DIGITAL EDITION THIS WEEK'S TOPIC: PROPANE AS A COMMODITY Propane is a uniquely difficult commodity to speculate upon By MARK RACHAL Cost Management Solutions     There are many factors that go into establishing the price of a commodity. Propane has unique characteristics that likely make it more difficult to trade than just about any other commodity. Before we discuss what makes propane unique among commodities, let’s consider what goes into establishing the price of commodities in general. The price of commodities is established based on commodity fundamentals, influencing events and technical trading. Let’s look at each category of factors. Fundamentals Fundamentals is the most important category of factors that establish a commodity’s value. Fundamentals are the basic supply and demand conditions that establish the general parameters within which a commodity will trade. To give us a reference, let’s consider the commodity of crude because it has a major impact on the commodity we are most interested in: propane. Imagine there are three stadiums in which the game of crude trading can be played. The names of the stadiums are low value, mid-value and high value. If fundamentals are weak – meaning supply is greater than demand – the game of crude trading will be played in the low-value stadium. If fundamentals are strong – meaning demand is greater than supply – the game will be played in the high-value stadium. Lastly, if supply and demand are fairly well balanced, the game will be played in the mid-value stadium. Currently, the game of crude trading is being played in the low-value stadium. The Organization of the Petroleum Exporting Countries (OPEC) is producing about 2 million barrels per day (bpd), which is more crude than the market needs from it. OPEC has changed its strategy from being the world’s swing producer to the world’s baseline producer, which means it will no longer increase or decrease its production to balance supply with demand. Instead, it will use its production cost advantage to maximize market share and force higher-cost crude projects out of the market to balance supply and demand. Globally, it is taking crude producers a while to adjust to this new paradigm. Crude supplies have not adjusted downward as rapidly as expected. Fundamentally, there is too much supply for current demand. That puts crude prices at the lower end of their historic prices, thus the game of crude trading is being played in the low-value stadium. Events Now let’s imagine that inside the low-value stadium there is a playing field that looks like a football field. To begin the trading game, the price of crude is placed on the 50-yard line. The price of crude can move up and down the field based on factors other than fundamentals. Events can cause crude prices to move up or down in the low-value field. Most commonly, the events are geopolitical. Crude prices moved higher, for example, when Russia invaded Ukraine. More recently, Russia’s involvement in Syria that could cause a conflict between Russia and the U.S. has been a geopolitical event that has moved prices higher. In addition to geopolitical events, economic or weather events can cause changes in prices. The recent collapse of the Chinese stock market was an event that caused crude prices to go down. Sometimes, an event can be so impactful that it will cause the price of crude to shift to another stadium. Traders can essentially change the venue, ignoring the underlying fundamentals and trade on the event. The event causes traders to speculate on the potential impact on fundamentals because of the event, rather than the current fundamental situation. Over time, if supply and demand are not actually affected by the event, the commodity price will at some point once again trade the fundamental realities. Technical trading Inside a particular fundamental stadium, prices will also fluctuate based on technical trading. Technical traders will use history and what the price has done in the past to try and predict what it will do in the future. Technical trading is based on the psychology of the market, which is nothing more than a collection of people with a common interest. It is driven by the constants of fear and greed that always exist with the people who make up the market. Imagine the price beginning at the 50-yard line of the low-value stadium. If prices move away from the 50-yard line, technical forces will try to return it to that point over the long term. However, over the short term, the market will form a bias, bullish (positive) or bearish (negative), causing prices to move away from the 50-yard line. Players who guess the price direction correctly will make money with their positions. However, the further prices move from the mid-point, the more pressure the market is under to adjust. Those making profits fear losing them and begin to look for reasons to close their position. Those who have not had a position begin to see a price far away from the equilibrium point as an opportunity for profit (greed). So if prices are falling, traders short crude are under increasing pressure to take profits so they won’t lose them. They have to buy crude to close the short position, which can cause crude prices to go higher. Other traders will see the low price as an opportunity to go long crude. In other words, they see it as an opportunity to buy at a low price and sell at a higher price down the road. Of course, the psychology of the market would be reversed in a rising-price environment. Fear and greed remain the constants no matter which direction prices are going, and those constants tend to push prices back to a “safe” point. Technical traders believe these constants make the market somewhat predictable. They are vigilant in watching for signals that a change is coming. Years of study have tried to quantify the psychology of the market and certain technical points have developed. There are many technical points, and different traders put more or less merit on a particular technical point than others. A simple example would be a technical bias that once a rally ends, prices will generally correct down 23.6 percent before beginning the next uptrend. If a trader has a strong belief in this theory, he may sell when a commodity has fallen 10 percent from a high and not buy again until the commodity falls another 13.6 percent from its high, for a total retracement of 23.6 percent. Let’s say the traders had bought crude at $75 per barrel and the price rose to $100 before falling. The trader would sell when crude fell 10 percent to $90. At that point, he would pocket $15 per barrel profit, and he would then stay out of the market. However, if prices dropped to around $76, he would likely buy back crude again on any uptick in the market. There are countless technical “disciplines,” but they all are based on the psychology of the market and how it has historically performed. (continued below) Propane’s peculiarity Many traders are willing to bet that they can determine the future price direction of a commodity based on understanding the fundamentals, events and technical drivers that affect that particular commodity. If you are going to speculate on a commodity, you need to be able to use your knowledge to correctly predict price direction at least 51 percent of the time. Most speculators don’t expect to be correct much more than half the time. An exceptional trader might be correct about 55 to 60 percent of the time. Propane prices may be more difficult to predict than most commodities. In the case of crude, producers will make adjustments on how much they produce based on the price of the commodity. Therefore, crude is fairly elastic, meaning that the price of the commodity will almost immediately impact the decisions of the producers of the commodity. That statement would be true for most commodities, but it is less true for propane. For example, 30 percent of the U.S. propane supply comes from refineries. A refinery will never determine how much crude to process based on the price of propane. The demand and price of gasoline and distillates drive decisions for the refiner. Propane is a by-product of the refining process. That makes propane production, at least from a refinery standpoint, inelastic. In other words, the amount of propane produced does not adjust with the price of propane. Seventy percent of propane comes from natural gas processing. The price of propane does have a greater influence on natural gas production/processing than it does at the refineries, but not as much as we might think. Natural gas processing yields a lot of fungible products including methane, ethane, propane, butane and natural gasoline. Propane is just part of a mix of natural gas liquids, so that does make its production less elastic than crude, copper, gold and most other commodities where production yields a single marketable commodity. Obviously, it is much easier to speculate on a commodity that is very elastic and supply and demand reacts rather quickly or predictably based on the price of the commodity. Propane would be among the least elastic of the commodities one might consider trading. A propane retailer must tread lightly when considering speculating on propane. Speculating means we are taking a position on the supply side without making a corresponding move on the sales side. It could also be making a commitment on the sales side without making a corresponding move on the supply side. It is best for propane retailers to be hedgers, not speculators. In general, it is best for a propane retailer to focus on the sales side of his business. He needs to use what he knows about his customers and their needs to help him establish programs and prices in his market. He then lets his needs and goals in serving his customers drive what is done on the supply side. Focusing on the supply side and letting that unilaterally drive when to buy is pure speculation and challenging at best. It might not seem like it, but propane retailers actually have a lot more control and understanding of the sales side of their business than the supply side. Most retailers can consider current market conditions and know what prices and programs are going to work in a certain period of time in their specific market. When retailers consider the customer side of their business first and let that drive hedging on the supply side, they are right almost every time. In contrast, if they focus on the supply side of their business first, they are probably going to find themselves in a favorable supply position only 50 percent of the time. The problem is that the 50 percent of the time retailers are wrong, they run the risk of losing customers, which is great risk to a retail business. Hedging, on the other hand, focuses on making sure the retailer has competitive supply that gives him the best odds of retaining customers no matter what price conditions turn out to be. Speculative commodity traders are truly betting and they can only put the odds slightly in their favor by using vast knowledge concerning the commodity fundamentals, impactful events and technical analysis. Further, they must focus 100 percent of their time on that commodity's market, which would likely make a high volume of trades to get the financial results they want. It is the only way they can make money. A propane retailer, however, is going to make the majority of his money on the margin he makes by selling propane to his customers. His focus should always have a supply portfolio coupled with marketing programs that gives him the best chance of realizing his margin target, regardless of pricing conditions. WEEK IN REVIEW Energy prices continued to fall as weak fundamentals continued to be the primary driving force in prices. Propane managed to limit its losses with a surprisingly large draw on U.S. propane inventory of nearly 600,000 barrels that provided some support. An 8-million-barrel build in U.S. crude inventory kept fundamental support bearish for crude. We went into the week neutral propane and bearish crude. LAST WEEK'S HIGHLIGHTS Propane kicked off the week resuming its downtrend with high inventory and low demand, keeping pressure on prices. Crude fell as Iran’s top nuclear negotiator said he believed sanctions against Iran that limits crude exports will be lifted before the end of the year. Propane prices remained stable after Monday’s loss and one day ahead of weekly inventory data. West Texas Intermediate crude fell through key technical support, leaving it vulnerable to fall more. A surprising draw of nearly 600,000 barrels in U.S. propane inventory allowed propane prices to hold steady despite a drop in crude prices. Crude was lower after the Energy Information Administration reported an 8-million-barrel build in U.S. crude inventory. Solid up day for propane as prices tried to rally following the previous day’s reported inventory draw and on some support from crude. The rebound in propane prices didn’t last long. Trading volume faded on the final day of the week and prices slipped along with retreating crude. Crude came under pressure as a rising dollar turned investors off commodities and toward equities.   CONNECT WHAT IS COST MANAGEMENT SOLUTIONS? The Propane Price Insider is an email service that provides: Three daily price Flash Wires Periodic option quotes Wednesday inventory data updates around 11 a.m. ET 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 email, sign up online here or call 888-441-3338. 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. Dale G. Delay, 888-441-3338 ddelay@propanecost.com Mark Rachal, 888-441-3338 mrachal@propanecost.com Many retailers simply don't have time to analyze the large amounts of data to make an informed purchasing decision. We offer: Detailed market recommendations on hedge and pre-buy entry points Prompt market execution of hedging strategies Supply cost analysis and recommendation as to effective hedging strategies Large volume consideration when we place your hedges GOT STORY IDEAS? Email Brian Richesson, Editor in Chief LOOKING FOR ADVERTISING OPPORTUNITIES? Email Brian Kanaba, Publisher You are currently subscribed to Trader's Corner as %%EMAILADDR%%. 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