36 • OIL
&
ENERGY
Market Stance
Price Protection and Downside Risk
By Rick Trout, Account Executive, Hedge Solutions
WE LIVE IN A VOLATILE AND UNPREDICTABLE
world, with ever-present geopolitical risk.
Consequently, people are aware that there
is always the possibility that crude oil
and petroleum products prices will spike
dramatically higher as a result of a major
world event.
An example of such an event would
be Israel attacking Iran’s nuclear facilities,
followed by Iran preventing the movement
of crude oil shipments out of the Persian
Gulf and into world markets. Such an event
would surely result in huge heating oil price
increases.
FIXED PRICE PROGRAMS
Therefore, heating oil retailers fre-
quently offer fixed price contracts because a
segment of their customers demand protec-
tion against spiking fuel prices. In the world
of price protection, however, fixed prices
are only half a loaf. That’s because the fixed
price customer can’t take advantage of
falling prices.
In theory, this shouldn’t have a nega-
tive effect on a heating oil retailer who has
hedged his fixed retail price with a fixed
wholesale price, thereby locking in his
margin. In reality, the retailer has solved
his price risk problem, while his customer
has swapped one price risk problem for
another.
When prices crash, as they did in 2008,
it doesn’t take the end-user long to realize
that he still has a price risk problem (on the
other side of the coin), sometimes resulting
in customer defaults and suddenly, the
price risk problem is back on the retailer’s
shoulders.
CAP PRICE PROGRAMS
The solution to the foregoing scenario is
for the retailer to sell price caps to the end-
user because price caps protect against both
rising prices and falling prices. This isn’t
passing on price risk from the retailer to the
customer; it’s near elimination of price risk.
This is the whole loaf.
Because it’s a far better offering, there’s
a cost associated with price caps (the cost of
option hedges). This, of course, is the rub.
Heating oil costs are already high and now,
the customer laments, you want me to pay
even more? Let’s explore the avenues
available to heating oil retailers to deal
with cap cost resistance.
The simplest way for a retailer
to hedge price caps is to buy call
options. If market prices rise,
the retailer receives an option
payout that he applies against
rising rack prices in order to
honor customer cap prices.
If prices fall, the option
expires worthless, and the
retailer drops his delivery
price with decreasing
rack prices. Unlike fixed
price hedges, the retailer
has no obligation to take
delivery of option hedged
gallons. The result is pro-
tection against both rising
and falling prices.
Another way to hedge
price caps is to buy future
wet barrels from a supplier
(contract gallons), while simul-
