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Trader's Corner

This week’s Trader’s Corner looks at using financial swaps as part of a comprehensive supply risk management plan.

In last week’s Trader’s Corner, we used the table below to aid our discussion on determining the amount of potential supply needs to hedge for a fictitious million-gallon retail propane company. We will review our thinking now for a plan to cover July 14 to June 15 supply and discuss a simple financial hedge we could use to carry it out.

At this point in the year (March), we want to guard against getting overhedged. For that reason, we begin our hedging volume estimates with our worst-case sales volume estimate. In our example, that was 750,000 gallons per year. As summer progresses and we get better information on how propane inventory is building, the potential for crop drying demand and more accurate winter weather forecasts, among other possibilities, we can adjust our position.

In order to build in month-to-month volume flexibility for the winter, we want a portion of our hedge volume to be “pull anytime October to March or nonratable” pre-buys from our regular supplier. We like using financial tools for the remainder of our hedges because of the ability to close these positions if our view of the market changes.

In our example, the initial max we established for financial hedges was 635,250 gallons (worst-case demand minus pre-buy volume). How much of that demand we actually hedge should be guided by our view of supply/prices. If we think prices are still high, we would set out with a goal of hedging less than a retailer who believes prices are likely to rebound by next winter.

Today we are going to discuss financial swaps, which is one of the tools we can use to establish hedges. For our discussion, we use the neutral view of supply/prices. We will have an initial target of owning 317,625 gallons of financial hedges that will cover the July 14 to June 15 timespan. We are going to buy swaps to accomplish this goal.

Swaps explained
So what is a swap exactly? It is a financial agreement between two parties, a buyer and a seller. Most of the time a propane retailer is the buyer because a buyer of a swap seeks protections from higher prices. The seller of a swap seeks protection from lower prices. Propane retailers most often become sellers of swaps when they want to “close” a swap position they bought.

In the opening phase of the agreement between the buyer and seller of the swap, the two parties must agree on the current value of propane for some period in the future. Swap agreements cover one-month periods.

For simplicity’s sake in this example, let’s assume we will cover all of our July 2014 financial hedge needs with one swap buy of 9,375 gallons. Part of our job is to put propane retailers together with other buyers and sellers of swaps. Additionally we bring transparency to the value of propane so the retailer knows its value in the month he is wanting to hedge.

The retailer calls us with the desire to establish a known price of supply on 9,375 gallons for July 2014. Propane prices in his area are based off Mont Belvieu. In fact, he has an agreement to buy from his supplier at Mont Belvieu plus 10 cents. We look at trading screens and previous deals to see about where July 2014 Mont Belvieu propane is being valued. We peg it at 106.75 cents.

We then contact traders who are sellers of July 2014 Mont Belvieu swaps and ask where they are offering to sell them. We get offers at the market price of 106.75 cents and relay that to the propane retailer. If the propane retailer accepts the offer, a strike price between the buyer and seller of the swap has been established at 106.75 cents.

Contracts establishing a financial agreement between the two parties exchange hands. The financial agreement is a July 2014 Mont Belvieu swap with a strike price of 106.75 cents on a volume of 9,375 gallons.

Both the buyer and the seller of the swap now have a known cost of propane for July. As the buyer of the swap, the retailer can use the known Mont Belvieu cost to establish a sales price for his customers.

To establish the actual sales price for his customer, he would begin with 106.75 (see budget column in table below) and add the difference over Mont Belvieu he will pay his supplier. This is established by their Mont Belvieu-plus-10-cents contract FOB a specific supply point. At that specific location, the propane is valued at 116.75 cents. It must be transported to the retailer’s location at a cost of 3.25 cents. The propane would be valued at 120 cents inside his bulk storage. The retailer adds his margin to cover his expenses and generate a profit. Let’s say that margin is 79 cents. The value of the propane in the customer’s tank is 199 cents.

With these knowns, the retailer contacts his customers and offers to sell July 2014 propane to them at 199 cents. Eventually enough customers agree to the offer to book about 9,375 gallons in July sales at 199 cents.

At this point, a true hedge has been established. A known supply cost and sales price resulting in a known margin have been established.

Swap scenarios
To complete an understanding of swaps, we now have to understand how they settle, how they work with the supply we buy from our normal supplier and how the money flows. It is actually very easy. In the chart above, follow the two examples below the respective higher and lower price scenario columns.

Swaps settle against the monthly average at the hub, in this case Mont Belvieu. When the July monthly average is known, it is compared with the swap strike to determine if the buyer or seller of the swap will pay. We will cover both scenarios.

Let’s say the monthly average for July 2014 Mont Belvieu propane is higher than the strike. The monthly average turns out to be 115 cents. The swap buyer (the retailer) will invoice the swap seller for the difference between 115 cents and 106.75 cents on the volume of the swap – 9,375 gallons times 8.25 cents per gallon or $773.44.

However, the retailer also will have paid more to his physical supplier for the July propane than originally budgeted, resulting in a lower margin. Instead of 116.75 cents at the terminal, he paid 124.5 cents, resulting in a 70.75-cent margin instead of the 79-cent margin originally budget. But the swap proceeds offset the loss on the physical side to bring the margin back up to budget at 79 cents.

It is easy to figure what will happen if propane prices go down, but it is this scenario that we really need to understand and accept if we are going to be hedgers. Let’s say that the July monthly average turns out to be 100 cents, which means the retailer paid less to his physical supplier, resulting in more margin on the physical side. But we have to pay our swap partner the 6.75 cents gained, resulting in the same 79-cent margin.

This is the scenario that causes most retailers to stumble. Life is grand when the swap pays and replaces our lost margin, but when we have to pay we suddenly get amnesia.

We forget how great it felt to have a known cost of supply and how aggressive we were in making sales against it.

We forget how good it felt to give our customers a fair price for propane that eliminated the threat of high propane price spikes.

We forget that when we made our budget we were happy to have established a known margin of 79 cents.

All that goes out of the window when the ink begins to flow from the pen to the check. We think we made a huge mistake. If only we wouldn’t have hedged, we would have made 85.75 cents instead of a paltry 79 cents.

The fact is, folks, if you can’t write that check with a joyful heart then you aren’t ready to be a hedger. If writing that check would anger you or frustrate you and you can’t see all of the benefits that the known cost of supply brought before that point, you should just buy at the street price, add your margin and not put yourself through the agony.

Small sampling
In our discussion today, we only dealt with our July 14 financial hedge needs. But the process simply repeats for each month we would want to hedge. If we were going to use just swaps to carry out the financial side of this plan, we would own a minimum of 12 swaps, one for each month.

Also, we don’t have to establish all of our hedges at once. We can layer swaps along the way. For example, when our plan is fully executed, we might hold three January swaps of 20,000 gallons each. Since they were bought at three different times, they each would have their own strike price. We might want to cover some months before others, so the order in which we accumulate the swaps could be random.

Today we had a long discussion with a young retailer who has never used financial tools to manage his supply risk. At the end of the conversation, we told him it would take more conversations to get him fully comfortable with using financial hedges and, quite frankly, get us comfortable that he could use them properly. It is not just buying; it is buying and selling. Each supply side hedge should be coupled with a sales side program/strategy to secure and grow your customer base and margins. As we told him, it takes an investment in time and willingness to ask questions and learn, but the payoff is worth it. Just about any retailer who is now a hedger would tell you they couldn’t imagine how they managed their supply side risk without financial tools.

Call Cost Management Solutions today at 888-441-3338 for more information about how Client Services can enhance your business, or drop us an email at
The occupation of the Crimea region of the Ukraine by Russia dominated crude markets for a couple of days, but demand concerns eventually carried the day.

Propane continued its selloff through midweek, but looked to be finding a floor by Friday. We are bullish this week.

Monday: Propane continued its correction, with Conway dropping the most and closing the gap with Mont Belvieu. Crude oil rallied hard after Russia occupied the Crimea region of the Ukraine.

Tuesday: Propane continued lower in heavy trade and crude fell as some of the tension surrounding Ukraine and Russia eased.

Wednesday: Propane inventories had a surprising build of 0.479 million barrels, sending prices down more. Crude continued lower on less worry about the Ukrainian situation. A large build of 1.4 million barrels in distillate stocks added to the weakness in the crude complex.

Thursday: Propane prices were finally showing signs of bottoming after their long correction, with a gain in Conway. Mont Belvieu was down on the day but was well off the session low by the close.

Friday: Propane prices continued to firm up with reports of good demand at most supply points. It looked as if some of the pent-up demand that built over February was being satisfied, which supported prices. Crude gained as the U.S. froze assets of Ukrainians it believes helped in Russia’s occupation of Crimea and in getting its parliament to vote to leave Ukraine and become part of Russia.

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Cost Management Solutions LLC (CMS) is a firm dedicated to the analysis of the energy markets for the propane marketplace. Since we are not a supplier of propane, you can be assured our focus is to provide an unbiased analysis.

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Many retailers simply don't have time to analyze the large amounts of data to make an informed purchasing decision.

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Dale G. Delay 888-441-3338,
Mark Rachal 888-441-3338,

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