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By Rick Trout and Jarrod Robinson, Account Executives, Hedge Solutions
Market Stance
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markets and petroleum markets, have, with
considerable help from the Federal Reserve,
made a stunning recovery from the 2008
price plunge. Does this mean that we are
in a position where we could experience
another hefty price drop? Perhaps, so it’s
relevant that we ponder the lessons learned
five years ago and consider a couple of
applicable hedging strategies.
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In the 2008/2009 heating season,
arguably the most disastrous outcome
experienced by heating oil retailers was
widespread consumer defaults on fixed
price purchase commitments. The problem
here is that customers committed to buy
heating oil at a fixed price, and the dealer
in turn committed to a lower fixed price
hedge, theoretically locking in an accept-
able margin. When prices went into the
tank and consumers refused to take delivery
of high-priced heating oil, the retailer was
compelled by suppliers to buy high-price
contract gallons with no opportunity to
resell these gallons at a corresponding high
retail price, resulting in inadequate, some-
times even negative, margins.
In response, dealers consulted with their
attorneys and tightened up their price pro-
tection contracts, so that they could more
successfully pursue legal action against
non-compliant fixed price customers. Many
also resolved that going forward, they will
offer only capped price contracts. The logic
behind this decision is undeniable. A lack of
price protection is great if prices are falling,
but the unprotected consumer is vulnerable
to price increases. A fixed price contract
protects against rising prices, but the fixed
price consumer can’t participate in lower
prices. Only the customer who opts for a
capped price is shielded from higher prices,
while being able to enjoy bargain prices.
The capped consumer elects superior (and
the only truly effective) coverage and not
surprisingly, there is a higher price, i.e. cap
premium add-on, associated with the best
insurance available.
However, there are markets where hom-
eowners rail against paying cap premiums
and prefer to purchase “free” fixed price
half protection rather than more expensive
capped price full protection. Heating oil
retailers in these markets must offer fixed
price programs or forego selling to a pos-
sibly substantial segment of the customer
base. In this circumstance, the dealer would
be wise to obtain payment for all or most of
the fixed price gallons up front or at least
prior to the start of the heating season.
If this is not possible for a sizable portion of
the fixed price volume and there is a real-
istic possibility of falling prices, the seller
has default risk.
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An example illustrates this risk and
how to hedge it. Let’s say that 200,000
gallons of pay-on-delivery, fixed price
gallons are sold to consumers. Based on
2008/2009, the retailer estimates that if
the price of heating oil falls $1.00, he is
likely to experience defaults on 30% of this
volume, which is 60,000 gallons. The goal
is to hedge the 140,000 fixed price gallons
that are not vulnerable to default and
to hedge the 60,000 gallons of potential
“involuntary, no premium caps” that carry
downside risk for the seller. Hedging the
140,000 gallons is easy; purchasing wet
barrel contracts on a heat curve will get
the job done. Hedging the potential default
gallons requires more creativity, and mod-
eling tools at Hedge Solutions verify that a
viable hedge is 20 cents out of the money
call options. The following graphs capture
this modeling:
If a heating oil retailer sells 200,000
fixed price gallons to consumers, hedges
these sales with 200,000 wet barrel contract
gallons purchased from a supplier and expe-
riences no consumer defaults, modeling
shows the following program profitability
profile. Note that margin is extremely
stable, whether prices rise or fall.
If, however, prices decline significantly
and 30 percent of consumers default and
refuse to take delivery of their fixed price
gallons, the retailer’s profitability profile is
altered as follows:
Since prices have presumably fallen at
least $1.00, the retailer’s margin has been cut
in half or worse. However, perhaps because
the petroleum products market showed
signs of weakness, the retailer anticipated
a price drop-off and the potential for
defaults, so he hedged 70 percent of his
fixed price sales with supplier wet barrel
contracts and the remaining 30 percent
with 20 cents out of the money call options.
What does this strategy do to his profit-
ability profile? The answer is:
This profile is considered quite accept-
able. Margin in a falling market is 67 cents
and stable, and margin in a rising market
is 63 cents and stable. The cost of the call
options in this illustration is about 8 cents per
gallon or $4,800 (less closer to the heating
season and more further from the winter),
is included in the modeling and cannot be
passed on to customers as a cap fee.
If you wonder what the profitability
profile looks like if you cover potential
defaults with 20 out call options and the
defaults don’t occur, please note the fol-
lowing graph:
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