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FEBRUARY 10, 2020 // THIS WEEK'S TOPIC: PROPANE PRICING
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In recent editions of Trader’s Corner, we have discussed the ultra-low price environment for propane, how propane fundamentals have driven prices lower, how propane prices responded coming out of a similar situation in 2016, and most recently, how fundamentals have become more supportive of prices in the early weeks of 2020.
We also discussed how propane retailers can use financial swaps to lock down their cost of supply for as much as three years out if they are willing to take the potential downside price risk that remains. In this Trader’s Corner, we assume a retailer is not yet comfortable with taking that risk. We will discuss another way to use financial swaps to manage upside price risk should that be the case.
If a propane retailer were to buy next December's propane, he would pay 48 cents per gallon. That is 9.25 cents higher than the current market price of 38.75 cents. The longer-term player is willing to assume the risk that difference will hold over the next 10 months. In other words, they assume the risk that propane’s value in Mont Belvieu, Texas, could be 9.25 cents or more lower than the 48 cents per gallon they just paid by the time December arrives.
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When the longer-term player locks down his supply costs at around 48 cents in Mont Belvieu for next December, he uses that to set the lowest price he will charge his customers. So, let’s say he uses 48 cents in Mont Belvieu, plus 25 cents difference between Mont Belvieu and what it usually costs him to put physical gas in his tanks, for a cost of supply of 73 cents. Let’s say he wants a minimum margin of 75 cents for a sales price of $1.48.
Even if the price of propane in Mont Belvieu is below 48 cents next December, his price is 48 cents, so he must hold his price at no less than $1.48 or lose margin. Some retailers are confident they can do that, so they are willing to assume downside price risk for the opportunity to lock in what they believe is a favorable price, giving them the opportunity to make more margin or protect customers from higher prices.
Other retailers may not be so confident in being able to hold their sales prices if the market is lower in the future. Yet, they may still feel like the current price of propane at around 38.75 cents is a good opportunity if they could have it next December. But, you can’t buy next December at 38.75 cents. As we stressed above, December 2020 is valued at 48 cents, or 9.25 cents higher.
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This brings us to the point of looking at how a retailer could use financial swaps to potentially capture this opportunity and manage upside price risk without immediately assuming the 9.25-cent difference between propane’s current value and its value in December.
Let’s say the retailer would like to have 100,000 gallons of price protected for next December. He could start by taking a February financial swap position for the remainder of February for 100,000 gallons. The position will be closed at the end of the month and whatever gain or loss will be realized. Since his strike price is 38.75 cents, if the average price for the remainder of the month is higher than 38.75 cents, he will receive the difference, and if it is below, he pays the difference.
Let’s say the average for the remainder of the month is 38.5 cents. He would pay 0.25 cents per gallon on 100,000 gallons, or $250. He could look at it as an insurance expense against higher prices. He should also add that quarter cent to his cost of supply for next December. When he buys his actual physical supply next December, he would add this quarter cent to it and build his retail price from there. That would be much easier to pass on than if he had committed to the 48-cent December swap and that position is now 9.5 cents out of the market.
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Then he would decide on whether to take the same positions for March. After the loss in February, if he is not seeing any improvement in propane fundamentals or the value of crude, he might decide to stay on the sideline, taking no position for March. This means he is willing to assume upside price risk over the next month based on the current market conditions. During March, fundamentals become a little more supportive of propane prices, so he decides to take out the insurance policy again for April.
He takes a 100,000-gallon swap position for April with a strike price of 40 cents. This time, the market goes higher with a monthly average of 40.5 cents. At the end of the month, he receives a check for $500 (100,000 gallons x $0.005). Between the $250 loss in February and the $500 gain in April, the retailer is now up $250.
The retailer would repeat this decision-making process with each month leading up to December. He is effectively managing upside price risk for the propane he wants to own next December without initially assuming the 9.25-cent price difference between the current price of February propane and the current price of December propane.
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The beauty of this strategy is that it forces the retailer to make a decision about his position each month. He becomes a price risk manager using current data to guide his decisions.
Each month, he can do one of three things to manage the situation. If he has no bias as to the direction of the market, he could stay on the sidelines for a given month. If his bias is that prices are going up, then he would own or buy a swap position that protects him from higher prices. If his bias is that prices are going lower, he could sell a swap position that would pay him if the monthly average turned out to be lower than his strike price.
The key here is that it is much more difficult to anticipate where propane prices will be next December than where they will be for the remainder of this month. That makes taking a next December price that is 9.25 cents higher than the current value of propane a much riskier proposition. Taking the month-to-month risk management approach allows the decisions to be made with much more timely information and knowledge. Though it does not guarantee your outcome will be better than if you did nothing, it does increase the odds of a successful outcome.
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In summary, if a retailer is confident that he will be able to hold his retail price high enough to insure his minimum margin target in the future, then buying the higher-priced future position works. But if the retailer is unsure he could assume the downside price risk, then he should not take a long-term position. As we have explored, that doesn’t mean there aren’t ways to manage the risk to higher prices and essentially take advantage of the current low price of propane.
The monthly risk management approach is certainly more labor intensive. Instead of making one decision to take the longer-term position for next December, there will be 10 decisions made between February and November. But more than likely, a retailer is following the market and knows what is going on, so the decisions can probably be made quickly.
If you would like more exposure to these types of supply risk management strategies, you may want to consider attending our hedging workshop in March.
ANNOUNCING HEDGING SEMINAR: Please note that Cost Management Solutions will be conducting a two-day hedging seminar on March 19-20 at the Houston Airport Marriott. This seminar will provide tools and strategies for helping propane retailers navigate the changes in propane pricing in the coming months. Please contact Dale Delay at 888-441-3338 for more details.
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About 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.
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