Propane retailers fulfill ‘dual mandate’ to manage price risk

July 3, 2023 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, explains hedging and the dual mandate of a propane retailer.

Catch up on last week’s Trader’s Corner here: Propane inventory possibilities to start the winter

In a recent Trader’s Corner, we mentioned that propane retailers have always had a dual mandate. The first part of the mandate is to protect propane consumers from high prices. The second part of the mandate is to fulfill the first part without taking undue risk that could harm the competitiveness of the retailer and lead to the loss of customers.

We do not believe the first part of the mandate is some type of moral obligation. It is simply good business. One of the first Trader’s Corners we ever wrote was titled “Checkbooks and Sneakers.” When propane consumers are faced with high prices, they only have two responses available. Pay or walk away from their supplier. Walking away could mean going to a competitor or going to another energy source. Another way to walk would be to conserve.

When we say high prices, we are talking about those big spikes in price that really get consumers’ attention and drive them into some type of decision-making process. For the most part, a propane consumer’s world does not revolve around the purchase of propane as some retailers seem to think. A propane consumer is generally happy to take propane for granted and focus on other, more interesting aspects of life. Don’t shock consumers, and most are happy to keep their heads down, write the check and keep the sneakers in the closet.

We are very fortunate that propane generally has been oversupplied for years now, and the exceptionally high spikes in price have been more on the rare side compared to years past. But we shouldn’t become complacent and assume they will never come again. The nature of price spikes is they often seem to come out of nowhere. In our view, a propane retailer should go into any winter with some hedge or price protection that could help mitigate the impact of an unusually high pricing environment.

We can’t avoid risk. When we try to avoid one risk, we assume another. Our job is to manage risk, not ignore it. Some retailers are never going to hedge. They are going to buy at market prices, add their markup and move on. They avoid the hedging risk by transferring all of the price risk to the consumer. Most of the time, that works, but there will come a time when making the consumer take all of the risk will result in the sneakers coming out of the closet.

Retailers have tools at their disposal to manage the risk of higher prices that the consumer simply doesn’t. That is where the second part of the mandate is in play. We can help the consumer without taking undue risk in the process. The risk is we mismanage the hedging process and have too much of our supply locked in at prices that become uncompetitive in the future.

As we said, we believe some hedging is always appropriate, but retailers should never be over-hedged. Being under-hedged can cause us to fail in the first part of the mandate, but being over-hedged can cause us to fail in the second part of the mandate.

Going into the winter, we should probably consider a hedge position that ranges between 30 percent and 70 percent of future sales. We would not include in these volumes contracted sales where the sales price and the supply is already locked. This is a true hedge, and we can put those volumes off to the side. We are talking about managing the risk of higher prices for future sales.

Why 30 percent to 70 percent? As we said, having 30 percent hedged, no matter the pricing environment, provides a way to mitigate the impact of an exceptionally high-price situation. Yes, by taking this 30 percent position we run the risk of this part of our supply being priced higher than market prices in the future. But it is a low enough percentage of sales that the retailer should be able to remain competitive even if a low-price environment develops.

On the other hand, limiting the total hedge volume to 70 percent always provides the ability to buy at market prices in a low-price environment, helping to lower the average total cost of supply. No matter how good prices might look leading up to the winter, there is always the potential for something to happen to cause a low-price environment to occur. We need only go back to the pandemic to find a case in point.

Where in the 30 percent to 70 percent range the hedges fall should be dictated by market conditions. When the pricing environment is providing opportunities to hedge on the lower end of the historic price range, taking higher hedge volumes has a reduced risk. On the other hand, when the pricing environment is on the upper end of the historic pricing range, we should limit our hedges given the increased risk of falling prices.

Market conditions can change during the time retailers are putting their hedging programs in place. One of the great advantages of using propane forwards to hedge is that these positions can be exited easily. Let’s say that at the beginning of summer the pricing environment is low, and a retailer is taking advantage of a perceived opportunity by hedging more of the expected futures sales volumes. Let’s say the retailer has gotten into a 60 percent hedge position at what seemed like good numbers at the time. However, as winter nears, it is becoming more apparent that an even weaker pricing environment could be ahead. Maybe propane inventories are building at a higher pace than expected or economic conditions are deteriorating. In that case, the retailer that is 60 percent hedged could take action to reduce the hedge position to a lower percentage of expected future sales.

When retailers take a propane forwards position to protect against higher prices, they agree to buy the further out month at a specific price. That position will remain active until the month that is far has come and gone. However, retailers can sell a forward position for that same month. The consequence is the two positions now counter each other, essentially shutting down the original buy at whatever gain or loss it has at the time.

Let’s say the retailer had hedged 50,000 gallons of expected future sales for October 2023 propane by buying a propane forwards position. As the summer progressed, the buyer of the position decided the pricing environment is no longer favorable for that position and wants to reduce exposure to lower prices now. Remember, the buyer originally purchased it to reduce the risk of higher prices, which is the default risk position of a retailer for future sales. But once a hedge is put in place, the risk on that specific volume becomes lower prices. To reduce this risk, the retailer decides to sell an October 2023 propane forwards position of 10,000 gallons. Once in place, that position counters 10,000 gallons of the original buy position. You could look at it as if that 10,000 gallons of buy hedge no longer exists and the retailer is now reduced to an active 40,000-gallon position that is hedging against higher prices. Of course, this reduces the percentage of overall future sales that are hedged.

None of us know the future. We only can manage the risk of the unknown by making decisions based on the perceived opportunities or threats the market is presenting us at any given point in time. In the case above, in say April 2023, there appeared to be an opportunity to own October 2023 at a favorable hedge price. But, by August of 2023, perhaps the risk to higher prices seems less and the risk to lower prices seems more. The propane retailer can adjust the position based on the new reality.

There is no doubt that letting the consumer take all the risk of higher propane prices is one heck of a lot easier on a propane retailer. But make no mistake, the retailer is not eliminating risk by doing so. They are simply assuming another type of risk. While it is not necessarily easy, we do believe that propane retailers can fulfill their dual mandate by using all of the tools available to them.

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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