Strategies for using financial swaps effectively

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 using financial swaps.

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In last week’s Trader’s Corner, we discussed why the financial swap market exists and how it works. This week, we are going to begin considering the process of how a propane retailer uses swaps to capture opportunities, turn unknown future prices into knowns and maintain the flexibility to adjust positions when market conditions change.

Perhaps the most important thing to understand at the beginning of this discussion is that physically buying propane from a supplier and using a swap to hedge the price of the propane are two separate activities. However, when the results of the two separate activities are combined, they allow the retailer to accomplish one or more objectives mentioned in the first paragraph.

The second-most important thing to understand is that the pricing of the physical propane a retailer buys is set in his particular market. The value of the financial swap is going to be set at the trading hubs of Mont Belvieu (MB), Texas, or Conway, Kansas. Therefore, for the two separate activities to work together, this pricing difference or differential between the retailer’s physical market and the trading hub must be taken into consideration.

Buying at index price

The fact that this differential exists is why we recommend, where possible, a retailer buy from their physical propane supplier on an index price basis rather than at posted prices. Most suppliers offer the ability to buy from them on an index price.

When buying from a physical supplier at an index price, the retailer will pay the hub price on the day of lifting plus a set differential that is agreed to in advance. Buying physical propane at a price indexed to the trading hub where the financial swaps will trade establishes a direct correlation between the two activities. Buying in this manner creates a clean hedge and eliminates basis risk.

Basis risk is a term used for the potential that the price relationship between two locations can change. For example, let’s say that posted prices around a pipeline terminal in Ohio normally run 8 cents above the price of propane in MB. That is the normal differential. Since the posted price is not contractually connected to the trading hub of MB, there is a risk that the posted price could become more than 8 cents above the price at MB.

If a retailer is using a financial hedge at MB but is buying physical propane at a posted price in Ohio, he is assuming the risk that the price relationship between the two locations could change. In other words, he is assuming basis risk. However, if he agrees to buy from his supplier at a price indexed to the trading hub of MB plus a set differential, he eliminates basis risks.

The supplier may want the ability to raise her posted price to reflect market conditions and demand a slight premium to provide an index price. The retailer may be willing to accept a slight premium to make sure he has a clean hedge by removing basis risk.

Paying this slight premium removes the risk that the price of propane where the financial hedge is trading and where physical propane is being bought separates.

Example swap

To set up an example, let’s assume that the retailer’s supplier agrees to sell physical propane to the retailer at a terminal in Ohio at the daily average price of MB propane on the day of lifting plus 8.5 cents.

Many suppliers will allow their customer to buy at their posting or at an indexed price. At the terminal, retailer X would have a posted account and an index account. When he calls the trucking company to pick up a load of propane, he would specify which of the two accounts to select from that supplier.

The billing department of the supplier would know any lifting off of the posted account would be billed at its posting on that day.

Any load pulled on the index account would be billed at the daily average price for MB propane as reported by Oil Price Information Service (OPIS) on the day of lifting plus the set differential.

In our example, that would be the MB daily average of lifting plus 8.5 cents.

This week, we have furthered our exploration of financial swaps by establishing two important points:

1. Physically buying propane from a supplier and using a swap to manage the price of the propane are two separate transactions. Yet, the combined results of the two realize several beneficial elements of propane supply risk management.
2. While retailers do not need to change their physical suppliers to enjoy the benefits of swaps, it would be beneficial to have the option to buy from the supplier on an index basis to eliminate basis risk between where the propane is physically lifted and the trading hub where the swap will trade.

In next week’s Trader’s Corner, we will continue this process by showing exactly how our retailer in Ohio buying on indexed prices from his supplier and using a swap can offer a fixed price to a commercial account months or even years in advance of when the propane will be physically delivered.

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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.