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Trader's Corner - Presented by LP Gas. Propane Market Insights from Cost Management Solutions
Can things be simpler?
We woke on Friday morning with news the former prime minister of Japan, Shinzo Abe, was assassinated during a political event where he was speaking. The previous day, the United Kingdom's Prime Minister Boris Johnson resigned because of a scandal. That was right on the heels of the horrific shooting in Chicago. Daily there is heartbreaking news from the war in Ukraine. Beyond the fighting and death is the terrible humanitarian and economic impact of the war on the entire world population. COVID-19 appears to be rearing its ugly head again with reports of a 30 percent increase in cases recently and new variants of the virus.

There are fears of a recession, inflation, interest rate hikes, partisan politics, divisiveness, polarization, attacks on every institution and norm. Daily we are told what we thought was normal is abnormal, what we thought was good is actually bad. It is all so fatiguing. Where in the world is love, joy, peace, patience, kindness, goodness, faithfulness, gentleness and self-control? Where are things like respect, reverence, admiration and appreciation? Are we tearing down everything to rebuild it better, or are we just tearing down everything because that is what people without hope do?

We know that asking the questions above, much less trying to answer them, doesn’t belong in the confines of Trader’s Corner. Our focus here is energy and more specifically propane. We aired the feeling above to set the stage for what we will discuss in this Trader’s Corner. Our mindset: Is there anything we can do in the context of our area of focus that could reduce stress and make things easier for the people who will read this article?
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Indeed, all of the things we mentioned at the beginning do impact the energy markets, and we see that reflected in the volatility in prices. We only need to go back to last Tuesday to see the manifestation of uncertainty in energy markets. On that day, West Texas Intermediate crude reached $111.45 before dropping to $97.43. Uncertainty causes such extreme volatility. The fall was attributed to the fear of a recession. We are not sure you have to attach the word recession to it. We could end at fear. Fear is enough. It seems every direction we look there is fearfulness. In the energy markets, there is fear of recession that will destroy demand, but there is also a fear that there won’t be enough supply. The direction of energy markets is determined by whichever source of fear is predominate on any given day.

In that environment, a propane retailer is supposed to make a couple of supply purchases for this upcoming winter to protect his customers from higher prices and/or provide a chance of improving profitability. We should not be called Trader’s Corner. We should be called Buyer’s Corner because, as propane retailers, that is what we do. We don’t really trade propane; we buy and then sell it to someone else. If we buy right, our world is good, and if we buy wrong, it’s not. How do you buy in an atmosphere of such uncertainty with only a couple of chances to get it right? Often, we don’t because the fear of being wrong is almost always stronger than any rationale for buying. If we don’t buy ahead of time, we can buy at market during the winter, apply our markup and hopefully justify it to our customer. In other words, we can simply let the customer deal with higher prices. It is a real dilemma for most retailers. They want to do right by their customers, but will their customers do right by them should they buy wrong? The unfortunate answer is they often don’t.

It is not a bad time to be taking position for next winter, and last week, we saw a lot of retailers doing just that. Expectations are that crude supply is going to be tight for the foreseeable future. Propane inventories built great for three months, driving the price down about 40 cents. But over the last five weeks, inventory builds have been on the light side, and that has caused prices to level out. If you are a technical trader, propane is below all of its moving averages and at a low relative strength reading, which are good buy signals. But, again, we only have to go back to last Tuesday to see what the fear of a recession, much less an actual recession, can do to crude and propane prices. There is also the potential for the war in Ukraine to end. Relief alone would probably drive prices lower, along with more stability in food and energy supplies.
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Ideally, the retailers that have been buying were hedging. That means they are taking the price they locked down, making an offer to customers who are accepting the offer. But we know some retailers are speculating. They are buying now but will not offer a price to customers until winter. They are taking the risk of prices falling. If that is the case, let’s take our buyer’s hat off and put on a trader’s hat. If the retailers are using financial swaps to establish the price they will pay for propane this winter, they can reverse that decision if the market turns against them. Buying the swap protects them from higher prices. Based on the reasons we listed above, many retailers believe the odds favor higher prices for the winter and are willing to take the risk of falling prices. But they don’t have to take infinite downside risk to take advantage of potential opportunity that current prices provide them.

What is a bit foreign to most retailers, since they are conditioned to be buyers of supply and only sellers to their customers, is that they can sell swaps as well as buy them. If a retailer speculated and bought swaps for winter, they can reverse that position by selling swaps for the same month and same volume later.

Let’s say a retailer just bought six swaps on a volume of 10,000 gallons each month from October 2022 to March 2023. The average price of those would be 116 cents per gallon. The total volume that the price is now known on is 60,000 gallons. If prices are higher at the trading hub (in the case of Mont Belvieu) in the winter, the retailer will receive the difference between 116 cents and that higher price. The retailer will buy physical supply from his supplier at market prices, but he will then receive a check on the swap that will take the net supply cost at Mont Belvieu back to 116 cents.
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Again, as we sit here today, knowing what we know, there is a good chance that having an established price of 116 cents Mont Belvieu for this winter will be a positive for a retailer. He can pass the good decision on to customers, make more margin or any combination of the two.

The decision on whether to take advantage of the potential opportunity is made now, in July. Once established, the retailer has assumed downside price risk over the next three to nine months because, if the value of propane is below 116 cents, he must pay the difference.

Now, let’s say that by September the economic situation is getting worse, and a recession is far more certain. This is becoming reflected in energy prices, and crude and propane values are beginning to fall. The 116-cent propane position no longer looks as promising as it did in July. Let’s say the value of propane from October to March is now at 111 cents in September.
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If the retailer looks at the new situation and decides there is more downside than upside risk, he can close the swap buys down by selling swaps of equal volume in each of the six months. He would sell six swaps, 10,000 gallons per month, October through March, for a total 60,000 gallons at 111 cents. From that point forward, the two positions offset each other.

The retailer has lost 5 cents on the position, and that will be an expense to his bottom line. That is not good and won’t feel good for the particular year in question. However, over time, if a retailer is making good, educated, logical (not emotion-based) decisions about taking these positions, he will be right more than he will be wrong. To make this work, the retailer has to become more of a trader and risk manager rather than just a buyer and hope-for-the-bester.

There is more work in this approach, but there is a lot less fear that tends to paralyze our decision-making, resulting in passing up opportunity. In a crazy, volatile, sometimes upside-down world, the proper use of financial tools such as swaps can bring more knowns and certainty into our world. In the current world, the current market environment, that can’t be a bad thing.
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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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