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JUNE 28, 2021 // THIS WEEK'S TOPIC: FINANCIAL SWAPS – PART 10
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In this Trader’s Corner, we continue with part 10 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, eight and nine). Also, our Trader's Corner of April 5, “The logic behind managing propane price risk,” is very pertinent to this series.
In the previous nine segments, we provided details about how to use swaps for both hedging and speculation. We went through the strengths and weaknesses of swaps and how they can be used with pre-buys and spot buying to manage the price risks associated with propane supply costs. Here is a list of key points for future reference:
1. A retailer does not have to change suppliers to use financial swaps.
2. It is recommended that a retailer buy physical propane from his supplier on an index basis when using financial swaps.
3. Financial swaps trade and settle primarily at the trading hubs of Mont Belvieu, Texas, and Conway, Kansas.
4. Buying at a price that is indexed to those hubs rather than at a local market posting ties the cost of physical supply and the financial swaps together, removing what is known as basis risk.
5. History shows us what price differential usually runs between the hub and the supply point.
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6. Most index contracts use the daily average price at the hub on the day the physical propane was bought at the supply point plus the agreed differential as the price the retailer pays at the supply point.
7. The purchase of physical propane and entering swaps are separate activities.
8. Though separate activities, the financial swaps offset the price movement in the physical market, thus providing the retailer a way to know the future cost of propane supply.
9. The swap market exists because there are producers (sellers) and retailers (buyers) that both wish to establish the cost of propane in the future.
10. Traders have relationships with both buyers and sellers, putting the two sides together in the swap market.
11. The traders work on very thin margins but high volumes.
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12. Cost Management Solutions (CMS) represents propane retailers in the swap market, keeping the process transparent and negotiating the best price with traders.
13. CMS also helps propane retailers understand how to use swaps and other financial tools to manage supply price risk and improve the retailer’s bottom line.
14. To protect against higher prices, a retailer buys swaps.
15. To protect against lower prices or to close a swap buy, a retailer can sell swaps.
16. The ability to both buy and sell swaps provides one of the key advantages to retailers, which is to change their supply portfolio as market conditions change.
17. A disadvantage of swaps is that they are month- and volume-specific, which means they are best used for a base load of price protection. Using non-ratable pre-buys to help with volume variations along with swaps is a strong combination.
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18. Since swaps do not have a storage component, their cost is generally less than pre-buys, which helps lower the cost of price risk management.
19. To use financial swaps, a retailer must establish relationships with traders, which CMS facilitates.
20. When establishing the relationship with the trading company, the retailer is usually provided a line of credit. Therefore, no money exchanges hands when a swap is implemented. Money exchanges hands after the average price for the month of the swap is known.
21. When buying a swap, the swap has a strike price. The strike price will be measured against the monthly average to determine which way money will flow at settlement.
22. If the monthly average exceeds the strike price (rising price environment), the retailer will receive the difference between the two.
23. If the monthly average is less than the strike price (falling price environment), the retailer pays the difference.
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24. Though points 22 and 23 are opposite, they both demonstrate how selling a swap can be used to close a swap buy position.
25. Financial swaps can be used for hedging.
26. Hedging occurs when the retailer has a sale against the swap position, which establishes a known margin.
27. Retailers can generally establish and forget about hedge positions since risk management isn't required.
28. A swap can be used for speculation.
29. Speculation occurs when the retailer has committed to the cost of supply but does not have an offsetting sell against it or has committed to a sale without an offsetting supply cost.
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30. Speculation requires diligent management of the position, making sure it is performing to the retailer’s advantage and perhaps closing it if it is not.
31. A good practice when using financial swaps for speculation is to establish a “stop loss.”
32. A stop loss is an amount of loss, determined in advance, that will trigger the closing of the position.
33. Traders that use financial swaps to take advantage of market opportunities will, over the long term, outperform retailers that do not use these tools and simply do a buy-and-mark-up strategy.
34. A good practice when speculating is to sell propane at market prices rather than a predetermined margin above the cost.
35. Selling at market prices allows the retailer to capture more margin in upward trending markets.
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36. It is important to understand that, when speculating, the retailer will not always be correct. That is why it is important to capture the extra margin when the position is positive.
37. By using all the tools available, propane retailers will be more profitable over time. Their success will allow them to maintain the personnel, equipment and assets to be more reliable suppliers to customers.
38. It will also allow retailers to have financially healthier businesses, providing security for themselves, their families and their associates.
39. Using these tools also helps retailers provide price structures desired by customers, which helps with retention and capturing new business.
We hope you have enjoyed and benefited from this series on financial swaps. Please don’t hesitate to call us if you have questions.
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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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