34 • OIL
&
ENERGY
Market Stance
THE SPECIFICATION CHANGE FOR THE NYMEX
heating oil contract brought an interesting
question from a heating oil dealer to my
desk. Essentially it asked, “What are the
benefits of paper hedging now that the price
ticking on my screen is
not
for heating oil,
but for ULSD?”
The confusion is understandable, and
it is a good hedging advisor’s duty to keep
advisees abreast of such changes and their
potential impact to their business. The short
answer is that the benefits of paper hedging
remain the same as before. Beginningwith the
May 2013 contract month (April delivery),
the specification for the NYMEX heating oil
contract changed over from 500 or greater
parts per million (ppm) sulfur heating oil
to less than 15ppm ultra-low sulfur diesel
(ULSD). Prior to the switch, however, enti-
ties along the chain from refiners, suppliers,
and large end-users of diesel, kerosene, and
even jet fuel traded in the heating oil futures
contract to manage price risk.
HEDGE COMPONENT REMAINS THE SAME
Those dealing in ULSD now enjoy the
perception of a cleaner hedge as the contract
specification more closely aligns with the
product they are involved in. This may
or may not spur some increased hedging
volume from some who may have previously
been reluctant to it, but the point is that the
component of the price they can hedge with
paper remains the same. Heating oil mar-
keters are in the reverse situation with the
specification moving away from the product
they buy and re-sell – but the NYMEX
portion of the price can be hedged just as
before. Call options will continue to protect
against price rises, helping ensure margins
on price-cap program gallons. Put options
will continue to protect wet barrel contracts
against the market collapsing. What has
changed is the basis component.
As the differential between the futures
price and the local wholesale price, basis
is by definition not covered by paper
hedges, which protect against changes in
the futures price alone. How much is left
unprotected as margin-at-risk? To study
this and other questions, I used a dataset
consisting of average wholesale heating
oil and ULSD prices at six rack locations
(Oil Price Information Service), New
York Harbor barge average prices for both
products (Platts), the front-month NYMEX
heating oil futures settlement price, weekly
East Coast heating oil inventories (Energy
Information Administration), and heating
degree days from weather stations near
the rack locations (National Climatic Data
Center) over the past six and a half years.
During that timeframe, heating oil rack
basis on average represented a relatively
small share of between 2.1 to 4.5 percent of
the wholesale price at the six selected rack
locations: Albany, Boston, Harrisburg, New
Haven, Newington and Linden. The trouble,
of course, is that these shares are far from
constant over time. Indeed, the standard
deviations for each rack location ranged from
1.5 to 2.4 percent of the wholesale price, and
the basis share of the price ranged from virtu-
ally negligible to 28.53 percent.
BASIS TRIGGERS
Such basis blowouts can be triggered by
any or a combination of factors such as thin
inventory levels, sustained weather-driven
demand spikes, and supply/infrastructure
shocks. While these events cannot be
perfectly predicted, thankfully they can be
protected against by entering into fixed dif-
ferential supply agreements. These can also
be focused, reducing cost and increasing
their expected value by placing them in time
periods where basis is most likely to spike.
The data backs common wisdom that
basis jumps are more likely at the tail end
of the season, from January through March.
Comparing averages by month, basis levels
were lowest in July and August as one would
expect. Average basis across the rack loca-
tions in the Jan-Mar period ranged from 3.51
cents (49.3 percent; Boston in Jan) to 6.49
cents (189.8 percent; Harrisburg in Feb) per
gallon higher than in July. Since the factors
driving these relationships have not changed
with the NYMEX switchover, there is no
reason to think they will not continue to hold
true in general. However, the specification
change did introduce a wrinkle that one of
my colleagues detailed in last month’s issue:
Since ULSD sells at a premium to heating oil,
fixed basis offers at levels which in previous
years would be competitive would now be
rather expensive.
Between late 2006 and March of this
year, the spread between ULSD and heating
oil prices at New York Harbor averaged
8.04 cents, and averages fell between 6.68
and 10.19 cents at the six rack locations.
Conservatively, let’s assume then that the
ULSD-spec futures contract would be priced
6 cents higher than the (hypothetical)
same-month heating oil futures contract.
We have reason to believe this is conserva-
tive because, for example, on March 28 the
May futures contract (with a ULSD specifi-
Close Scrutiny of Spec
Change Reveals Opportunities
By Dan Lothrop, Hedge Solutions
