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Click here for a free, 10-day trial of The Propane Price Insider!
Dear Propane Price Insider readers:
On Oct. 6, your PPI newsletter is getting a makeover. In addition to a fresh redesign, the newsletter is undergoing a name change. It will be called Trader's Corner. The new name will reflect the strategic role that propane marketers play — deciding when to buy and sell their supply in order to protect customers in a volatile energy market and maximize business profits. Please be on the lookout for this name change in your inbox so you won't miss this valuable weekly propane market report.
Trader's Corner
This week’s Trader’s Corner will continue filling a hedger’s toolbox.
We’re into the fourth and final week of filling a hedger’s toolbox with the tools any retailer can use to manage supply-side price risk. Having a toolbox full of the right tools necessary to manage supply-side risk is essential for the success of a propane retailer in today’s high-priced, highly volatile marketplace.
Our goal with this series has been to introduce these tools, tell you when to buy and sell them, explain how they are best used and reveal a few things about how each works.
We may not provide all you need to know to use a tool, but you will at least know the tool is there and what you can do with it. Later, we can help you use the tool and explain more fully how it operates. So the goal here is to fill your toolbox and let you know what “project” the tool can help you accomplish.
So far, our hedger’s toolbox includes a financial swap buy, a financial swap sell and a call option buy. Today we will add a put option buy.
Tool: Put option
Action: Buy
Buy when:
- You own product, pre-buys and swap buys and when you are concerned about falling prices
Best used:
- As protection from falling prices
Other considerations:
- Unlike swaps, in which risk is shared and an upfront cost is incurred, options transfer risk and an option premium must be paid at the time of purchase
- Options are like insurance; the premium you pay represents your total risk
- Options settle on the monthly average at the particular hub location owned. Just like a swap, the strike price of the option is compared with the monthly average at the hub. In the case of a put option, if the monthly average is less than the strike, the holder of the option will be paid the difference.
- If the monthly average is higher than the strike, nothing happens; the option simply expires
For the most part, propane retailers are net short of the supply they will sell in the future. Therefore, their natural position makes rising prices their greatest supply-cost risk-management challenge.
However, once long positions have been taken, the holder is at risk from falling prices. Retailers’ supply becomes longer when they buy physical product to put into storage, make pre-buys and/or buy financial positions such as swaps.
Keep in mind, the long position(s) only remains at risk from falling prices until retailers have not made sales against the long position(s). Once sales are made against the position(s), the risk from falling prices is eliminated. Making fixed-price and budget-program sales to customers against supply positions is the absolute best way to manage downside price risk.
However, if we take the long positions and do not have sales against them, the risk from falling prices remains. One way of managing that risk is by selling swaps, a tool already in our toolbox. However, another way is by buying a put option.
A put option is the reverse of the call option discussed last week. Like a call option, a put option has a premium because it transfers risk to the option provider. The option provider, just like an insurance company, charges a premium to assume the risk. In the case of a put option, the option writer is assuming the risk of falling prices.
When a put option is bought, the retailer (buyer) pays a premium and gets a strike price for the option. The buyer owns that strike for the particular month bought at a particular trading hub. In the case of a put option, the buyer gets paid if the monthly average at the hub is lower than the strike price.
Let’s create a scenario in which downside price risk is present. On Aug. 1, propane retailers whose supply cost is based off Mont Belvieu put 25,000 gallons of propane in their bulk storage. The purchase is made because propane prices have been falling and it looks like a good time to buy in preparation for the crop drying season that will be coming up in September.
Retailers did a good thing by watching the market and making a buy when they thought prices were at a low point. That is a good thing for their farm customers because it gives them a good chance to sell farmers propane at a good value.
However, they will not sell this propane to farmers until September. While the propane sits in their tanks during the month of August, it is at risk from falling prices. Supply bought at a perceived good price on Aug. 1 could become a liability by Sept. 1 if the bottom falls out of propane prices. This is a very real possibility if reports come in that weather conditions are such that crops will be drying naturally in the field, setting expectations for low crop drying demand.
Today, the strike price of an at-the-money Mont Belvieu put option is 100 cents. The premium is 1.5 cents. At press time, the offers (what we would pay as a buyer) are at 100.5 cents. If what retailers paid for the physical gas going into storage is based on Mont Belvieu plus a differential based off today’s price, then their price for gas in storage would likely be Mont Belvieu at 100.5 plus the differential. Since the strike price of the put option is 100 cents, the market would have to fall a half-cent just to get to the put option strike.
Holders of the put option don’t receive payment unless the monthly average is below 100 cents. Further, they do not break even until the market falls to 98.5 cents because of the premium paid for the put option.
So if the market goes up during August or doesn’t have a monthly average that is 98.5 cents or less, retailers would have been just as well off without the put option. But for a 1.5-cent premium, retailers have no risk from falling prices on the product they have in storage.
Let’s look at it another way. Without the put option, retailers will be building their prices to farmers based off 100.5 cents Mont Belvieu, plus differential to Mont Belvieu, plus margin to get the sell price to the customer.
With the put option, they would be building their price based off of 100.5 Mont Belvieu, plus 1.5 cents put option premium, plus differential to Mont Belvieu, plus margin to get the price to farmers.
So let’s ask ourselves: What is the fair proposition? Retailers can sell to farmers 1.5 cents lower and assume all the downside price risk during August. Or, they can sell to farmers 1.5 cents higher and have no downside price risk.
To us it is an easy choice. Retailers bought supply for storage on Aug. 1 because they thought it would be a good price for farmers and they were protecting farmers from a price blowout if crop drying came in like gang busters. For protecting farmers from higher prices, retailers charged 1.5 cents more to protect themselves from falling prices.
If the market falls more, to below 100 cents, retailers can lower their price because the put option will pay them, offsetting the loss from the physical gas in storage. That way, they don’t have to worry about losing these accounts to competitors in a falling market. At the same time, if the market runs higher in August, the gas they have stored will protect farmers and allow retailers to make the same margin. For 1.5 cents, a fair value proposition can be made between retailers and farmers that does not unduly place risk upon either party.
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 info@propanecost.com.
WEEK IN REVIEW
A well-supplied crude market and concerns about crude demand have offset the headline-grabbing threats to supply. Worries the U.S. Federal Reserve is going to start raising interest rates early next year has added to those demand concerns.
Propane has had enough builds in inventory to allow it to be more sensitive to crude’s value. The weight of sharply falling crude this week pulled propane down. We will stay neutral for propane to start the week, but if Mont Belvieu closes below a dollar, we may move to bearish.
LAST WEEK'S DAILY HIGHLIGHTS
Monday: Propane prices fell to start the week in response to falling crude and a pullback in overseas propane prices. Crude fell as traders became more confident in a good global crude supply-demand balance, despite ongoing threats to supplies.
Tuesday: There was heavy selling pressure on propane in the early part of trade. It was reported that a large player was in the market as a seller. The loss was reduced in the afternoon; the downtrend continued nonetheless. The prospects for another high build in U.S. gasoline inventory had West Texas Intermediate crude down on the day.
Wednesday: The Energy Information Administration reported another above-average build in U.S. propane inventory, sending Mont Belvieu prices lower, but Conway managed a slight gain. Crude traders shook off another large draw on U.S. crude inventory and prices continued to decline.
Thursday: A default by Argentina on its sovereign debt sent commodities and equities markets sharply lower. The Dow was down more than 300 points and crude fell $2.10. Propane prices were weighed down by falling crude.
Friday: Propane opened the new month very weak. Prices at both hubs dropped as falling crude was a weight on propane. Prospects for the Federal Reserve to raise interest rates sooner than expected had commodities and equities markets moving lower again.
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COST MANAGEMENT SOLUTIONS
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.
Market Information Services
The Propane Price Insider, an e-mail service that provides:
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Three Daily Price Flash Wires
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Periodic Option Quotes
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Wednesday Inventory Data Updates around 11 a.m. ET
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Evening Report with Executive Summary, Trader's/Hedger's Corner, Weather maps and complete review of energy prices that are based on Propane's Btu Equivalent
Free trial!
For a free 10-day trial subscription by e-mail, sign up online here or call toll-free at 888-441-3338.
Client Services
Many retailers simply don't have time to analyze the large amounts of data to make an informed purchasing decision.
We offer:
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Detailed market recommendations on hedge and pre-buy entry points
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Prompt market execution of hedging strategies
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Supply cost analysis and recommendation as to effective hedging strategies
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Because of the volume of transactions we place annually, we receive large volume consideration when we place your hedges
Visit us online at www.propanecost.com. Or e-mail info@propanecost.com.
Contact us today to see if you can benefit from having the Energy Price Watchdog working for you.
Dale G. Delay 888-441-3338, ddelay@propanecost.com
Mark Rachal 888-441-3338, mrachal@propanecost.com |
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