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By Rick Trout, Account Executive, Hedge Solutions
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.
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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 protec-
tion 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.
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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.
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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.
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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.
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A more complete hedging strategy that
can be implemented for longer periods is
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