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Trader's Corner

This week’s Trader’s Corner gives an example of how to manage supply-side risk with a focus on how to close a swap position.

Through years of trying to manage price risk with pre-buys, propane retailers are conditioned to feel that whatever decision they make concerning supply will have to be lived with until the bitter end. It makes pulling the trigger on a winter position very difficult. With the many new tools available to manage supply-side risk, that simply doesn’t have to be the case any longer. That fact should help retailers be more aggressive and confident in making opening buys for next winter’s supply. A supply decision does not have to be a fait accompli.

In the past, retailers tended to buy pre-buys and hold them through the winter. If they timed the market well, the pre-buy would be viewed as an asset, but it was just as likely to be a liability.

It is asking an awful lot of a propane retailer to make just a couple of pre-buys each year and expect him to be right about where the market will be in the future. Frankly, no other price risk manager is going to take a position where he has no exit option. With all the new risk management tools available, a propane retailer doesn’t have to, either. Let’s walk through a scenario of how financial tools can be used to manage risk.

It is April 21, 2014. Propane inventory is setting five-year lows and the current conditions (what we know) increase the risk of higher propane prices next winter. To manage this risk, the propane retailer decides to cover 35 percent of his next winter demand. Buying a swap or a traditional pre-buy are ways to manage the risk to higher prices. They both establish a known cost of supply for some point in the future.

Pre-buy: The traditional pre-buy has an advantage if it is non-ratable by providing volume flexibility in the winter. For example, let’s say the pre-buy allows us to pull 150,000 gallons as needed from Oct. 14 through March 15. We might pull 25,000 gallons in October and then 75,000 gallons in November, depending on market conditions and demand.

Swap: A swap, on the other hand, is totally inflexible on volumes. For example, if we own a 50,000-gallon swap for a given month, that is the amount of gallons the contract will settle on when the month owned is complete. The swap’s advantage is that it is significantly easier to close if our perception of the propane pricing environment changes.

Therefore, for month-to-month volume/demand flexibility, the non-ratable pre-buy is the perfect risk management tool, whereas for overall position flexibility, the swap is the risk management tool to own. The combination of the two tools is extremely powerful and flexible. You should be able to enter comparable swap positions for less than the cost of the pre-buy, making them a good choice when position flexibility is the key goal.

For the point we want to demonstrate with this Trader’s Corner, we will focus on the swap from this point forward to explain how we would close the swap position down if new information warranted.

Now back to April 21, 2014. Based on a view that A) there is upside price risk due to low inventory positions; B) current prices encourage propane exports; C) the uncertainty in the Ukraine threatens to drive crude higher, which could in turn push propane futures higher; we decide to take action to manage upside price risk. We purchase six swaps to cover our base demand during winter.

The six swaps will be October, November, December, January, February and March and each will have a volume of 50,000 gallons. They would not have to have equal volumes, but for our example they will. When we enter the deal, we get a strike price of 117 cents. That means if the monthly average for propane is above 117 cents at the hub (Mont Belvieu or Conway), we will get paid the difference. If it is below, we will pay the difference to the swap writer. At this point, we are happy because we are protected from higher prices, which is where we view the predominant risk at this time. Remember, we are risk managers and this is how we are managing the risk to higher prices. We are willing to assume the risk to lower prices at this point.

Things move forward and over the next three months, propane inventory builds are not as fast as expected, causing propane prices to move higher. By July 2, 2014, the value of the same winter strip of swaps we bought is at 127 cents.

But also on that day, the U.S. Energy Information Administration releases an inventory report showing a much higher-than-average build in U.S. propane inventory and the general perception is that rate of build is likely to continue for the rest of summer. In addition, we are getting reports that crop-drying demand is not expected to be spectacular.

With our position valued at 127 cents and this new information about inventory, our perception of price risk is likely to shift. We most likely will see less upside risk. We have reached a point of decision concerning propane price risk and how our current position is affected. What we do will depend on our overall risk assessment.

If we are convinced that price risk has definitely shifted to the downside, our action will now be to preserve the gains. We can do this by selling swaps for the same months and volumes that we bought on April 21. So, we sell the 50,000-gallons swaps that we hold from October through March. Since we are a seller, let’s say we are only able to strike at 126 cents because of the bid/offer spread.

With counteracting swap sells in hand, we now hold 12 swaps. We own the original six swaps with a strike of 117 cents entered into on April 21, 2014. We also hold six swaps sold on July 2, 2014, with a strike of 126 cents. The swaps will offset each other from this point forward. No matter how the markets move, from this point we will gain 9 cents (126 minus 117) from the position when all the swaps settle over the course of the winter.

Essentially, this move puts us back to buying at market prices. We get no help from our position if prices go higher, nor do we have risk if prices go lower.

It is important to note that throughout the swap transaction above, we have not put any money on the table. The reason: We took one side or the other of the price risk. When we bought the swaps, we were protected from upside price risk, but assumed downside price risk. When we sold the swaps, we were protected from downside price risk, but assumed upside price risk. Swaps are risk sharing and therefore do not require initial payments upfront. Money exchanges hands when the swap strikes are compared with actual monthly averages at the end of each month owned.

If we are not convinced prices are going down, but acknowledge an increased risk to falling prices, we could choose to manage the risk with another tool in our arsenal. When we do not have a strong bias about price direction or we feel that scenarios exist that make the risk to higher and lower prices about equal, we can use a put option. In the case of a put option, we are not risk sharing, we are risk transferring and must immediately pay an option writer a premium to assume the risk. It is like insurance; we are paying for protection from falling prices.

Let’s go back to July 2, 2014, and instead of selling swaps, let’s manage the new downside price risk by buying a put option. We find we can strike at the same 126 cents, which means we will have the same 9-cent gain on the swaps we bought. However, the put option is going to cost us a 9-cent premium. We are therefore investing all of our swap position gain to manage our new downside price risk.

Under this scenario, our swap buys are still active and will protect us if prices continue higher. For example, if prices average 150 cents through the winter, we will get the difference between our original strike of 117 cents set on April 21, 2014, and the winter monthly averages. The gain is 33 cents. But we paid 9 cents of that gain for the put option, which in this case had no value, meaning our position provided us a net of 24 cents of upside protection.

On the other hand, if prices fall after July 2, 2014, as we feared when we bought the put options, they would pay us the difference between its strike and the monthly average. For example, if the winter averages 100 cents, the put options would pay 26 cents because we struck them at 126 cents. That 26 cents would be used to pay our obligation on the swap. At a 100-cent market, we would owe 17 cents on our swap loss, plus we paid 9 cents to own the put option, so we are even.

The combination of the bought swaps and bought put options gives us the best of both worlds. We get to hold our upside price protection while the premium we paid represented our entire risk to falling prices. This strategy assured us we would have competitive prices in both rising and falling markets. What made this particular scenario so good is that our original gains on the bought swaps funded the put option cost.

Through this process we have managed risk. We did not try to predict the future of propane prices, which is pretty much folly in the first place. Instead, what we did is evaluate risk and take appropriate actions to make sure we had competitive supply by managing the known risks at given points in time.

Here is another important point: If you would have originally used a traditional pre-buy for all of the upside price protection in the scenario we created above, you could essentially shut them completely or partially down on the same news using the same tools. If we own a pre-buy and want to capture gains or protect it from loss, we can sell a swap against it or buy a put option. However, we then need to pull our pre-buys in a way that matches our swap sell or option volumes. Therefore, we lose the benefit of volume flexibility.

We hope this example helps you see the stark difference in making market “bets” and being a risk manager. With bets, we will win some and lose some. In the long run, the wins and the losses tend to balance out, so really, what have we accomplished?

On the other hand, if we see actions as risk management and have in mind ways to alter our position based on new information, we are accomplishing a very important function. We are making sure our supply cost is always properly positioned to allow us to be competitive, no matter market conditions. The real money in our retail business is on the margin we make selling to our customers. Our supply decisions should be made to make sure we are always competitive so that we reduce the risk of having a situation that would drive customers to other suppliers or alternative energy sources.

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 situation in the Ukraine keeps crude well supported. We had been bullish on propane, but Friday felt more neutral, with no upward price movement on very good volume.

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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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