How to take advantage of opportunity

In recent weeks, Trader’s Corner has looked at the reasons for the ultra-low price environment that has developed for U.S. propane. We have explored what happened with propane prices during 2015-16, when fundamental conditions were similar. Then, we looked at how and why propane prices rebounded from January 2016 through October 2018.

Propane retailers who saw the opportunity created by the low price environment in 2015-16 and acted upon the opportunity put themselves in a fantastic position, which added a lot to their bottom line over the next three years. It is not surprising that many retailers are asking themselves if the same opportunity is present again.

To be sure, the fundamental conditions that have driven propane prices lower are still present. It is probably still too early to commit to longer-term speculative positions in propane. Anyone who has speculated by going long propane since October 2018 knows the pitfalls of being long propane too early. But as we have discussed, the opportunity may be upon us well before the changes in fundamentals are blatantly obvious. In fact, as we will point out below, depending on a retailer’s individual market conditions, the opportunity may already be here. As we pointed out, propane inventories were still rising when propane retailers started taking long-term positions in propane in January 2016.

There are signs that the fundamental conditions that caused the rapid growth in propane supply, which is the root cause of the current downtrend in prices, could be changing. The huge increases in propane supply are the direct result of massive drilling programs for crude oil and natural gas, primarily in shale formations. Through the week ending Jan. 17, there were 673 active rigs drilling for crude in the United States. That is down 179 from a year ago. There were 120 active rigs drilling for natural gas, down 78 from a year earlier.

U.S. production companies, especially those that operate primarily in shale formations, have announced reductions in capital spending programs as they respond to a need to provide returns to investors, who see investment dollars dwindling. Producers were drilling wells at such a rapid pace that the inventory of wells that were drilled but uncompleted reached 8,473 in May 2019. Finally, the slower drilling rates are causing that inventory to decline, falling by 900 to 7,573 over the past seven months.

The Energy Information Administration (EIA) expects natural gas production to continue to rise this year but is predicting a small decline in 2021. Recently, natural gas has fallen to under $1.88 per million British thermal units (mmBtu), and several major oil companies have announced multi-billion dollar write-downs of the value of their natural gas assets. Keep in mind that natural gas was over $13 per mmBtu before the “shale gas revolution” began. The current price is not conducive to more drilling. Just last week, the EIA projected that U.S. production of natural gas from shale formations during February will be up just 0.1 billion cu. ft. That will be the smallest rate of growth since January 2019. The growth in crude production will be up 22,000 barrels per day (bpd) next month from shale formations, the smallest gain since last February.

The possible slowdown in supply growth will also need more demand to help turn prices. The EIA has estimated propane exports at over 1.2 million bpd over the last two weeks. That is a strong export rate, but it will need to stay there or grow to lower inventories. A lack of growth in domestic demand for propane puts all of the pressure on exports to contribute to a change in price trajectory. China has been putting hefty tariffs on U.S. propane imports, which has forced U.S. propane into other markets. Should China reduce or eliminate those tariffs, it could contribute to higher rates of exports. More propane export capacity will be added this year. Targa is working on a project that could add between 125,000 and 260,000 bpd to U.S. export capacity.

While the fundamental conditions in propane that have resulted in low prices have not yet changed, there are reasons to believe they could begin to change in the coming months. When a propane retailer believes a shift in fundamentals and a corresponding change in price trajectory is occurring, what can they do to take advantage of the opportunity? The best instrument, and perhaps the only instrument for taking a long-term position in propane, is a financial swap. That is exactly the instrument that propane retailers used in January 2016 to lock down their propane cost for three years.

Financial swaps are actually very simple. Just imagine a retailer called their supplier and agreed to a price of propane for the next 36 months. If such an agreement were made, it wouldn’t matter if prices went up or down – that is the price the retailer would pay. That is exactly the result of using financial swaps.

A financial swap fixes the future price of propane by countering the future changes in the prices of physical or wet propane. As an example, let’s look at where a financial swap would strike in the next three Decembers at Mont Belvieu, Texas: December 2020, 49 cents; December 2021, 49.5 cents; December 2022, 51.50 cents.

Those prices are above the current price of 40.25 cents. It might be hard for a retailer to agree to buy propane at that premium, but if they did, it would establish a base price of propane at around 50 cents for the next three Decembers. First, a retailer should ask, “Regardless of which way prices go from here, could I sell propane based off a 50-cent Mont Belvieu price?” If a retailer believes they could hold a retail price based off that value, then the opportunity is already present.

Let’s walk through how this would work by first focusing on the December 2020 financial swap with a strike of 49 cents. A retailer would consider that their cost of propane at Mont Belvieu for that month. To that they would add the difference between that price of propane in the Mont Belvieu market and their market. For this example, let’s say the typical difference between Mont Belvieu and what it costs to physically put propane in their tank during December is 21 cents. That covers things like pipe tariffs, wholesale margins, truck transportation, loading fees, etc. So, the retailer budgets a cost of supply of 70 cents in their tanks next December. To that they add an 80-cent margin and budget a sales price next December of $1.50 per gallon. The mindset is that no matter what direction prices go from now until December the lowest retail price offered will be $1.50 on the gallons based off this swap.

Now, let’s fast forward to next December and assume that we were wrong and propane fundamentals didn’t improve and in fact got worse. When it is time to buy propane, it is trading at 39 cents per gallon in Mont Belvieu instead of the budgeted 49 cents. They are paying to have propane in their tank at 60 cents instead of the budgeted 70 cents. If they sell at $1.50, they will make a 90-cent margin rather than the budgeted 80-cent margin. However, since the financial swap was struck at 49 cents, they will owe 10 cents on it. They will use the extra 10 cents of margin to pay this loss, putting them back to the budgeted margin of 80 cents. The key to this scenario is the retailer being confident they can hold their retail price at $1.50 in December, even if the propane market is lower than what their sales price was based upon.

Let’s continue on to December 2021. The retailer has a financial swap with a strike of 49.5 cents. They add the 21-cent market differential for a budgeted supply cost in their tank at 70.5 cents. This time they add an 80.5-cent margin with a budgeted sales price of $1.51. When December 2021 arrives, the Mont Belvieu market is 55.5 cents. Therefore, they are paying 6 cents more for the supply going in their tank. Let’s assume they had agreed to sell to their customers at $1.51. After getting money from their customers and paying their suppliers, they have a net margin of 74.5 cents, 6 cents less than budgeted. However, in this case, they will get paid 6 cents from the swap, putting their final margin at the budgeted 80.5 cents. If they did not commit to selling to their customers at $1.51, they are free to take the retail price higher. Let’s say they take it up by the 6 cents to $1.57 to reflect the current market. In this case, the gain from the swap goes directly to the bottom line, making the margin 86.5 cents.

The opportunity to put this additional money to the bottom line or to protect their customers from higher prices came only because the retailer was confident that they could hold a retail price of no less than $1.50, even if the value of propane did not improve or even moved lower.

That was the mindset that many retailers had in 2016, when they established swaps in January of that year. They believed the propane was valued low enough that they would not see downward price pressure in their market and thus could hold their sales price even if the value of propane dropped. As it turned out, the price of propane went higher, and they were able to realize higher margins for three straight years. On March 19-20, Cost Management Solutions is going to have a seminar in Houston, teaching these and many other trading and hedging concepts for improving margin. In this seminar, you can learn how to be set up and prepared to take advantage of the opportunities that may come following this major downturn in propane’s value.

ANNOUNCING HEDGING SEMINAR: Please note that Cost Management Solutions will be conducting a two-day hedging seminar on March 19-20 at the Houston Airport Marriott. This seminar will provide tools and strategies for helping propane retailers navigate the changes in propane pricing in the coming months. Please contact Dale Delay at 888-441-3338 for more details.

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.