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NOVEMBER 21, 2022 // THIS WEEK'S TOPIC: PROPANE PRICES
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Propane retailers have to deal with a creep from time to time. As the name implies, a creep sneaks up on us, and before we know it, has taken something from us that is very precious: margin. The creep often comes in winter when the propane retailer and his staff are working to the point of exhaustion to meet the needs and expectations of their customers.
Propane wholesalers are quick to respond to changes in the price of propane, but it is widely known that propane retailers can be slow to pass on those changes, especially in a rising price environment. When trucks are rolling and gallons are being sold, it’s all too easy to overlook a bump up in wholesale prices of a penny here or a penny there. That is what creep is – a slow, almost undetectable erosion in gross profit margin.
Propane retailers need to avoid creep. With competitive pressures and higher costs at every turn, it has been harder and harder to protect margin, much less grow it. We just can’t afford to let things get creepy if we can avoid it.
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One way to avoid creep is by establishing a cost of supply at the beginning of the month and setting sales prices accordingly. Then it doesn’t matter how busy and distracted the retailer becomes over the course of the upcoming month; his gross margin will be according to plan.
Let’s say a retailer is expecting 200,000 gallons of sales in the upcoming month. One hundred thousand gallons are on a fixed-price basis. The supply side has already been secured by a prebuy, putting gallons in storage, or securing a swap buy. Based on that supply cost, a price was set for the customer and a gross margin locked in. But let’s say the other 100,000 gallons in expected sales has neither the supply nor sales side locked down. These are the gallons that are subject to creep.
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A strategy for avoiding creep is to buy a swap on or near the final day of a month to establish the price for the upcoming month on the gallons that are not already contracted. As we write, a December swap could be struck at around 88 cents at Mont Belvieu. If you buy from your physical supply based on Mont Belvieu’s price, you should buy a Mont Belvieu swap. If you buy your physical supply based on Conway, you will buy a Conway swap instead.
For the purposes of this discussion, let’s stick with Mont Belvieu. A retailer doesn’t have to wait until the end of the month to buy the swap. He could lock it down at a strike of 88 cents today. The advantage of waiting is it reduces the time where supply cost and market prices could separate. For our example, let’s assume the strike price of a December swap will still be 88 cents on Nov. 30.
If on Nov. 30, a retailer buys a December swap with a strike price of 88 cents, he would then add the normal difference in price between his storage tank and Mont Belvieu. This works best if he is buying from his physical supplier at a price indexed to Mont Belvieu. Let’s assume that he buys from his supplier at Mont Belvieu day of lifting plus 10 cents FOB a pipeline terminal. Then he has an agreement with a transportation company to move the propane from the terminal to his tank for 6 cents. Adding the strike price of the swap, plus differential, plus transportation results in a cost of supply of $1.04. To that, he adds the desired margin of, let’s assume, 75 cents for a customer price of $1.79.
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Cost of supply has gone from an unknown to a known. Everyone in the office can now know that the sales price on non-contract gallons for December will be $1.79. Creep has just been eliminated.
Now, let’s execute and see how this works. The retailer is going to buy 10 loads of propane over the course of December from his regular supplier, totaling 100,000 gallons. Let’s say the price of propane is creeping up through the month and instead of the supply cost FOB the retailer’s tank being $1.04, it is $1.07. The gross margin drops from 75 cents to 72 cents. So, on the physical side, he has paid his supplier and received money from his customers and grossed $3,000 less than expected.
At the end of December, the swap will settle. The strike was 88 cents, and the month average turns out to be 91 cents. Since month average is more than the strike, the retailer will get a check from the swap partner for 100,000 gallons x $0.03, or $3,000. The swap is the creep eliminator or exterminator or whatever you want to call it.
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Under this program, we assume the retailer will be able to hold the $1.79 sales price even if propane prices go down. If a retailer doesn’t want to take the downside risk, he can do the same concept but with a call option. A call option works just like the swap in terms of what we described above, but the buyer pays a premium to transfer the risk of falling prices. So, let’s say a retailer pays a premium of 5 cents for the call option. In that case, the cost of supply is $1.09, and the sales price $1.84 with the premium added.
With the swap, the retailer can’t lower his price even if the price paid to the physical supplier goes down. Why is that? Because the retailer will owe on the swap if the monthly average is below the strike price. So, if the strike price is 88 cents, and the month average is 85 cents, the retailer will owe $3,000 to the swap partner. That $3,000 comes from holding the sales prices at $1.79 even though the supply cost has dropped to $1.01. In this case, more is made on the transactions between the physical supplier and customers than expected, but that is used to cover the swap. The net result is the same 75-cent margin if the sales price remains unchanged. With the call option, the risk to falling prices has been transferred by paying a premium to an option writer. If the cost of that option is included in the retail price, the retailer is free to lower the retail price to match the drop in his supply cost without impacting margin.
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If holding a $1.79 sales price would be a problem if prices drop, then go with the call option. But the truth is, the market would likely have to make a significant turn in a 30-day window for that to be the case. In fact, data shows retail tends to be slower to lower prices, so it is unlikely that competitive pressure would be felt immediately. Remember, the whole structure resets in 30 days. Further, if it feels a longer downturn in prices is ahead, the program is skipped the next month.
Of course, retailers make the most of their sales during these winter months. If they get busy and let creep occur, that penny or two or three that leaked out the door becomes harder to recover when things finally slow down and chips are counted.
There will be those times when propane prices spike during the month. The retailer could choose to raise the sales price during those months and make more margin since increases in supply cost are covered by the swap. How creepy would that be?
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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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