Solid hedging strategies give retail propane marketers an edge

March 17, 2016 By    

hedging-strategiesDone properly, hedging protects our business, streamlines our supply chain, guarantees margins and ultimately results in happy customers.

These days, however, hedging no longer takes place in a vacuum, removed from the context of business and customer expectations. Best practices in hedging for energy marketers must now consider program type and customer preference, program timing, automation and reporting, and customer service and competition.

Best practices for program type selection

When establishing a price protection program, it is important to identify programs that will be effective in your local market area, ensure a healthy margin and give you an edge on competition.

The idea is to offer price protection programs that will serve customers and the company better in the long run. These plans include: capped price plan, capped price plan with budget, and capped price plan with auto bill-pay and e-statements.

Price protection contracts have evolved over the decades to become more sophisticated and feature-rich, providing both energy marketers and consumers with many choices. In the beginning, most price protection contracts were fixed-price contracts, usually requiring pre-payment (pre-buys). As energy markets have become much more volatile, the popularity of capped-price contracting has increased dramatically – and for good reason.

While fixed-price contracts remain popular and have a place in many markets, a capped-price program is a better choice for consumers and energy marketers alike.

For a consumer, there are many benefits, such as price protection from rising or falling markets, which precludes the potential buyer’s remorse of fixed-price contracts; the ability to bundle a variety of products and services into a single monthly budget payment; and the ability to terminate an agreement with less financial impact.

For the energy marketer, there are even more benefits. Customers who choose capped-price programs are less price-sensitive and less market-timing sensitive than fixed-price or pre-buy customers. Capped-price customers are generally more contractually obligated to the company due to the popularity of combined budget/price-cap contract programs. A capped-price plan is also less risky for an energy marketer to hedge because the customer price-cap fee is used to purchase downside option protection, which protects the active customer program as well as the energy marketer’s margin on any undelivered volume.

Program timing

Traditionally, price protection programs have been released only once a year or during a narrow window of time chosen by the company. While this is a common method used in program enrollment, it creates a number of difficulties for both consumers and energy marketers.

First and foremost, it is extremely difficult to provide high-quality customer service during periods of high calling volume and strenuous administrative overhead taking place during the narrow sign-up period. Given the fact that some price protection programs have become more complex, such as a capped-price/budget bundle, they require more time for a customer service agent to adequately explain the features and benefits to customers.

Another important consideration with the traditional approach is customer defection and exposure to competition. When large numbers of customers have price contracts expiring at the same time, your customer base is exposed. Predatory competitors will see this and aggressively target these “free agents.” Moreover, an energy marketer providing price protection only one time of the year is at greater risk to market volatility and unfavorable market conditions. And finally, the last consideration comes back to your customers: It is disheartening for a customer to call your company, request to enroll in price protection and hear the program isn’t available. In many cases, your customer will just make a beeline to the competition.

So what is the recommended solution? Incremental price protection, which is the practice of providing price protection programs year-round with contract begin and end dates spread throughout the entire year.

The benefits of incremental price protection are many. First, customer service call volume is dramatically reduced and spread across the entire year, giving customer service agents the ability to spend quality time with each customer explaining features and benefits. An incremental price protection program also keeps customers away from competition because at no time during the year are large quantities of customers ending their contracts. It also allows customers to choose when they want to enroll, rather than forcing them into a company-chosen time slot. Moreover, incremental price protection further insulates your business from competition and price shopping because incremental price protection programs commonly use indexed pricing that fluctuates with the market, making outside price comparison more difficult. Lastly, an incremental program can be easily managed and hedged.

Auto-renewal programs are another worthwhile program type to consider. In general, I like the concept of an auto-renewal program, especially a capped-price budget plan. However, they do carry some risk – and are actually not legal in some states, such as my home state of Connecticut.

The risk associated with an auto-renewal program is that the company is generally obligated to provide an opt-out period where the customer has the opportunity to reject the program. I have seen these opt-out periods last as long as 45 days. This is a challenge for hedging because hedging fundamentally requires sales commitments (contracts) and hedges to be as closely synchronized as possible. A 45-day timing exposure can be significant in a volatile market.

That said, an auto-renewal program does provide customer automation, which reduces price sensitivity and helps with customer retention, and auto-renewals can also be internally automated to a great degree.

Contract enrollment

Prior to hedging, enrollment must take place, and best practices must create an optimized customer experience, easy administrative management and proper, legally binding contracts with protection mechanisms from early termination.

From a hedging standpoint, we want to make sure commitment-delay risk is eliminated because sales commitments and corresponding hedges must be executed in lockstep in order to eliminate price movement exposure. Due to this, best practices dictate that all enrollment methods must take place in real time, by direct online sign-up, telephone/online hybrid sign-up, telephone sign-up or walk-in enrollment.

As you may notice, postal mail enrollment is absent from this list – and for good reason. Postal mail is not a real-time contract execution method, and customers who receive postal mail contracts may or may not return them in a timely manner – if at all. This window also allows customers to shop competition.

Contracts

Contract law is quite extensive, especially when it comes to electronic contracts, which is one reason they are highly recommended for real-time commitments.

My best advice for price protection electronic contracts is to make them look as little like contracts as possible while following all state and federal compliance requirements. All contracts should be thoroughly vetted by legal counsel, but be mindful to minimize the “Philadelphia lawyer” language in order to put your customers at ease and provide confidence.

Fixed-price contracts require the most stringent terms and conditions, including well-defined liquidated damages clauses. In contrast, capped-price programs can be provided to consumers with little or no termination clause penalty, making them an easier sell.

Reporting and analytics

Following enrollment comes reporting and analytics, the basis for hedging. No matter the system used for price protection and hedging implementation, great reporting is essential.

Every responsible energy marketing company needs to know at any given time its forward long/short positions, projected margin over rack, the overall price protection margin, its blended contract/variable program margin, and, most importantly, its risk in a changing market.

In an incremental program, an energy marketing company can view its margin in near real time, and if margin is slipping, it is easy to shore up any deficiency. If one’s system allows it, I recommend a daily email notification provided to anyone on your team involved with hedging or supply management.

Forecasting and hedging

Hedging can be a daunting task for many marketers simply because there are many ways to do so.

My first best-practices recommendation is marketers should not be afraid to enlist the help of experts, such as commodity brokers, energy trading consultants or folks who provide risk management system solutions. Even with outside help, energy marketers need to understand the basics of their own programs and the principles of hedging in order to act in the best interest of their companies.

My hedging strategy includes nearly every available tool, but as a personal preference, I generally like the idea of hedging with wet barrels (also known as fixed forward contracts) whenever available from a local wholesale supply source and when conservative delivered gallons can be accurately forecasted.

Energy marketers deliver wet barrels, not paper, so programs which have a reliable forecast for wet barrels can be effectively hedged with wet barrels. I also prefer wet barrels because they make the supply chain more reliable and secure due to the fact that upstream commitments are made to wholesalers, ensuring product will be delivered at terminals when needed. Lastly, wet barrels inherently protect an energy marketer against volatile basis (rack price) movement because they are contracted at a delivered price rather than an indexed price.

Swaps or futures can be used as an alternative to wet barrels to hedge fixed-price contract sales, but they do not protect a marketer against basis risk. I generally prefer paper hedges for gallons that may be more tentative, such as gallons that may not be delivered during a warm heating season.

Paper options (OTC) are also recommended when sales commitment volumes are small or when wet barrel pricing is not available. Ironically, paper options are more “liquid” than wet barrels and can be traded off quickly if needed. To protect a capped-price program, a marketer can simply add put protection on top of fixed forward wet barrel commitments. A marketer can also hedge a capped-price program using call options. However, call options, like most paper derivatives, do not protect the marketer against basis risk.

Customer volume forecasting – how much fuel you allow customers to buy under contract – is critically important to a price protection and hedging program. I always recommend that a defined term with a conservative volume forecast be implemented.

In times of high volatility and higher price, I recommend marketers limit customer purchase volumes to no more than 85 or 90 percent of their forecasted volume for fixed-price contracts. This provides a layer of risk protection for the energy marketer in the event market prices sharply decline, which is commonly caused by reduced degree-days and lower sales volumes.

As mentioned previously, the same type of hedging exposure does not necessarily apply for capped prices. Oversold capped-price contracts hedged with wet barrels and put options, or call options, continue to protect margins, even when forecasted sales volumes are not met.

Process automation

With a carefully considered program in place, it’s time to automate processes, including hedging, for efficient administration and an optimized customer experience.

This involves the ability to have customers easily sign up for price contracts and those contracts to automatically transfer into the back-office system. This ensures that contracts come in real time without commitment-delay risk, and it also eliminates data-entry errors and provides timely information to your supply or hedging desk.

As can be seen, price protection and risk management best practices are inextricable from other best practices across your business, including your program types, their timing, automated processes and overall customer experience.

Gary Sippin is marketing director of Destwin Energy Systems LLC. You can contact him at gary@destwin.com.

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