Protecting gains when speculating with swaps

June 8, 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, explains best practices for speculating with financial swaps.

In this Trader’s Corner, we continue with part seven of our series on financial swaps. Since these segments build upon each other, we highly suggest you review the previous segments if you missed them (parts one, two, three, four, five and six). Also, our Trader’s Corner of April 5, “The logic behind managing propane price risk,” is very pertinent to our segment this week.

In earlier segments, we covered using financial swaps as a hedging tool. Hedging occurs when the retailer has locked down the price he will pay for propane in the future and made a sale against that supply to lock in a margin.

Then, last week, we moved on to using financial swaps as mechanisms for speculating. Speculating happens when a retailer locks down only one half of the equation. If retailers buy propane without a corresponding sell or sell propane without a corresponding buy, they have speculated.

When we hedge, risk management doesn’t really need to be considered with regard to the positions. All of the risk is removed because both sides of the equation are set. Speculation, on the other hand, requires vigilance in monitoring the position and making sure it is performing as expected. If it isn’t, then the prudent step might be to close the position.

In the scenario we set up for discussing speculation, our propane retailer bought six financial swaps – 100,000 gallons per month covering the October 2021 to March 2022 time frame. The average price of the swaps bought in April was $0.7908. The retailer did this because the price was close to what propane averaged last winter, and both propane fundamentals and crude prices were more supportive of higher propane prices.

Imagine, if you will, that this propane retailer is blessed with a propane tank farm at Mont Belvieu, with a working capacity of 600,000 gallons. In April, the retailer decided to put 600,000 gallons in the tanks at an average cost of $0.7908. The result would be exactly the same as the financial swap. In both cases, he is now long propane, valued at $0.7908. Now that he is long 600,000 gallons of propane, he has eliminated the risk of higher propane prices but assumed the risk of lower propane prices. Since the retailer has no sale against this supply position, he is speculating and must therefore manage the risk of falling propane prices.

As of this writing, an October 2021 through March 2022 strip of propane is valued at $0.8968. Whether you look at the physical propane in the tanks or a swap position, there has been a $0.106 gain in the value of the positions. This last week, the U.S. Energy Information Administration reported a much higher than expected 4-million-barrel build in U.S. propane inventory. Let’s say our retailer believes that is a harbinger for lower propane prices this coming winter, so he wants to capture the gains on his positions.

If the propane he owned were in tanks at Mont Belvieu, he might try to ship it up the pipeline, transfer it to his local bulk tank and sell it off to his retailer customers. That might be a tough hill to climb in June, and, if he is right about prices falling, he could lose a lot of the gain before all the physical movement and sales are complete.

Managing the risk to falling prices for the financial swap position is much easier and quicker. Remember, our retailer holds six swaps, one each for the months of October 2021 to March 2022, at a volume of 100,000 gallons each. He bought swaps to put this position in place. To close the position, he simply has to sell swaps for the same months and volumes.

To do this, the retailer calls Cost Management Solutions (CMS) and requests it closes the entire October 2021 to March 2022 swap position. CMS calls traders on behalf of the retailer and informs them that it has 100,000 gallons per month of October 2021 to March 2022 Mont Belvieu swaps for sell and would like bids. The traders would tell CMS what they would be willing to give for the propane. Bids, the price to buy, are generally lower than offers, the price to sell. Above, we said the value of the position was $0.8968, up $0.106, but that was based on the current offers in the market. The bids will be less.

Let’s assume the best bid is $0.8868, a penny less than the current offers. CMS accepts the bid, which essentially locks down a $0.096 gain for the retailer. Remember that swaps settle when the monthly average for that month is known. The six swaps the retailer originally bought in April do not go away. They are still active. He now owns twelve swaps – two for each month from October 2021 through March 2022. There is one buy position and one sell position.

Going forward, the positions will offset each other. Once all the swap positions are settled at the end of March 2022, the retailer will show a net gain of $0.096.

In summary:

  1. In April, the retailer bought the six swap positions. The retailer became long propane at that point, meaning his risk was to falling prices.
  2. When speculating, the position should be considered everyday to make sure it is performing as expected. The retailer did this from April to June. In June, a high inventory build made the retailer reconsider the position. Believing that gains were at risk, the retailer decided to capture them.
  3. To capture the gain, the retailer sold swaps in the same months and at equal volumes. From that point forward, until the monthly average was known for each month and the swaps settled, the swap buy position and swap sell position countered each other, ensuring a net gain of $0.096 per gallon on 600,000 gallons.

In this case, the swap position worked out well, but there could be a situation where the market fell as soon as the swap position was entered. In that case, a retailer may take the action above to mitigate losses. The important part of that would be setting a stop loss. In our next Trader’s Corner, we discuss where to set a stop loss.

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