Strategies for managing high propane prices

September 28, 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, presents part two of a series about short-term price protection strategies as propane prices rise.

In last week’s Trader’s Corner, we began a two-part series on strategies for managing rapidly rising propane prices. Our assumption was that the current high prices have buyers hesitant to try to buy price protection for the entire winter. No one wants to believe the current price of winter propane will be the reality for the entire winter. The fear is if you buy here, you will lock in high prices only to see prices fall before the end of winter.

We would say that current propane fundamentals and outlooks for crude’s price would suggest high prices are here to stay for this winter. Yet, we acknowledge there have been plenty of cases where buyers have been hung out to dry after buying in similar circumstances when a seemingly untouchable bull market suddenly becomes bearish. Because of the hesitancy we see in buyers at this point, we suggest some retailers may be more comfortable managing upward price risk one month at a time rather than for the entire winter.

One reason we suggest this is that history shows propane retailers delay passing on rising prices to their customers. Meanwhile, their suppliers are quicker to pass on price increases. The result is propane retailers see their profit margins shrink significantly in rapidly rising price environments. Thus, establishing supply costs and fixing a sales price even for short durations becomes very beneficial for maintaining margins.

Our strategy is to fix supply costs for one month at a time using one of three financial tools: call options, swaps or physicals. Last week, we covered call options. If you missed it, you may want to go back and review that article as well.

An example of the strategy: At the end of September, you will establish your supply cost for October by using one of the three financial tools. Once the supply cost is known, you establish your sales price for October using your standard margin. Once this is done, you do not have to worry about your margin being squeezed if prices continue to rise.

Just as importantly, since you are not locking down supply for a long period of time, you will be able to adjust your sales price the next month should propane prices suddenly turn lower, thus lowering the risk of losing customers because your price is too high.

Price protection tool: swaps

If you feel fairly confident of higher prices over the next month, the best tool is probably to buy a swap because of its simplicity. Sometime this week, you would buy October propane at whatever its market price is at the time of purchase. As we wrote this past Friday morning, the price was 134.25 cents at Mont Belvieu and 135 cents at Conway. The prices will probably be different when you buy this week, but this gives you an idea of where October propane is trading.

If prices in your area are based off of Mont Belvieu propane, then you will want to buy a Mont Belvieu swap. If they are based off of Conway, then you will buy a Conway swap. To that strike price, you will add the normal differential between the hub and your location. Hopefully, you are already buying from your supplier on an index price at your supply point. That means you pay the Mont Belvieu or Conway average on the day of lifting plus a fixed differential.

If you are buying on an index, the process is simple. You use the strike price of the swap, add the fixed differential, add transportation cost from the supplier to your bulk tank and add your desired margin. That establishes your retail price for the month of October. At that point, it wouldn’t matter if prices continue to rise during October since your customer’s price will be set and your margin protected.

If prices surprise and start falling, you only have to hold the retail price through the end of the month, and then you can adjust it lower. With a swap, if prices rise and the monthly average is higher than your strike price, you receive the difference. In a rising price environment, you will pay more for the physical propane you put in your tanks than you used to establish your retail price, but the swap payment will offset the difference. That is why you can confidently set a price to your customers and not worry about your margin being hurt.

On the other hand, if prices suddenly turn lower and the monthly average is lower than your strike price, you must pay the difference. That is why you can’t lower your retail price in October. You must use the extra margin to pay the swap loss. If you don’t think you can hold a price for a month during a falling market without losing your customer base, then you may want to consider a physical.

Price protection tool: physicals

A physical is purchased just like the swap and at the same strike. But instead of settling at the monthly average, the holder of the physical decides when to close the position. Let’s say that on Oct. 15 propane prices turn lower and the holder of the swap believes that trend will continue. He can close the position on that day. He will receive the market price for his propane on that day.

Of course, the risk is that the dip in October’s price is short, and prices suddenly turn higher again. With the position closed, the retailer has no price protection for the remainder of the month. Thus, he will need to quickly raise his retail price if prices start going higher again or his margin suffers. On the other hand, if prices continue to fall, he can hold his price and make more margin or lower his price to respond to competitive pressures.

There are two primary hindrances to using the physical versus the swap. First, the buyer has to keep up with the market throughout the course of the month to choose the day they will close the position. The second is known as the bid-offer risk or spread. When we buy a physical, we pay the offer, and when we sell, we get the bid. Right at this moment, the bid-offer spread for Mont Belvieu LST is three-quarters of a cent, and Conway is 1 cent. Literally, if we bought a physical in Conway at 135 cents and decided to close it a minute later, we would receive 134 cents. Because of this spread, if we’re going to use a physical to set our sales price to customers, we would add about a penny to cover this spread. Otherwise, the spread would take away from our planned margin.

With this subject, we are not saying that retailers should not be considering longer-term positions to cover all of winter. Current fundamentals would suggest that would be the right move. But if you don’t feel comfortable taking longer-term positions at current prices, then the short-term strategy we have discussed can be beneficial in protecting margins while providing the maximum flexibility to respond to a change in price direction.

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