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November cover


How the physical and financial markets work together to yield predictable results
Cost Management Solutions    
Cost Management Solutions
Last week, we spoke with a propane retailer and spent a lot of time discussing how the physical and financial markets work together to help him meet his goals and objectives.

The conversation probably lasted two hours. It twisted and turned through many aspects of risk management concerning his particular situation. Rather late in the conversation, a comment suggested the retailer wasn’t quite clear on how the swaps he held worked with the supply he was buying from his regular supplier.

This is not an uncommon occurrence, and it seems to be the most difficult aspect of using financial tools to offset the risks associated with propane supply costs. Most retailers understand the physical supply market very well. Most are aware of the value of propane at the major hubs (Mont Belvieu and Conway), and they understand why the price they pay for propane is higher than that price.

Retailers understand that propane at a hub must move through a pipeline or travel by railcar to get to their location. They know there are tariffs and fees associated with this movement. Usually, truck transportation is needed to take propane from a supply point to their bulk storage tanks. They understand their suppliers need to make money and therefore will charge a certain amount to perform the services necessary to provide supply.

Some suppliers take care of the entire process for the retailer and send them an invoice for the price of getting propane into the retailer’s bulk tank. In other cases, the retailer may buy the supply from the wholesaler or producer at a particular supply point and then be responsible for securing and paying for the truck transportation in a separate transaction.

In either case, the retailer knows the laid-in cost of each load of propane that was delivered into his bulk tank. Most keep a spreadsheet of the cost and can quickly know the cost of the propane that sits in his tank at any given time. The retailer adds the desired sales margin to the supply cost to set the price to customers.

Retailers have long used pre-buys to know the cost of their supply in advance of when it is going to be put into their tanks. In this case, they understand that when they go to the pipeline and pick up a load of propane off their pre-buy, it is the pre-buy price they must use for the cost of that propane, not the current market price. It would not be unusual for a retailer to lift a load of posted or indexed-priced propane at one price and a load of pre-buy from his supplier on the same day. He simply would average the cost of the two loads to get the cost of supply in his tank.

When buying a pre-buy, the cost of gas in the future is fixed. Let’s say a retailer buys 40,000 gallons of pre-buy for propane he plans to deliver next December. Let’s further assume that Mont Belvieu is the price basis. The supplier uses the current value of December 2015 Mont Belvieu propane, plus transportation costs, plus storage costs, plus margin, and agrees to sell the pre-buy at 105 cents. When next December comes, it does not matter if propane is selling for a nickel a gallon; the retailer knows his cost of propane is 105 cents.

Buying a financial swap functions like a pre-buy. As we write this, a retailer could own a Mont Belvieu December 2015 swap with a strike of 86.75 cents. When next December comes, that strike price, not the market price, will be the cost of propane.

To use the swap properly, the retailer uses the strike price as the basis of his sales price to customers. To that he adds the price difference between Mont Belvieu and his location. So if his supplier normally sells to him at the Mont Belvieu price plus 10 cents, then that is added to the strike price to determine the laid-in cost of propane at 96.75 cents into the retailer’s bulk storage. When next December comes, the retailer will use 96.75 cents as his cost of propane and not what market prices are at the time. We reiterate that this works just like a pre-buy.

Yet to get to that understanding of the use of financial tools, there is often a roadblock. So let’s see if we can figure out why, and get to a better comfort level on how they are the same.


Let’s say Targa is a retailer’s only supplier. From Targa he buys pre-buys, a few posted loads, and he has a contract to buy on index (Mont Belvieu plus a fixed differential).

When he picks up the phone to buy a pre-buy, he talks to the same rep that he talks to when buying index or posted-price loads. The same transportation company - and probably even the same driver - that brings the index or posted price load will bring the pre-buy load. The only difference the retailer sees is in the invoice. Even though the pre-buy is a hedge or speculation, just like a swap, it doesn’t feel any different.

When a retailer buys a swap, he doesn’t call his supplier; he calls a different company (like Cost Management Solutions). Terms like strike price and monthly average are thrown around and suddenly it all feels different, more complicated, than the pre-buy. Just because another party is involved, a disconnect between the financial and physical markets can begin.

Buying the pre-buy didn’t feel any different, but this financial stuff does. Targa isn’t involved in this financial transaction at all. The retailer has suddenly ventured into a dark and mysterious world. In the strangeness of this world, it is easy to believe the situation is complicated. It really isn’t, however. Let’s walk through how it works.

The retailer owns a December Mont Belvieu swap with a strike price of 86.75. The strike price is the equivalent of what Targa based its pre-buy off of, before adding transportation, margin and storage costs. To set a sales price based on that strike price, the retailer needs to add some of the same things that Targa added to its pre-buy quote.

Because the retailer is buying propane from Targa on an index basis (Mont Belvieu plus a fixed differential) for most of his propane, the calculation is easy. To the strike price, the retailer simply adds the difference he pays on his index contract above Mont Belvieu. So if the retailer normally buys from Targa at Mont Belvieu plus 10 cents, he adds 10 cents to his strike price. That’s the value he must use when setting his sales price in December.

Therefore, the retailer will use 96.75 cents as his cost of propane, just as he would use 105 cents as his cost of propane on the pre-buy. He knows this month's sales price in advance, when he buys the pre-buy or swap.

Now, let’s move to December 2015 and see what the retailer has to do. If the retailer bought a pre-buy, he calls Targa and says, “Send me a load of propane off my pre-buy.” The transport driver goes to the terminal, punches in the code for this customer and his pre-buy account, lifts the load and takes it to the retailer. Targa generates an invoice for 105 cents per gallon and sends it to the retailer.

If the retailer has a swap, he calls Targa (surprise, the same process he has always used) and tells it to deliver a load of propane from his index contract. The same driver who loaded the pre-buy load goes to the pipeline, punches in the retailer’s code for his index contract, lifts the load and delivers it. Targa generates an invoice by determining the daily average of propane at Mont Belvieu on the day of lifting, and adds the fixed 10-cent differential.

It is highly unlikely that daily average will be exactly 86.75 cents, equal to the strike price on the swap when the physical load is lifted. So, the final piece of the puzzle is to connect how the financial swap and the physical supply from Targa - even though they are separate activities - now work together to yield the expected result.

We will need to examine two scenarios, one where the price in December is higher than the strike price of the swap and one where it is lower.

Months ago, when the retailer bought the swap, he used it to build a sales price to a customer of 146.75 cents per gallon. That customer is going to take four 10,000-gallon loads of propane, one each week throughout December. In the tables below, we will show how the physical and financial activity works together to yield the expected result in both a higher-priced and a lower-priced market.

First, a higher-priced market.

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In the top table (Physical Activity Higher Priced Market), the retailer called Targa and had the four loads brought in, one during each week of December. His spreadsheet shows that the average laid-in price of those loads was 111.75 cents.

The second table (Physical from Regular Supplier) compares the budget, where the original sales price of 146.75 cents was calculated using the strike price of the swap compared with what prices actually were. Because the invoices from Targa were higher than budgeted, the cost of propane in the retailer’s tank was 111.75 cents, not the 96.75 cents budgeted. Therefore, after the customer pays the retailer and the retailer pays Targa, the retailer is left with a 35-cent margin instead of the 50-cent margin expected.

The next table (Financial) shows the financial activity of the swap. The strike price of the swap was 86.75 cents. The holder of the swap gets paid if the Mont Belvieu monthly average is more than the strike. Because the monthly average was 101.75 cents (note the monthly average may not be exactly the average price of the loads because the loads were priced off of the daily average the day of lift, whereas the monthly average is based off of all trading days during the month), the retailer will receive from the swap provider a check of 15 cents per gallon.

The final table (Combined Results) shows the actual physical margin of 35 cents, plus the gain of 15 cents from the swap, to show the combined result of 50 cents, exactly what the retailer budgeted.

Now for the results in a lower-priced market.

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The retailer schedules the four loads to be pulled off of his index contract from Targa and receives invoices that average 81.75 cents per gallon as shown in the top table (Physical Activity Lower Priced Market).

The next table (Physical from Regular Supplier) shows that, once the retailer’s customer paid him and he paid Targa, he made a 65-cent margin, 15 cents more than the 50 cents expected.

The next table (Financial) shows the loss on the swap. Because the monthly average was below the strike price, the retailer must pay the difference of 15 cents. He uses the extra margin he made on the physical side to pay the financial loss.

The bottom table (Combined Results) shows the net result of the 50-cent margin expected.

In the Financial table in the examples above, had we used the term pre-buy and the cost of a pre-buy in place of a swap, we would have had the same result.

Whether using a swap or a pre-buy, the same physical supplier is used. With both of these financial tools, a fixed cost of supply was used to set a fixed sales price to the customer. In both cases, it doesn’t really matter how the market moves because the cost of the supply and the sales price are fixed and the margin is the same as budgeted.

If the retailer had not pre-sold the propane bought under a swap or a pre-buy, it doesn’t matter what market prices are in the month of delivery because the strike price of the swap or the pre-buy must be the basis for the price that he charges customers. If it is not, the resulting margin will be either higher or lower than expected. The key with both a swap and a pre-buy is that the retailer should not lower his price in a falling market when he has used pre-buys or swaps to lock in his cost of supply. When he does, he will lose margin.

Swaps and pre-buys both provide the retailer and his customers protection from falling prices, but can cause problems for a retailer in a falling market if he has not pre-sold the propane to his customers.


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A surprise build in U.S. propane inventory had propane moving lower. Crude continued its fall on weak fundamentals. We go into this week bearish on both.

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Last Week's Highlights
Once again, Conway propane got off to fast start on a Monday with crop drying and weather in support. Mont Belvieu closed flat to Friday, which was at the year’s low of 84 cents. Crude dipped to near its low for the year before rallying to a $77.40 close.
Propane prices were little changed despite good trading volume in Mont Belvieu and heavy trading volume in Conway. Mont Belvieu once again closed at the year low of 84 cents. Lowered expectations for next year’s crude prices did not prevent West Texas Intermediate from posting a gain against a falling dollar.
Propane prices gained one day ahead of the holiday-delayed Energy Information Administration (EIA) inventory report. Traders were anticipating a 850,000-barrel-draw on inventory due to crop drying and cold weather. Crude fell as the Organization of the Petroleum Exporting Countries (OPEC) decreased expectations for demand on its crude next year.
Propane prices plunged after the EIA reported a 926,000-barrel build in U.S. propane inventory. The data completely caught the market off guard and it reacted decisively. Comments by Saudi Arabia that continued to suggest it will not cut production to support prices had crude lower.
Propane managed only a slight rebound of an eighth-of-a-cent after falling more than 5 percent on Thursday. The paltry gain was also in light of a 2 percent gain in crude. Despite the gain, propane still felt very weak. Crude gained, as some traders began to bet that OPEC would have to announce a production cut at its meeting later this month to support prices.

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