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DIGITAL EDITION
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THIS WEEK'S TOPIC:
SWAPS AND OPTIONS
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Determining what route to take under current conditions
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It is the time of year when propane retailers start looking at positioning themselves for next winter’s supply. Of course, they can do pre-buys with their physical supplier. But more and more retailers like the flexibility of financial tools like swaps and options. We are going to compare swaps and options and decide which one might work best under current conditions.
Last week, we priced both swaps and options for Mont Belvieu and Conway for the last quarter of this year and the first quarter of next year. Below is a table of the results that we will use for our discussion.
When you buy a swap or an option, you own a price - called the strike price - that will be compared with the actual monthly average to determine how money will flow between the owner of the swap or option (the retailer) and their counterparty.
We got the price quotes based on quarters, but the owner would actually own three separate swaps or options for each quarter. For example, to cover the fourth quarter of 2015, a Mont Belvieu swap or option buyer would own an October, November and December swap, each with a strike price of 62.75 cents. At the end of those three months, the owner would receive the difference between 62.75 cents and the monthly average, if the monthly average is higher. If the monthly average is lower, the owner of the swap would pay the difference, whereas the owner of the option would pay nothing.
Should you own a swap or an option? That depends on a couple of factors. The first consideration would be risk concerns. If not concerned with falling prices, then the swap is best. If upside protection is wanted, but there is concern for falling prices, the option might work best.
The second consideration is what the retailer will do with the supply position. If the plan is to sell a fixed-price or budget program soon after taking the position, a swap would be best. If the retailer is speculating or using the position to offer a cap program, an option would likely be the choice.
Options transfer downside price risk to another party. It is like insurance. The premium is the cost of transferring the risk. In the case of a 2015 fourth-quarter Mont Belvieu call option, the premium is 9.5 cents. The owner of the options will get paid for any amount the monthly average is over the strike, but when the cost of the option is considered, all of the premium is not recovered unless the monthly average is 72.25 cents or higher, with 72.25 cents called the break-even point.
If prices fall, the option will expire without payment to the holder, but the holder will also have no payment or obligation because the monthly average is less than the 62.75-cent strike. The premium already paid transferred that risk.
With the swap, there was no premium, but the owner assumes or self-insures against downside price risk. If prices rise, the swap beats the option because the option premium is avoided. But if prices fall, the option could beat the swap if the fall in prices is greater than the cost of the premium for the option. For example, in the Mont Belvieu 2015 fourth-quarter swap, holders could see the monthly average drop to 53.25 cents and be out of pocket no more money than if they had paid the premium of 9.50 cents to transfer the downside price risk. If the monthly average is less than 53.25 cents, the retailer would come out better with the option.
The bottom line is, if a retailer has little concern that propane prices will be less than 53.25 in Mont Belvieu during the fourth quarter of this year, they should own a swap. If a retailer sees a scenario where prices could fall below that mark, they may prefer to use the option to transfer the risk.
If you need to walk through these scenarios for a better understanding, do not hesitate to give us a call.
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WEEK IN REVIEW
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Another big jump in propane inventory pushed the separation of propane with crude further. Propane inventory builds of 6.6 million barrels over three weeks are causing the relative valuation we discussed last week in Trader's Corner to change.
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LAST WEEK'S HIGHLIGHTS
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Conway propane gained, as less-robust inventories in the Midwest - when compared with the Gulf Coast - make the 8-cent discount to Mont Belvieu a little much. Crude was down slightly, as some traders started taking profits on a 20 percent gain in April.
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Propane prices turned higher with crude, but markets were rather subdued as traders turned their focus toward fundamentals, with inventory reports beginning after the close.
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A 2.6-million-barrel build in U.S. propane inventory caused a major separation between propane and crude prices. Crude climbed 2.66 percent on a falling dollar and a draw in Cushing crude inventory. But propane, which had been consistent in following crude’s price direction, fell nearly 2 percent.
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Even though propane prices were little changed and Mont Belvieu even moved slightly higher, it was still a bearish day for propane. Once again, crude posted solid gains and propane could not follow. Since Wednesday, there was a definite revaluation of propane against West Texas Intermediate crude, prompted by 6.6 million barrels in propane inventory builds over the past three weeks.
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Once again, propane prices were moving lower, with falling crude a contributing factor. Mont Belvieu propane continued to show a lot of weakness, outpacing crude to the downside after failing to follow up moves by crude on Wednesday and Thursday. Crude was seeing profit, taking on 20 percent gains during April, with a rising dollar encouraging the move.
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CONNECT
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WHAT IS COST MANAGEMENT SOLUTIONS?
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The Propane Price Insider is an e-mail service that provides:
- Three daily price Flash Wires
- Periodic option quotes
- Wednesday inventory data updates around 11 a.m. ET
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Evening report with executive summary, weather maps and complete review of energy prices that are based on propane's Btu equivalent
For a free 10-day trial subscription by e-mail, sign up online here or call 888-441-3338.
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Cost Management Solutions LLC (CMS) is a firm dedicated to the analysis of the energy markets for the propane marketplace. Since we are not a supplier of propane, you can be assured our focus is to provide an unbiased analysis.
Contact us today to see if you can benefit from having the Energy Price Watchdog working for you.
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Many retailers simply don't have time to analyze the large amounts of data to make an informed purchasing decision.
We offer:
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Detailed market recommendations on hedge and pre-buy entry points
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Prompt market execution of hedging strategies
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Supply cost analysis and recommendation as to effective hedging strategies
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Large volume consideration when we place your hedges
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