The logic behind managing propane price risk

In Trader’s Corner, we often share with our readers fundamental data that assesses the risk of higher or lower propane prices in the future. The underlying question is whether this data suggests that retailers should be protecting themselves and their customers from the risk of higher propane prices.

Perhaps this is a proverbial “cart before the horse” question. Perhaps the better question is: Should propane retailers be trying to manage the risk of higher propane prices at all?

Learn from past winters

At the end of March, we updated a table of monthly propane averages. Mont Belvieu LST propane averaged 92.38 cents in March. Last March, it averaged 29.33 cents. Let’s say that, last March, a propane retailer took advantage of the low-price environment and locked in propane for the next winter. Had the retailer done that, he may have been able to offer propane to his customers 40 cents less than what actual market prices allowed.

Would the retailer have gotten any credit from its customers for making such an astute move? Would his customers have given him any credit for managing the risk of higher future propane prices on their behalf? The answer is probably not. The customer opens their propane bill and, if they are not shocked, they will pay the bill without a thought about how the price they pay relates to the current value of propane.

When updating our monthly propane average table, we glanced at 2014. In March 2014, propane averaged 106.12 cents. Propane prices that month were 39 cents below where they had averaged the previous month. That winter, propane prices at Mont Belvieu averaged 125 cents.

The prices that March for the upcoming winter might have looked very tempting given the high prices of the winter that had just finished. Let’s say the propane retailer decided to protect its customers from the high prices they had just experienced by locking in prices for the upcoming winter. Let’s assume it was able to lock in next-winter prices at 95 cents, 30 cents less than what customers had paid during the prior winter.

As it turned out, during the next winter, propane prices averaged 64.81 cents or about 30 cents less than the price the retailer had locked in. Now imagine that the retailer is billing customers based on the higher price it paid. Would the customers notice that its prices are higher than the overall market?

Customer behavior

Actually, they might not if left to their own devices. They may have a vague memory of higher prices last year and be glad to see them lower this year. There still may be a lack of awareness of the overall propane market and an indifference to the price since it is lower than last year. The real risk comes from competitors or customers of competitors telling them what they are paying this year is higher than current market prices.

If customers call the retailer to get an explanation for the higher price, do you think they would give the retailer any credit for taking steps to protect them from a repeat of the previous winter? We would all like to think so, but probably not. The reality is that the retailer that made the effort to protect that customer may have to lower its margin to keep the business. The retailer is punished for having done the right thing.

This highlights the dilemma of trying to manage propane price risk. Retailers are judged by their price at a given moment in time and not a history of their price relative to the overall market.

Let’s say that same propane consumer is looking at investing for retirement and at mutual funds as a tool to do so. She would probably look at the prospectus of many mutual funds. She would be able to read about their investment philosophy and their performance over the history of the fund and then make the best choice for her and her family. We bet most propane retailers don’t have a prospectus or that many propane customers ask if they have one.

The propane consumer is not positioned to manage propane price risk. Propane retailers have many tools to help manage that risk. We can almost guarantee a retailer that uses all the tools at its disposal to manage propane price risk will, over a long period of time, perform better for its customers than the retailer that does nothing to manage propane price risk. Yet, the market does not tend to reward the retailer that manages that risk for its customers.

Ideally, propane consumers and retailers would work together to manage propane price risk, providing the customer with the lowest energy bills and the retailer a fair margin. Unless you live in Shangri-La, nurturing such a relationship is difficult, if not impossible, with other than a few exceptional customers. Doing budget billing can help, but we know that doesn’t apply to all customers.

Manage price risk

So that settles it: no propane price risk management, no using the many risk management tools available, no taking advantage when the market is giving us really good buying opportunities, no capitalizing on our many years of experience. We are relegated to just buying at market prices, adding our margin and making the customer take all the propane price risk.

We may feel that is our only choice, but if it is, then our opportunity to grow our margin is limited. If we operate like everyone else, then we are going to make about the same margin as everyone else.

Before we conclude, let us remind you of what we said above: “We can almost guarantee a retailer that uses all the tools at its disposal to manage propane price risk will, over a long period of time, perform better for its customers than the retailer that does nothing to manage price risk.”

How would you define “perform better for its customers”? Most would say that entails providing a lower price than competitors. What if we rethink what that means? What if we thought of our successful, profitable performance as a retail propane company being better for our customers? If we are able to consistently give customers a fair market price (not the lowest price) but do so at a higher margin than our competitors, does that give us an opportunity to perform better for our customers?

Wouldn’t operating at a higher relative margin allow us to hire and retain better employees; operate newer, more reliable equipment; provide better service; and invest in assets that improve supply reliability, among many other possible benefits that allow us to perform better for our customers?

What prevents propane retailers that try to “buy right” from achieving this is that they keep the same buy-and-mark-up mentality. They buy right but then they apply the same mark-up as always on the propane instead of pricing at market price. Can we all agree that we are not going to buy right 100 percent of the time? So, if we always sell at the same margin, even when we buy right, we build no cushion or contingency for when we buy wrong.

You know why we love buying right and putting the same old margin on our propane, don’t you? Because we love, more than anything else, driving our competitors insane. The problem is that, in a year when we buy wrong, we drive ourselves insane and vow never to buy in advance again. We will just buy and mark up like everyone else and not take on any risk. Fine, but over the years, you are going to leave a lot of money on the table that could have allowed you to be a better propane company.

Our suggestion is very simple. Use all of the market knowledge and risk management tools available to you. Over time, you will lower your propane supply cost over a simple buy-and-mark-up model. To capture the lower supply cost, you must sell at market prices, thus improving margin in more years than not. Reserve some of that improved margin for those years when you buy wrong and take a little less margin to keep those handful of customers that call and complain about your price. Be honest – it isn’t going to be every customer.

Once that reserve is built, then use the extra margin to be a better propane company that performs better for your customers doing all the things mentioned above and more. One day, your market may become Shangri-La, where propane customers respect their propane retailers and never question their prices. Then, you can buy right and pass the savings on to customers, while making a great margin and never having to worry about them leaving you in those years you buy wrong. Until then, use all the tools available to build a better propane company that performs better for its customers.

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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.