How hedging differs in the propane industry

May 22, 2023 By Mark Rachal

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 hedging.

Catch up on last week’s Trader’s Corner here: Reactions to record low US propane demand

Two weeks ago, front-month May propane prices dropped into the mid 60s. According to traders and our own experience, that triggered a lot of hedging activity. The buying from that hedging activity pushed prices back to about 70 cents, causing the hedging activity to slow considerably. Propane prices are presently back down to where the flurry of hedging activity occurred two weeks ago.

Anticipating that we may be reporting increased hedging activity again, we thought it a good time to make sure we are clear on what is meant by hedging and, more specifically, how it is different with the commodity of propane than it is with many other commodities. Some of you who are in the agricultural business and other parts of the energy industry may be familiar with futures trading. Hedging in propane does not deal in futures. It would be more accurately called the forward market and even that is not 100 percent applicable.

Commodities futures are traded on large exchanges. The futures markets are highly regulated. Trading is done in contracts that represent a specific volume of the underlying commodity. For example, one crude contract is 1,000 barrels. A wheat contract is 5,000 bushels and so on. In contrast, propane forward contracts have a high degree of variability in volume, and it is usually the placer or buyer of the hedge that sets the volume. For example, a client last week requested forward contracts of just 400 gallons per month to hedge a sale to a specific end-use customer. These types of small, custom volume hedges are done routinely in the propane forward market. A propane retailer that wants to hedge future sales is not stuck with having to adapt to specific volumes in a contract that is typical in the futures market. The shape of the forward deal is driven by the needs of the propane retailer in establishing a known cost of supply in their commercial business. Referencing those commercial needs, the retailer (buyer) establishes the volume, months covered and the price point by which the performance of the hedge will be measured and then utilizes generic forward hedges that are widely offered by traders to fulfill the hedging need.

In the futures markets, there is no counterparty risk. The traders of futures must put up margins (money) before taking a futures position. The exchange where futures are trading has large clearing houses that handle the finances of the trade. The clearing houses balance buyer and seller positions literally every day. If a futures position goes against the holder of a future where the initial margin deposit does not cover their loss, they are required to immediately wire more funds into their account. The clearing houses guarantee performance of futures position, so there is no counterparty risk. The clearing house acts as the buyer for every seller and the seller for every buyer. So, the trader of futures does not have to worry about another party not performing or becoming insolvent.

By contrast, in the propane forward market, there is a risk to counterparty performance. Propane forward markets are largely conducted through the trading arms (traders) of large companies that are generally in the propane or energy business in other ways. They may be producers, have transportation assets, conduct wholesale operations, retail operations or some other activity that connects them to the industry. Other producers or processors may come to these trading arms to hedge their production. These traders then make a market by offering their and/or other producers’ forward production to buyers.

U.S. propane retailers and petrochemical companies, as well as foreign buyers, are the primary pool of counterparties. The traders that are making the market do not act as clearing houses. Instead, they issue lines of credit through the various entities with which they do business, so there is risk to counterparty performance. The trader will require entities to put up more money, known as a margin call, if their lines of credit are nearing their limit, or they will require the forward position to be closed. In the forward market, the propane retailer or buyer does not generally have to put up margin with each trade, but they must provide financial information so that a line of credit can be established with the trader. The trader assumes the responsibility of monitoring a counterparty’s position against their credit line and taking appropriate action.

Another important difference about hedging activity in the retail propane industry has to do with product delivery. In this way, propane hedging is certainly different from futures and even unique in the futures market. When a party enters futures contracts, they are expected to be able to make or take delivery of the physical commodity. The exchange sets the places where the delivery can occur, and the seller of the commodity chooses at which of these locations the physical commodity will be delivered in the month specified by the future. Most futures do not end up in physical delivery. About 98 percent are closed with a countering transaction before delivery occurs. But the ability to make physical delivery of the commodity is essential for futures markets to function properly.

Many forward hedges do end up with the underlying physical commodity being delivered, with the terms negotiated by the buyer and seller as in an over-the-counter transaction. But, in the case of hedges placed in the forward market by propane retailers, there is never the expectation that the retailer will take physical delivery of the propane. It is simply a financial or paper transaction. In fact, many refer to the activity as a paper barrel, or paper forward. In the case of propane, both the retailers/buyers and the producers/sellers have customers for their propane that will take actual physical delivery in the future. Therefore, setting the expectation of physical delivery in the paper hedge is not necessary for the market to function. The purpose of the hedging activity is to allow both the buyer and seller to do price discovery for future production or supply and to share price risk that is mutually beneficial to both parties by using the hedge or paper transaction to counter the unknown movement in the cash or spot market.

In the future, the buyer of the paper position will make physical deliveries to customers they already have. These customers will be homeowners, commercial businesses, industrial companies and government entities. The seller will make future deliveries to customers they already have. These customers will be propane retailers (but not tied to the paper transaction in any way), petrochemical companies, some domestic commercial and industrial accounts and foreign buyers.

The propane retailers buy their propane supply from well-established supply sources in the spot or cash market that reflects the value of propane at the time of delivery. This activity is not connected to the paper hedge or financial activity in any way. The price of propane in the cash market may be higher or lower than the retailer was expecting. However, the paper or financial transaction will also settle at this time and will counter whatever the price movement in the cash market was after the hedge was put in place.

The retailer is generally hedging against higher prices and will receive monies from the financial position if the cash market has gone higher after the hedge was put in place. They will pay monies to the financial position if market prices have gone lower. The idea is they will make more money on the physical transactions than expected when the hedge was placed, and they will use that gain to pay the obligation on the financial transaction. Remember, the trader with which the retailer entered the financial or paper position has producers on the other side that will ultimately receive the funds. Basically, in a rising spot market, the producers (sellers) are keeping buyers from feeling the full impact of the higher prices and in a falling market, the retailers (buyers) are keeping the producers from feeling the full impact of the price decline.

The propane retailer has a dual mandate:

1. Use various hedging techniques that establish a known cost of supply that protects customers from very high prices.

2. Implement the hedges when the market yields a cost of supply that will be in a competitive range at the time of delivery. There has always been this need by the propane retailer to balance protecting the consumer, which protects the retail business, and not taking undue risk in the process.

What we do at Cost Management Solutions is to help propane retailers and consumers manage the risk that is inherent to commodities markets. We do not advocate speculation. Our focus is risk management related to supply cost for a commercial propane business. What we do with Trader’s Corner and our flagship Propane Price Insider report is to put propane fundamentals and pricing into historical context so that the propane retailer has the best chance of successfully achieving their dual mandate. Our aim is to provide timely information and aid the retailer in establishing the relationships needed to bring the full arsenal of hedging tools to bear to manage supply-side risks. We also aid in price discovery and market transparency during the process of placing a hedge.

We feel this activity is essential to a healthy propane market and industry by keeping pricing inside parameters that are fair to both the end consumer and the producer. This activity allows producers a known value in the goods they will sell so they can make the investments necessary to remain a reliable supplier. It also allows propane retailers to protect their customers from price extremes. Retailers have the flexibility to offer fixed and budget pricing programs that help customers remove budget-busting price uncertainty for the propane they will consume.

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.