Managing supply price risk in the second half of winter

January 2, 2024 By    

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, analyzes the risk of higher prices in the second half of winter.

Catch up on last week’s Trader’s Corner here: Top 10: The best of Trader’s Corner 2023

The first half of this winter is almost in the books. Propane inventories are still setting five-year highs. There is a good chance that inventories will remain high at the end of March, keeping prices depressed going into the summer-build period. However, we hear plenty of folks projecting cold weather in the second half of winter.

It presents a conundrum for propane retailers concerning supply positioning. Given the weak fundamental support for propane prices, a retailer must be very careful in committing to fixed prices on supply for the next three months. Yet, crude’s price is on a run higher, and if the forecasts for cold weather materialize, some price protection might be desirable. Rising crude prices by themselves could lift propane prices, even with weak fundamental support. Add a little cold weather, and we could be surprised by an unexpected rise in prices.

Call options

This is a situation that is perfect for using call options. When we want protection against rising prices, but conditions elevate the potential for falling prices, then call options should rise to the top of our supply price risk management toolbox.

Propane retailers and their customers are normally or naturally at risk of rising prices. Propane retailers know they will sell propane, and propane customers know they will consume propane in the future. They are not harmed by prices falling, so the natural need is to manage the risk of rising prices.

Propane retailers can manage this risk by storing propane, committing to pre-buys that lock in future prices based on current prices or committing to propane forwards (swaps) for future months.

As soon as the retailer takes any of the positions, unless they make sales against the fixed-priced supply position with fixed-priced offers to their customers, they are assuming downside price risk. There are times when a retailer might feel comfortable taking on that downside price risk. With propane fundamentals not supportive of prices, as they are currently, it might not be one of those times.

To illustrate why a call option works best in these situations, let’s compare it to a propane forward, which we discussed in a recent Trader’s Corner comparing propane forwards to storing propane for winter.

When we enter a propane forward position, we establish a strike price for a future month. When that month comes, if the monthly average is higher than the strike, the holder of the forward is paid the difference between the strike price and the monthly average, enabling protection from higher prices.

If the monthly average is below the strike price, the propane retailer must pay the difference. Therefore, if a propane retailer enters a forward, they need to base their price to the customer on the strike price of the forward and should not lower that price if prices fall because they will need the extra sales margin to pay the loss on the forward position. Any lowering of the sales price lowers the gross profit margin. Given the lower sales volumes retailers are seeing due to mild winters, the last thing they need to do is lower margin. But with the forward, they may feel compelled to do so if prices fall too far and they are getting pushback from customers by holding prices firm.

With the call option, the propane retailer gets the same strike price as they would with the forward, which works just like the forward in protecting against higher prices. But rather than assuming the downside price risk, the retailer transfers that risk to an option writer by paying a premium. With that risk transferred, the option holder is free to lower retail prices should propane prices fall, thereby avoiding an uncompetitive pricing situation.

It is the best of both worlds with upside price protection and the flexibility to respond to a lower pricing environment. The problem with call options is that the premium can be a little pricey. That is especially true if it is a long time between when they are acquired and the month protected. But when they are entered into near the month they are protecting, the premium is reasonable.

If a retailer entered a call option at the end of December to cover the month of January, the premium might be around 6 cents. That is not unreasonable for managing upside price risk while avoiding downside price risk. If a retailer did a call option, they would add the premium to the cost of supply and build their retail price for January with that included. That is unlikely to be enough to cause a problem with competitors that are just buying at the spot price, especially if prices do go up. If prices are going up, they will need to increase prices or suffer a margin loss.

The retailer with the call option can hold their price firm all month long without taking a hit to margin in a rising price environment, while the retailer buying at spot prices must change their retail price regularly to avoid margin loss. Of course, the retailer with the call option can hold prices firm and fully protect the customers, or they can raise prices and make more margin.

In a falling market, the retailer with the call option theoretically will remain priced 6 cents higher than the competitor. However, they are free to follow competitors’ prices down, if necessary, without hurting the margin.

It has been shown that propane retailers do not raise prices to consumers as fast as suppliers raise prices to retailers. Therefore, propane retailers almost always take a margin hit in a rising price environment. The use of a call option or a forward for the upcoming month prevents this from happening.

If the risk of falling prices is very low – for example, when inventories are low – we would choose the forward every time to avoid the premium of a call option. However, with plenty of risk of falling prices because of the current high inventories, a call option allows the protection of margin no matter which direction the market goes during the upcoming month.

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.

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