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November cover


How propane retailers should play the current situation
Cost Management Solutions    
Cost Management Solutions
Last week in Trader’s Corner, we looked at the four legs of propane demand that support propane prices and suggested we may be down to just one leg to support prices from this point forward. We suggested retailers might want to consider buying put options if they are concerned about more downside price risk, and we are going to expand our discussion to consider call options as well. But before we do, let’s set the stage for why options may be the best way to manage the supply-side price risks associated with this winter.

Four legs of propane demand
Demand for propane comes from four primary areas: petrochemicals, exports, crop drying and winter heating. As we discussed last week, three of the four are weak or threatened at the moment.

Petrochemical companies are light on propane consumption, running about 174,000 barrels per day (bpd) less than this time last year the last time we checked. They are heavy on cheaper ethane, and we don’t see that changing anytime soon.

All summer, the expectation was for strong propane exports to continue. A major reason for that assumption was that international propane prices based on higher Brent crude were far higher than U.S. propane prices. The assumption was the United States would have no problem exporting at its maximum capacity. However, over the past two months international propane prices have collapsed. In September, Far East propane was priced at $865 per ton, or $1.66 per gallon; today it is down to $668 per ton, or $1.28 per gallon. Northwest Europe propane was at $725 per ton, or $1.39 in September; today it is $520 per ton, or $1 per gallon.

Mont Belvieu was trading at a 57.75-cent discount to Far East propane in September; now the spread is 44.38 cents. Mont Belvieu traded at a discount of 30.75 cents to Northwest Europe propane in September; now the spread is down to 16.38 cents.

The official export data lag by about three months, so it is hard to get a good feel whether this price shift has made a major impact on exports. However, we can certainly assume that it has, and is likely to be negative for exports going forward.

Crop drying
All fall, we have heard about the record 14.4-billion-bushel U.S. corn crop, which represented the potential for high propane demand. The crop drying activity was late getting started, and the feeling is that it is going to be much shorter in duration than originally expected.

If it is heavy, it certainly has not shown up in inventory data so far. Two weeks ago, there was a 1.3-million-barrel draw on U.S. propane inventory, but last week the draw was just 144,000 barrels. Given what prices have done, we can assume it was as much of a surprise to the overall propane market as it was to us.

Frankly, the full impact of crop drying is not known at this point. It’s like an election when only a few precincts have reported. But if we had to make a projection based on early returns, we would predict crop drying would not be the inventory drawdown event anticipated.

Winter heating
That brings us to the fourth and final leg of demand, winter heating. As usual, the forecasts for winter demand are varied. Some expect a very severe winter, especially during the second half, whereas others predict this winter will be normal or below normal. Could winter demand pull down inventories from their current record levels and push prices higher? Absolutely. Could winter be normal, keeping prices flat to slightly higher? Yep. Could winter be a bust that we exit with record-high inventory? Could be.

We would be remiss if we did not mention one other factor that could have a big impact on propane prices this winter. The fortunes of crude prices could have a bearing on the value of propane prices. For right now, the position the Organization of the Petroleum Exporting Countries (OPEC) is taking concerning prices, the current supply-and-demand balance and the weak global economic situation would seem to suggest a neutral-to-bearish pricing environment for crude in the midterm (this winter).

Managing the risks
We established the current environment; now let’s manage the risks. First, let’s assume retailers are 50 percent long on their winter needs. That means they established a price on 50 percent of expected winter demand through pre-buys, swaps and other financial tools and supply arrangements. Given what we know right now, that probably is a good position to be in.

If the consensus was that this is going to be a mild winter, we might consider 50 percent too long. So we would probably suggest retailers close down some of their length by selling swaps.

If the consensus was that this is going to be an exceptionally harsh winter, we might suggest using this latest pullback on propane prices to add a little more length, especially for the end of winter, by buying swaps or pre-buys.

But because we cannot know for sure, this kind of situation pushes us toward options to manage both downside and upside price risk.

Retailers may want to get rid of their length at this point in the winter, yet they may be concerned that the 50 percent they hold is going to make them uncompetitive if pricing keeps falling. In that case, they should consider buying put options. The higher above 50 percent long they are, the more they should consider this strategy because they are at a greater risk for falling prices.

On the other hand, if they aren’t concerned about street prices falling in their market, they may be interested in getting more protection from higher prices or just flat out betting on a price rebound. But do they want to own more pre-buys or swaps with three of the four demand legs for propane and crude looking weak? That might be a bigger risk than most are willing to take. The better way to make that play would be to buy call options. That would be especially true if they are less than 50 percent long on their winter needs.

We must understand the difference between a swap and an option to understand why an option could be a better choice when two very distinct pricing scenarios are present.

How swaps work
If retailers manage risks with a swap, they take one side or the other of the price risk. If they buy a swap, they are protected from prices going higher, but will have a trading loss if prices go lower. The assumption is they will not lower the price to customers in a falling market and thus use the higher margin made to cover the trading loss. But in that case, a new risk is assumed. The risk is that their price will be so much higher than their competitors’ that they lose customers.

If they sell a swap, they are protected from prices going lower, but they will experience a trading loss if prices go higher. In general, propane retailers will only consider selling a swap if they already own pre-buys or bought swaps and are trying to protect themselves from a trading loss on those positions.

However, by doing so they essentially lose the benefit of the pre-buy or swap position should prices go higher. The risk is if prices go higher, they no longer have protection and are buying at market prices. If prices go higher, the swap sold will be losing, and gains from pre-buys and/or swap buys would be used to cover the trading losses.

The bottom line of this situation is, pricing to customers will have to reflect current market prices. That means that if competitors all kept their long positions, they don’t have to raise prices to make their desired margin, whereas the retailer that employed this strategy does. Once again, the ultimate risk is that the retailer’s price will get too high, increasing exposure to competitive pressures.

Now for options
With options, one side of the price risk is not assumed. Instead, a premium is paid to have someone else assume that risk. Options are more like insurance in this respect. The premium for an option is an expense that must be rolled into the price charged customers. If the premium expense does not get retailers' price out of line with their competitors’ prices, it is likely a good choice. If it does, the risk is losing customers to competitors.

For now, let’s assume the premium expense was not so much as to make prices unreasonably high; therefore the premium expense is worth assuming.

If a put option is bought to protect against exposure to falling prices from pre-buys and swaps owned, then the put option will pay if prices fall. Because the retailers' street price will come down in the falling pricing environment, they will make less margin due to the high cost of pre-buy and/or swap positions. The put options will essentially reimburse that loss, however.

On the other hand, if prices go higher the put option will not pay, but there will be no obligation other than the premium already paid and factored into prices. That means the value of pre-buys and/or swaps will do what they were meant to do from the beginning, which is either provide a competitive edge or yield more margin.

A call option that is bought benefits its holder if prices rise. Retailers might consider a call option today because prices have been retreating recently and they believe it is a good price point to own. If prices do rise, retailers will get a financial gain from the option and may use that to protect customers from rising prices or put more money to their bottom line.

If prices fall, there is no obligation on the trade other than the premium that has already been paid and passed on to customers. Therefore, retailers are able to remain competitive in a falling price market. They are under no pressure to hold their street price like they would if they held pre-buys and/or had bought swaps.


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Propane prices fell last week, pushing us to bearish. A very light draw of just 144,000 barrels on U.S. propane inventory was a bearish surprise. Crude fell, as fundamentals remained weak and a sharply rising dollar provided a headwind. We begin the week bearish on propane and crude.

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Last Week's Highlights
Conway propane got off to fast start for the week, with a solid gain on strong trading volume. Mont Belvieu retreated, with falling crude a factor. A rising dollar and more reported weakness in China’s economy were the key drivers.
Mont Belvieu propane retreated exactly in line with crude, and Conway gave up the bulk of Monday’s gain. Crude fell sharply after Saudi Arabia cut its crude sales price to the United States.
A much-lighter-than-expected draw on U.S. propane inventory of 144,000 barrels sent propane prices lower. Crude posted nearly a 2 percent gain on a crude inventory build that was far short of expectations. Supporting crude were reports that Canadian crude producers were cutting back on capital expenditures in 2015 because of falling crude prices.
Propane prices tumbled, perhaps influenced by a forecast by the Climate Prediction Center that lowered the expectations of an El Nino event occurring this winter to 58 percent. Comments by Secretary of State John Kerry increased expectations that a deal would get done this month between Iran and six world powers concerning Iran’s nuclear work, which put downward pressure on crude. So did an increase in the value of the U.S. dollar.
Propane prices continued to retreat, with Mont Belvieu setting a new low for the year. A falling dollar pushed crude higher.

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