for short periods. Why take possession
of a product that is a depreciating asset?
This leaves dealers and consumers to
fight for supply, creating spikes in basis
that reflect the short supply. We are inching
toward a potentially serious problem,
although probably not one of historic
precedent. Think more about basis being
volatile in bursts than long duration. But, if
it turns super cold, all bets are off.
Dealers need to assess their dimensions
of risk now. First, if you used call options
to cover cap programs, then you should
certainly investigate fixed diff wet product
contracts to protect margins, since calls do
not account for real world basis. Secondly,
many dealers are buying these same fixed
diff contracts for their rack-to-retail business
in an effort to gain competitive advantage
should basis blow out. In theory, they will
be locked low while others have to ride the
basis up. For all, the most crucial period to
plan around will be now through March.
Most importantly, don’t forget your
customers. Prepare your staff to deal with
questions surrounding prices should basis
spike. In the end, remember that consumers
bear the burden of basis blowout since it
flows right down the supply chain to their
fill pipe and checkbook.
NOTE: On behalf of everyone at Hedge
Solutions, I would like to offer our heartfelt
condolences to the victims and families of
those affected by the Newtown, CT school
shooting. The murder of innocent children
and the brave adults charged with protecting
them is an unthinkable tragedy, and no one
ibl f h h i hi h can poss y at om t e pa n t s town as
endured. Through the pain, it provides a
moment for all of us to think of ways we can
bring kindness and compassion to a world
that is all too often defined by evil. It is also a
moment to treasure life and give your kids an
extra big hug.