How hedging and speculating with financial swaps differ

Trader’s Corner, a weekly partnership with Cost Management Solutions, analyzes propane supply and pricing trends. This week, Mark Rachal, director of research and publications, explains best practices for using financial swaps.

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In this Trader’s Corner, we continue with part six of our series on financial swaps. (Revisit parts one, two, three, four and five.) Last week, we completed the segment on how to use a financial swap as a hedge. Let’s be clear about what we mean by hedge.

If you recall, in the example, our propane retailer had a commercial, industrial or municipal account that needed a fixed price for propane. The financial swap coupled with the retailer’s normal physical supply allowed the retailer to quote a fixed price to the customer for a period of 12 months with no risk to his margin. When a retailer uses a financial swap to lock in the price on a known sale, it is a hedge.

Both sides of the equation are known or fixed. The retailer knew what he was going to pay for a specific amount of supply as soon as he entered into the financial swaps. He also knew the price he was going to receive from the customer on those gallons months before the delivery. This established a known margin. With a hedge, the retailer can put the position to bed. There is no price risk management that needs to be done.

Hedging is the easiest and best way to use financial swaps. But we can also use financial swaps to capture an opportunity that may be present in the market. Being able to quickly and efficiently act upon market opportunities when prices seem below where they should be or drop into a price zone that a retailer is confident will work in his market can be one of the great benefits of financial swaps. But make no mistake, when we use swaps in this way, we are speculating, not hedging.

Speculative positions

Anytime we enter into a supply-side agreement, physical or financial, without a corresponding sales-side agreement, we are speculating. When we are speculating, we can’t put a position to bed and forget about it as with a hedge. Rather, we must constantly monitor, evaluate and manage the risk around the position. It is no different than if we bought a stock for our 401(k). When we buy a stock, we look at it regularly and ask if it is performing as we expected. If not, perhaps we should consider selling that stock and buying a different company’s stock.

Financial swaps provide some flexibility in managing the risk associated with a speculative position. Let’s see how that works. Two months ago, on April 26, a series of six financial swaps covering the months of October 2021 through March 2022 could have been struck at 75.6460 cents at Mont Belvieu. Propane averaged 73.74 cents during the same months during the winter of 2020-21. However, the retailer was aware that propane inventories are much lower this year and crude prices much higher.

The retailer perceived that locking in some propane supply at or near last winter’s price presented an opportunity. To capture that opportunity, the retailer decided to buy six swaps covering the winter months at a volume of 100,000 gallons per month and at a price of 75.6460 cents per gallon.

The 600,000 gallons represent only a portion of expected winter demand. The retailer could have bought varying volumes each month to line up better with demand by month, but that would have changed the price.

Let’s assume the retailer intends to come back later and lock in the price on more gallons during higher demand months. This transaction represents a baseload to begin a price risk management strategy.

Setting up this swap position would take a matter of minutes, assuming the relationship with counterparties is already set up. Helping propane retailers get set up with counterparties and negotiating the strike price of the swaps on their behalf is part of what Cost Management Solutions does. The process is not difficult. Once the counterparty relationship is established, which generally includes a line of credit, swap transactions are very easy. Money would not have exchanged hands when the swap position was taken on April 26. Money will exchange hands after the monthly average for each swap month is known.

If the monthly average is higher than the strike price, the retailer receives the difference. If the monthly average is lower than the strike price, the retailer pays the difference. In either case, the price of propane supply on that 600,000 gallons will be 75.6460 cents at Mont Belvieu.

Market conditions

As of May 27, a strip of propane swaps for October 2021 through March 2022 was valued at 87.1667 cents. That means the retailer’s assessment on April 26 that propane bought at or near last winter’s average represented an opportunity was spot on. The position is up 11.5207 cents. If the current price were to hold through the winter months, that is 11.5207 cents that goes straight to the retailer’s bottom line, assuming the retailer actually sells propane based on market prices during the winter months.

At this point, we strongly suggest you go back and read our Trader’s Corner for April 5, “The logic behind managing propane price risk,” for background on why the retailer should sell at market prices in this situation.

Everything is going great for a retailer that bought propane on April 26, isn’t it? But the swaps haven’t settled, and it is a long way until they do. As we all know, things can change dramatically between now and October. Any retailer that has ever done a traditional prebuy has seen this movie before. A position looks great and then market conditions change and you slowly, agonizingly watch what looked like a great decision turn into a bad one.

Right now, in reality, the position above still looks very strong. Fundamentals for propane and crude’s expected price rise suggest the gain on this position is likely to increase. However, in our next Trader’s Corner, we are going to assume that market conditions turn more bearish. We will show the simple step a retailer can take to protect most of the gains on the position.

Again, just imagine that you own stock in a company. That company had been performing very well, and its stock price had been rising. Perhaps new information comes to light about the company or the industry that suggests its stock price could fall. The stock investor is very likely to sell this position, take the gains and reinvest in a company or market sector that is not as susceptible to these new risks. Next week, we will do no different with our swap position established in this example.

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Call Cost Management Solutions today for more information about how client services can enhance your business at 888-441-3338 or drop us an email at info@propanecost.com.