Propane supply and price volatility — risk or opportunity?

September 1, 2001 By    

Reaching a consensus on whether propane supply and volatility presents more of a business risk or opportunity would be an unrealistic expectation today, especially within the retail marketer segment.

Most marketers recognize that their approach to this critical business aspect has required dramatic change in recent years. In my opinion, marketers who have not changed their approach to supply have indeed placed their business at increased risk, financially and competitively; they are missing business opportunities.

Let’s identify some components of the change, considering supply and price volatility as one for discussion purposes as they directly impact each other.

Those who participate in the stock market are quite familiar with “major economic indicators” and their influence on that market. Their impact is often limited to a few hours or trading days but sometimes can set longer-term moods and trends.

Most individuals have limited time to capture, analyze and act upon these indicators. Instead they rely on people and firms who commit 100 percent of their time to this challenge. There are many parallels to propane supply and markets.

Some major propane supply and market indicators and (the list is not complete) that must be considered in making supply decisions are:

  • U.S. propane inventories
  • U.S. propane prices (current and out-month)
  • Canadian propane prices
  • Canadian propane inventories
  • Natural gas inventories
  • Natural gas prices
  • Natural gas processing rates
  • Natural gas processing margin
  • New processing capacity
  • Shut-in processing capacity
  • Crude oil inventories
  • Crude oil prices
  • Refinery thru-put rates
  • Changes in EPA regulations
  • Refinery turnaround schedules
  • Petrochemical cracking rates
  • Propane value for cracking vs. other feedstocks
  • U.S. import netbacks
  • U.S. export netbacks
  • Global inventories
  • Global prices
  • Global demand forecasts
  • OPEC direction
  • U.S. economy (dig out those latest “major economic indicators”)
  • World economy (especially Europe, Far East and South America)
  • Brine storage and availability
  • Gas liquids storage conversion to natural gas
  • Changes in pipeline capacities/allocation procedures
  • Rail car availability
  • Rail terminal additions
  • Import/Export terminal capacities
  • Transport availability
  • Petrochemical propane feedstock inventories
  • U.S. marketer inventories
  • Consumer storage levels
  • U.S. politics
  • Corn crop forecast
  • Corn prices
  • Global weather forecasts
  • Tropical storm forecast (possible effect on Gulf Coast production)
  • Consumer tank sets
  • Consumer energy conservation plans
  • Status of alternative fuels legislation and fuel cell development.

To be meaningful, one needs historical data of 1-5 years on most of the above for comparison and decision making purposes. Oh … I almost forgot one of the indicators – the U.S. weather forecast by region and month could well be a factor!

By now you can see that there is no exact science to projecting propane supply and market prices because there may well be over 50 factors at play. An individual – especially a marketer who has all the other daily management responsibilities of running a business – simply cannot dedicate the time and effort needed to manage supply and price risk on a daily basis.

There are a few computer models that incorporate a few of these indicators One in particular is used by entities to establish premiums for various financial tools. But they still must rely on judgmental thinking to a large degree.

Until recently, the prevalent and traditional supply procedure was to purchase at market-related “posted” prices on an annual contract and let the producer/supplier and retail customer carry the inventory and price risk. With the exception of an occasional severe prolonged winter or a major political skirmish in a producing region, this practice worked fairly well for marketers. However, several events have changed in the last 10-15 years.

Today, we compete in a global market to a much larger extent in industrialized and developing countries.

Today, propane as a commodity is “traded” by a much larger community of players, both inside and outside of the industry. This segment relies on price volatility to a large degree for their profit margins and, in fact, must have volatility to succeed. With a global market, other large markets (petrochemicals) and a trading arena, producers have opportunities to liquidate their production without carrying large “at risk” inventories.

Today, the more sophisticated end-use consumers, including an increasing number of propane customers, require some control over their energy costs. They want options and are finding them available from an increasing number of propane marketers.

The U.S. retail marketer as an industry segment in today’s world has a shrinking influence on product values and supply in the propane marketplace. Even with continuing marketer consolidation, the industry remains quite fragmented. With other segments of the industry pressing market volatility and with propane becoming increasingly aligned with other energy commodities, retail marketers should pursue “management of price volatility”.

Product Hedging Tools
The good news is that there are more price risk management tools available than ever before. They are being used by an increasing number of marketers to bring some stability to their propane supply and help them capture business opportunities. Some of the tools for physical product include:

  • Pre-buy (to back up sales volumes sold at a firm price)
  • Firm market differentials between major markets and destinations (to prevent large price spikes and to provide for “clean” hedges)
  • Price cap provisions as a part of traditional contracts
  • Specific contract volumes for specific out-month or future delivery
  • Traditional market related “posted price” annual contracts
  • “Spot market” purchases for pipeline or rail shipment

There are individual supplier variations of some of the above. It is important to remember that any physical purchase volumes with a firm price that are not covered or backed with a sale at a firm price are speculative and do not allow the purchaser to take advantage of lower market prices should they occur.

Paper Hedging Tools
As for financial or “paper” or derivative-type hedging tools, a partial list includes:

  • “Call option” allows a buyer of the call the right to purchase but without an obligation to buy at the “strike price” you bought. This protects you from price spikes but still allows you to buy at lower prices if the market goes down. You will be charged a premium for a call option; the amount will depend on the month(s) and the strike price chosen.
    At Mont Belvieu, for example, in mid-August a strike price of $0.425 for October carried a premium of about $.04 per gallon. For a February strike price of $0.4325 the premium would be $0.06 per gallon.
    For a call at $0.05 over the cash market, the premiums would be reduced $0.015-$0.02 per gallon as the buyer assumes the risk on $0.05. Call options are an excellent tool for
    hedging capped price marketing programs for end-users.
    Your market may allow you to involve the customer in the cost of the protection. Call options are widely available today. (Remember: the strike price is usually a monthly average.) The upfront cash requirement for the premium is similar to a “nickel down” pre-buy, but provides the opportunity to participate in falling or lower markets.
  • “Put option” works like a call but is designed to protect your firm priced purchases in a falling market. A put gives you the right to sell at a pre-determined strike price.
  • A “collar” is a combination of a call and a put, resulting in a cap and a floor price. A “costless” collar can be negotiated with the other party by raising the call strike price and lowering the put strike price until the risk is equalized.
  • A “swap” is a negotiated strike price that represents equal risk. As a buyer of the swap, you agree to pay the other party if the market price for the month(s) selected is below the swap price. The other party agrees to pay you if the market price is above the swap price.
    In effect, you are setting the price you will be obligated for on the volume contracted. A swap is speculative unless it is backed by a sale at a firm price, similar to a pre-buy.

It is important to remember that the financial or paper tools do not replace the need for good physical product purchase contracts with good reliable suppliers, and adequate storage and transportation. Rather, they are used to hedge or help remove the risk of the physical purchase or sales commitments.

I believe there are opportunities in the market place with end-users who are looking for optional ways to purchase their propane needs. Capturing these opportunities and remaining competitive with other marketers requires more than traditional sales and supply programs. Use of tools available today can allow you to both capture opportunities and manage the risk associated with the new market volatility.

As we approach a new heating season, I would encourage you (if you have not) to sit down with your supplier(s) and/or a third party with fresh eyes and review your sales and supply program to pick up any helpful tools. Then enjoy some fall golf or fishing with less apprehension about price volatility.

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