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MAY 10, 2021 // THIS WEEK'S TOPIC: FINANCIAL HEDGING – PART 3
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This Trader’s Corner will be the third in a series about financial swaps and how retailers can use them effectively. We highly suggest you read the prior two installments if you missed them to get more out of this Trader’s Corner.
In part one, we discussed that the financial swap market exists so buyers and sellers can establish the value of propane in the future. It allows both parties to turn the unknown future price of propane into a known. It is not a supply agreement where one party provides the other with physical propane. Instead, it is a financial agreement where money is exchanged between the counterparties.
But it works in conjunction with a propane supply contract to offset the change in the price of physical propane, thus allowing the future value of propane to be established (see part two).
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In today’s Trader’s Corner, we will provide an example of how a retailer can use a swap to provide a fixed price to a customer for months or even years in advance.
Before we look at that example, remember in part two that we discussed index-based pricing for propane. Propane swaps trade and settle at the trading hubs of Mont Belvieu, Texas, and Conway, Kansas. Meanwhile, the price that a retailer will pay for physical propane is established in a specific market area at a supply point like a pipeline terminal.
It is advantageous to connect the value of propane between these two points so the financial swap and the physical supply contract can work smoothly together.
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This is best done by buying physical propane from suppliers on a price indexed to the hub rather than at a posted price for a particular supply point. History has provided an average price difference or differential between physical supply points and trading hubs.
Most suppliers will allow their retail customers to buy physical propane from them at a supply point based on the daily average price of propane at the trading hub plus this differential.
By buying in this manner, retailers connect what they will pay for physical supply and their financial hedges, allowing the two to work together to provide predictable results. Buying this way removes what is known as basis risk, which is the potential for the price at the physical supply point to be higher than its normal differential.
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Chart: Cost Management Solutions. Click to expand.
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For our example, we had previously established that a propane retailer is buying from a supplier at a pipeline terminal in Ohio at the Mont Belvieu LST daily average plus 8.5 cents per gallon.
Let’s say a prospective commercial, industrial or municipal account contacts the propane retailer and says that, for budgetary reasons, it needs to know its propane cost from July 2021 through June 2022, and it is May 2021. The account provides the retailer with minimum usage per month in gallons.
The retailer is a client of Cost Management Solutions (CMS) and, providing the month and volume schedule, asks CMS to negotiate the market or strike price of propane swaps for each of the months at Mont Belvieu. CMS obtains the offers and provides a quote to the retailer.
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Note that CMS provided a price for specific months and volumes. Should the retailer use swaps to provide the financial hedge, there would be 12 separate swaps, each with a specific volume and strike price. At the end of each month, when the monthly average for that month is known, the swaps will settle.
We will get to the settlement processes and details later, but, for now, the retailer needs to close the deal, so let’s continue on with the sales process.
The retailer’s prospective customer may want the price by the month, but, most of the time, one single price per gallon over the course of the agreement is preferred. The weighted average price per gallon for this quote is $0.7908.
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Chart: Cost Management Solutions. Click to expand.
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With the swap quote in hand, the retailer is ready to build the sales price for the prospective customer. He begins with the swap strike and adds the differential from his physical supply contract, trucking cost from the pipeline terminal to his bulk tank and, finally, the desired margin.
In a matter of minutes, the retailer can provide a firm price quote of $1.70 per gallon on 229,000 gallons delivered according to the customer’s month and volume schedule. Impressed by the speed and confidence with which the retailer provided the quote, the prospect agrees to become a customer.
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In next week’s Trader’s Corner, we will go over the settlement process to show how the financial hedge above will work with the physical supply delivery to provide the desired result. But before we conclude, we want to make a few comments about the above process.
The retailer could have provided quotes beyond one year if the customer desired it. Swap prices are available three years out from the current month.
No money exchanges hands between the retailer and his swap counterparty in May when the swap agreement is signed. Money will first exchange hands after July when the monthly average for that month is known.
In this example, there is a challenge with the small monthly volumes, especially in the low-volume summer months, in the settlement process, which we will discuss next time. It is the reason we provided a cushion in our quote.
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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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