Price relief despite bad inventory report

October 12, 2021 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, addresses propane pricing trends in the context of a recent inventory draw.

We titled last week’s Trader’s Corner “No price relief despite good inventory report.” That title was selected because the U.S. Energy Information Administration (EIA) had reported that as of Friday, Sept. 24, U.S. propane inventory had increased 2.642 million barrels to 72.921 million barrels. The build had exceeded significantly both industry expectations and the five-year average build for week 39 of the year.

Propane prices that were already on a steep climb did not even hesitate when the good inventory build was reported. In fact, propane added another 6 cents before the end of the week. Overall, for that week, Mont Belvieu LST propane was up 15 cents, or 11.19 percent, and Conway was up 14.25 cents, or 10.56 percent.

This week, we title Trader’s Corner just the opposite of the previous week. Last week, the EIA reported a disappointing 633,000-barrel draw in U.S. propane inventory. That went against the five-year average build in inventory for week 40 of the year and the expectations of industry analysts for an 803,000-barrel inventory build.

Despite the inventory draw, propane prices moved lower. Mont Belvieu LST propane opened last week with a close of 152 cents, and Conway closed at 151.75 cents. As we wrote this past Friday morning, Mont Belvieu LST propane was at 146.25 cents and Conway at 147.5 cents.

The pullback in propane’s price came even as crude prices were posting big gains, adding an even more bearish tone to the price activity. As we wrote Friday, West Texas Intermediate crude had just exceeded $80 per barrel after opening the week with a $77.62 close.

Explaining the price drop

When the market moves counter to expectations, we all want to know why. Four items occurred during the past two weeks that may have contributed to propane prices dipping despite the inventory draw:

1. In last week’s Trader’s Corner, we mentioned that, in addition to the inventory build reported by EIA, U.S. propane production jumped 158,000 barrels per day (bpd), ending a four-week, 217,000-bpd slide in production. The latest EIA report added another 29,000-bpd increase in propane production. The improvement in domestic production has certainly been a relief to the propane industry.

2. When propane reached 150 cents, propane traders were reporting that propane producers were suddenly becoming aggressive sellers. Perhaps it was the breaking of the $1.50-per-gallon mark for propane – or other factors we will mention – that pushed producers to aggressively sell, but either way, their new aggression in trying to sell their propane applied downward pressure on propane’s price.

3. Russia announced it thought it could help Europe with its shortfall in natural gas supplies, causing natural gas prices to fall. Natural gas had moved to over $45 per mmBtu in Europe and nearly that high in Asia. That is equivalent to a propane price of $4.12 per gallon. With natural gas so high, consumers were trying to find anything to use besides natural gas. Propane would certainly be a prime target because of its versatility. Not only can propane be used to replace natural gas in some instances, but it can also augment natural gas supplies. A natural gas utility company can inject propane into its methane stream to increase Btu content and pull down costs. Any news that would suggest less need for propane as a replacement for natural gas (methane) was going to help take the upward pressure off of propane’s price.

4. An industry report said that the price and demand for polypropylene was falling sharply. Polypropylene is made from propylene. The report also said that the price of propylene was falling to a lesser degree. Much of the new demand for propane has been coming from propane dehydrogenation plants. These plants take propane and convert it into higher-valued propylene. The propylene can be used to make a variety of plastics. A fall in the value of propylene and downstream products could lower the demand for propane and thus take upward pressure off of propane prices.

Short-term price protection

This kind of sudden change in the pricing environment is exactly why we suggested the short-term price protection strategies in two of the September Trader’s Corners. The strategy was to lock in supply costs at the end of one month for the upcoming month to protect margins in a rapidly rising price environment. The reason is that propane retailers tend to delay passing on price increases to their customers, so their margins get squeezed. By establishing supply costs one month at a time and setting retail prices accordingly, margins are protected. However, the short-term nature of the strategy allows the retailer to respond to a sudden change in price direction.

On the last day of September, October Mont Belvieu LST propane could have been locked in at 143.75 cents by buying a financial swap. Retailers locking in that price would add the differentials they pay to suppliers, transportation costs and margins to that price to set their retail prices for the month of October, thus protecting their margins. The retailers must hold this retail price during all of October, or they will lose margin. So even if supply prices fall, the retail price needs to be held for the strategy to work.

October propane had moved up to 152 cents by Oct. 4, so all was well with the strategy to that point. But now, surprisingly and suddenly, propane prices are retreating. Currently, the price is 146 cents, so the price protection taken remains a good choice. However, with the decline in propane’s value over the past five days, it looks like market prices could go below the price that was established by the swap. That means our swap position would lose money.

That is why it is essential to keep the retail price locked even if supply costs go below 143.75 cents Mont Belvieu LST. The extra margin gained on retail sales will go to pay for the swap loss. Once retailers purchased the October swap and set prices for the month, their margins were protected, but their ability to respond to a fall in the market was taken away.

That is where the short-term duration of the strategy comes into play. Retailers only need to hold retail prices for one month. If markets are continuing to fall at the end of October, retailers can reset everything in November. If retailers are totally confident that prices in November will continue to decline, they won’t use the swap and will instead buy at market prices, allowing retail prices to be set at more competitive levels. If retailers are concerned prices will start rising again, they can buy a November swap but likely at a lower price than what was locked in for October.

The whole idea is that retailers are not locked in to a price for a long enough time to cause a customer retention issue as a result of having to maintain a retail price that is too high for too long. Obviously, if prices continue to fall in October, retailers will prefer to have not been locked in to the swap so they could pass the lower cost on to customers.

But the strategy strikes a balance between the needs of retailers and customers. Using the price protection strategy protects the margin of retailers during a rapidly rising market. At the same time, it allows them to reset their prices after just one month, which is beneficial to customers should prices turn lower. In any case, we do not want retailers in a position where they feel they must lower prices and take a margin hit in order not to lose customers. The short-term nature of the strategy should avoid that dilemma.

For now, the overall market situation with low propane inventories would suggest there will be more upward pressure on prices this winter, making the short-term pricing strategy viable for protecting retail margins. But last week’s surprising and sudden dip in propane’s price gave us the perfect opportunity to discuss why the short-term duration of the strategy and the ability to reset prices is also a key component.

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