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JUNE 21, 2021 // THIS WEEK'S TOPIC: FINANCIAL SWAPS – PART 9
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In this Trader’s Corner, we continue with part nine of our series on financial swaps. Since these segments build upon each other, we highly suggest you review the previous segments if you missed them (parts one, two, three, four, five, six, seven and eight). Also, our Trader's Corner of April 5, “The logic behind managing propane price risk,” is very pertinent to our segment this week.
If you have been following this series, at some point, you may have asked how using financial swaps is any different than doing a pre-buy. They are exactly the same from the standpoint of setting the future value of propane. They both establish a known future cost of propane for the propane retailer. They both can be used for hedging or speculation.
There are also several differences, which we will cover in this Trader’s Corner. However, we want to stress that it is not an either/or situation when using pre-buys or swaps to manage propane supply risks or capture opportunities. We need to understand the strengths and weaknesses of both and use them together in a comprehensive supply cost risk management plan.
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Advantages of a financial swap:
1. Easy to get into and, just as importantly, easy to exit.
2. Available for three years out.
3. No upfront payments as they settle, and money exchanges hands once the monthly average is known for the month covered.
Disadvantages of a financial swap: Volumes are month-specific and do not carry over from month to month.
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Advantages of a non-ratable pre-buy: Non-ratable pre-buys are generally for a larger block of supply that can be pulled over the entire winter at the discretion of the retailer, providing a lot of volume flexibility.
Disadvantages of a non-ratable pre-buy:
1. Generally only available for the upcoming winter.
2. Can have some upfront and load costs. The load costs are generally associated with storage cost necessary to allow the retailer to pull over a period of time.
3. May be difficult to exit.
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First, let’s consider using these tools for a hedge. Perhaps a commercial account wants to lock in supply for the coming year. We could use a series of 12 swaps to cover the absolute minimum volume that would be demanded each month. We could then do a pre-buy to cover the variability in volume each month above the minimum demand. Since the swap does not have potential higher cost of storage, it lowers the overall price quote to use swaps for the base load. But, we likely need the volume flexibility provided by the pre-buy. We are willing to pay a premium for the pre-buy to gain this needed volume flexibility.
But, what about if a retailer is speculating (no sale against the supply position)?
First of all, if a retailer is speculating, it is generally not wise to cover all of his expected demand. That could only be done if he is 100 percent certain prices are going higher, and such certainty never exists.
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If propane fundamentals are supportive and crude prices are expected to go higher, retailers might decide to speculate on 60 percent of their overall demand, leaving 40 percent bought at market prices when the demand occurs. If propane fundamentals are less supportive or crude is expected to go lower, retailers might limit speculative positions to no more than 40 percent of total expected demand.
Remember, a retailer can exit swaps relatively easily, so, if conditions change, the position can be reduced. It is very important in supply cost risk management to have the flexibility to adapt to changing market conditions. As listed, that is one of the key advantages of using swaps.
Let’s say the retailer has decided to speculate on 50 percent of total expected demand. The retailer will buy the supply to cover the remaining demand at market prices when the demand actually occurs.
The retailer might cover the remaining demand at an 80:20 ratio of swaps and pre-buys.
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By owning 80 percent of the speculative amount in swaps, the retailer leaves the maximum flexibility in making changes to the supply portfolio. The retailer also is likely lowering the cost on the price protection since storage or other fees are not in the mix. The 20 percent of the position covered by non-ratable pre-buys provides the needed volume flexibility. There are ratable pre-buys available usually for less than a non-ratable pre-buy, but that takes away a key advantage of the pre-buy and makes it work more like a swap.
When speculating, retailers are trying to take advantage of perceived market opportunities to add money to the bottom line. But, they must guard against putting the company in the position of being uncompetitive in the marketplace or risk losing customers or having to sacrifice margin.
Buying some of their propane at spot prices and using a combination of financial swaps and pre-buys to get price protection on the rest provides the ability to take advantage of market opportunities while reserving the flexibility to remain competitive no matter which way propane prices ultimately go.
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Remember, this process always begins with a market assessment. If retailers believe market conditions suggest lower prices in the future, they should obtain price protection on none or on a lesser amount of future demand. If conditions increase the potential for higher prices, then the amount of price protection should be increased. It is important to acknowledge that we never know for sure exactly where the market is going to be in the future. That is why it is called price risk management. The retailer must constantly evaluate and manage the situation. That is where the convenience and flexibility of financial swaps help.
A retailer should never be swinging for the fence or go all in on any one expectation. They should play the odds, get base hits and diligently manage the situation. If retailers do that, over time, they will add to the bottom line, have a more successful company that is better capable of meeting customers' needs without putting themselves in a position that risks margin or even the viability of the company.
Next week will be our 10th and final segment on financial swaps. We will review and summarize all that we have discussed. Please don’t hesitate to contact us if you have questions or need clarification on anything covered in this series.
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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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