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Trader's Corner
This week’s Trader’s Corner looks at basis risk.
A big part of what we do at Cost Management Solutions is help propane retailers manage the risks associated with propane prices. Obviously the rapid or dramatic movement of propane prices in either direction can have an adverse impact on a propane retailer’s bottom line.
If a retailer has bought a lot of supply (he is long supply), falling prices can hurt his competitiveness. If he has not bought his supply (he is short supply), rising prices can make him uncompetitive, assuming his competitors are long supply.
Even if we are not at a competitive disadvantage in a rising-price scenario, high propane bills can drive our customers to seek a new propane supplier or, worse, choose a different energy source. That can put a lot of pressure on a retailer to take supply positions to guard against spikes in propane prices.
The uncertainty concerning future costs of supply also makes it difficult to be aggressive in markets and grow our business.
There are many strategies and tools a propane retailer can use to manage the risks associated with volatile supply costs. On the sales side, moving as many customers as possible to budget, fixed price or cap programs is a good start. All of these provide predictability for the customer, eliminating nasty surprises that could drive them away.
On the supply side, a retailer can employ pre-buys, swaps, options and storage assets to allow them to provide these programs for their customers while protecting their own margin. When doing this, they are implementing hedges.
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment. In the case of propane supply management, a hedge is any action or tool we use to offset the potential losses that could be incurred in supplying propane to customers.
As propane retailers, there are two primary supply-related risks. The most obvious is being on the wrong side of a supply position that causes us to make a reduced operating margin or even lose money while providing propane to a customer.
The less obvious risk, but perhaps the more damaging from the long-term viability of our business, is that of losing customers because we have not done a good job in managing supply-side risk. If we do nothing to manage supply-side risk, the burden by default falls on our customers to manage it.
Propane consumers do not have hedging tools and few have storage assets at their disposal that are adequate enough to manage the price risks associated with using propane as an energy source. When propane prices are too high, the consumer generally has only two viable alternatives – seek a new source of propane supply or seek a new energy source altogether.
Most propane retailers understand that they are in a better position to manage supply-side risk than their customers. They also understand it is in the best long-term interest of their company to protect their customers as best they can from supply-side risk.
We know we can’t stop long-term inflation in energy prices. What we can do is manage volatility within the framework of overall energy costs. Over the long term, a consumer can make adjustments to steadily rising prices. What they struggle with, and what will often drive them to make changes concerning their use of propane, are rapid price swings or price spikes.
While retailers are in a position to help propane consumers with short-term volatility, and it is in their best interest to do so, it is not easy or risk free.
We are going to use a current situation to highlight one of the key risks associated with hedging propane supply and what you can do to manage it. This specific risk is known as basis risk.
Basis risk is the risk of disconnect between propane prices at a propane hub like Belvieu and where we will actually buy the physical supply necessary to meet our customers’ demand.
First let’s look at a specific situation underway where basis risk is being experienced. It is occurring at locations on the Dixie Pipeline, which runs through the Southeast. The Dixie is supplied from Belvieu, so any hedges a propane retailer puts in place would be based off of the price of propane in Belvieu.
The chart above tracks the price difference between Belvieu and Hattiesburg. We can see the recent price spike that is far above the typical differential.
There are unconfirmed reports that the line connecting these two points has been temporarily reversed. That would mean the only supply into Hattiesburg is from local refineries that feed the facility. That has limited supply and caused shippers/wholesale suppliers to raise their prices. Of course, this situation affects prices at every terminal east of Hattiesburg as well.
Let’s quantify the basis risk resulting from the situation. After establishing the hedge in Belvieu, a propane retailer would determine the normal price difference between what propane trades for in Belvieu and what it trades for at his local supply point or points. In the chart, the black line is this year’s average, which has been less than 4 cents. It is unlikely a retailer buying at posting would use the average in establishing his sales price. Instead, he would look at the highest differential. Normally that would be around 7 cents. A retailer might use 8 cents to cover contingences.
After establishing a hedge in Belvieu, which has a specific strike price, a retailer who uses Hattiesburg as his supply point would add 8 cents to the strike to estimate actual physical gas cost FOB Hattiesburg. To that he would add loading and transportation cost to his bulk plant as well as his desired margin to establish a sales price to customers.
In this case, he is buying his propane from a supplier at the suppliers posting. Since the retailer does not control the posting, but is establishing a sales price to his customer based on an “estimated” Hattiesburg posting relative to Belvieu, he is assuming basis risk.
Theoretically the risk he is assuming is any posting above Belvieu plus 8 cents. Essentially the risk is unlimited. Of course in practice, if his supplier’s Hattiesburg posting got too high, he could have transport loads delivered all the way from Belvieu or other supply points. In any case, those options would not be cheap and the increased cost would eat directly into budgeted margin.
With Hattiesburg now selling for more than Belvieu plus 16 cents, a retailer who is still lifting at posting at Hattiesburg, and had made sales based on an estimated posting at Belvieu plus 8, is seeing an 8 or more cent hit to his margin.
This retailer is going to hope the situation is short-lived. He will avoid purchase if he can. Hopefully he had propane in storage to help him through. But almost any retailer could only avoid suffering the consequences of the basis risk he assumed for a brief period.
Is there a way to avoid basis risk? Yes there is. When you are a hedger, and we most definitely think you should be for the long-term security of your business, you should try and tie what you will pay for physical supply at your local supply point to the hub where your hedges will settle.
Instead of buying at posting, negotiate with your physical supplier to buy on an index price. An index price can be based off anything, but in this case we would want to buy indexed to Belvieu. So instead of buying at posting, we buy at an index price of Belvieu plus a differential.
The starting place in the negotiation for the differential would be the average differential between Belvieu and Hattiesburg when we have bought loads in the past. But even if we had to pay more than the average, it would likely be worth it in the long run.
By buying on an index, we have established what is known as a clean hedge, meaning there is no basis risk. The price we will pay for our physical gas is directly related to the price our hedge will settle against. That will allow us to be much more aggressive in our pricing, while making the same margin, which will lead to more sales, etc.
To begin the process of establishing the differential in an index price, find the date and price of what you paid per gallon for supply from a specific location. Then get the daily average price that propane traded at the hub (Belvieu or Conway) on that day. Calculate the difference and get the average. Also be aware of the high and low.
This should give you what you need to establish a mutually beneficial index price between you and your supplier. Hedging is all about managing risk and substituting knowns for unknowns. Avoiding basis risk where possible is a key step toward that goal.
Call Cost Management Solutions today at 888-441-3338 for more information about how Client Services can enhance your business, or drop us an email at info@propanecost.com.
WEEK IN REVIEW
Propane experienced another above-average inventory draw. Inventory is setting a new five-year low for this time of year. But propane prices were flat despite looming cold winter weather. Crude rallied on Thursday, but its rebound could be short-lived if negotiations on Iran’s nuclear program have a positive outcome.
LAST WEEK'S DAILY HIGHLIGHTS
Monday: Propane prices were little changed from the previous week as crop drying demand played out. The exception was pricing along the Dixie, where prices spiked due to line allocation.
Tuesday: Propane prices remained in their flat to falling trajectory, even though U.S. inventory hovered near five-year lows. West Texas Intermediate (WTI) posted a small gain but remained technically vulnerable to more downside price movement.
Wednesday: A larger-than-expected inventory draw on the U.S. Gulf Coast sent Belvieu propane higher. Conway lost a little ground as the Midwest inventory draw was below average. WTI crude was little changed, as traders were cautious ahead of a meeting on Iran’s nuclear program and minutes from the latest Federal Reserve meeting showed there was still consideration of cutting back on stimulus measures before the end of this year.
Thursday: There wasn’t much follow-through buying on the propane inventory draw, limiting propane prices to small gains. Crude surged higher aided by a good report on U.S. factory activity.
Friday: The price rally in propane appears exhausted. Prices fell to close the week despite the currently low inventory position and cold weather on the way. |
