New Yorkers: Don't Read this Column

Written on: October 4, 2013 by Phillip J. Baratz

With all due deference to Billy Joel, we are not in a New York State of mind, this month. Despite growing up and spending the formidable years of my life in the Big Apple, there is a current issue for heating oil dealers that applies most specifically to those outside the Empire State. Perhaps a little history would help:
In an effort to distribute a “cleaner” fuel, many industry, environmental, regulatory and legislative groups have been engaged in an effort that officially launched about a year ago. Last summer, in July, 2012, New York enacted rules requiring heating oil dealers to deliver a “new spec” of heating oil with 15 ppm sulfur (as opposed to the “standard” 2000 ppm that is commonly delivered—and the same 2000 ppm spec that the Merc futures contract was based upon).
For NY dealers, this meant that the product that they were buying for delivery to their customers was now a premium product, as compared with the standard reference point for supply pricing and for hedging, the Merc (2000 ppm) futures contract. A good way to think of it would be to imagine that the Merc futures contract were for “regular unleaded” gasoline (which it is), and that you were suddenly required to deliver premium gasoline, despite the fact that you could only hedge with the regular gasoline futures contract.
During the summer, and into the winter, NY dealers faced not only the knowledge that their product had jumped in value, relative to the Merc contract, but also the uncertainty of not knowing by how much. There were times where the premium paid was almost 30 cents per gallon higher than “normal”, and times that the premium was “only” about a nickel. Lacking a known “diff” from a supplier, many NY dealers were operating with supply costs, and associated hedging, at the whims of the marketplace.
While this was going on in New York, the rest of the heating oil space was enjoying (perhaps the wrong word) business as usual—if you ignore the effects of “Superstorm” Sandy, which are hard to ignore—with “diffs” within range of where we had historically seen them. “Old spec” (2000 ppm) was being delivered, and it matched up against the spec on the Merc. Then, effective with the May futures contract on the Merc becoming the “spot” or “front month” futures contract, the “diff world” did an about-face. The Merc contract—since renamed “NY Harbor ULSD” from “Heating Oil Futures”—changed the spec to what we will call “new spec,” with a 15 ppm (as mandated currently in NY, and only in NY) sulfur content. Accordingly, all dealers outside of NY are now buying a product that is a “lower quality” (via the higher sulfur content) than the spec of the Merc contract.
To review: outside of NY is buying “old spec”, and Merc contract is now “new spec.”
Interestingly, because the Merc contract is for a more valuable product, the “diffs” have shrunken—or at least appear to have done so. Not really a bait and switch, but if the cost to transport from New York Harbor to, say, New Haven, is the same as it has always been, AND you are buying a product (old spec) that is inherently a lower costing product than the Merc contract (new spec), then the “diff” versus the Merc will be lower.
Now that you might be thoroughly confused, what is the point? There are two main “diff issues” that we work with our clients on. The first is simply moving them in the direction of “differential certainty.” In other words—regardless of old spec or new spec—the small and medium sized dealers generally do not have any assuredness of what their costs will be when they lift at the rack, relative to the Merc (or other Index) contract. In sharp contrast, most of the largest dealers do have “fixed diffs.” Before the wheels start spinning in your mind about the incredible value of being a rack shopper, please consider the following:
Most small dealers buy almost all of their supply from one or two suppliers, despite wanting to be “shoppers.”
Getting the “low rack” on a day where the “diffs” have gone way up is just the best of a bad situation.

HO vs. ULSD spread
—Chart from Bloomberg Finance

The bigger purchasers, those who fix their diffs, are not doing it as a matter of getting the absolute best price every day. One can argue that had they shopped the racks every day, their costs might have been lower. The REASON they fix their diffs is because they want pricing certainty. They set goals, targets and budgets, and having their basis jump around—even if sometimes the rack diff would be lower than their fixed diff—wreaks havoc on daily price setting, and ultimately on earned margins.
Fixed-diffs are generally NOT for 100% of vol
umes. Some will fix 40%, while other will fix closer to 85%. Some do winter-only; some do
every month. It is a conversation to be had, and something to be thought through as part of a planning process. Contact your risk management consultant, or feel free to contact us, if you would like to talk it through.
Witnessing our clients getting reasonable fixed-diffs is not something that is the norm, but we are hopeful that over time, more suppliers will understand the value of ratability and predictability, and work with dealers in that direction. This applies to all dealers, regardless of their location. Making the unpredictable more predictable resonates well with those who embrace the notion.
As to the second—or related—“diff,” for those gallons that are not indexed to the Merc, simply because suppliers can’t or won’t offer it, or because the offered diff is just unreasonable, the old spec versus new spec is still something that should be on the minds of dealers. Last December–February, when more than 50% of deliveries are typically made, the spread between “old and new” averaged a discount of about 6½ cents per gallon (see chart from Bloomberg). The winter before, it averaged during the same time period about 3¼ cents per gallon. As of early August, it was 15 cents under, and in the past year, it has been as wide as 27 cents under (for a few days in the spring), and as low as less than 2 cents under (in December—when there are many more gallons delivered than in May!).
The bottom line on this is that you make certain assumptions in your business, and you need to see how many of those assumptions are controllable. If your cost of product—relative to a hedge or to your competition, or to a promised “program gallon” (fixed or capped)—can vary by 5-, 10- or 15-cents per gallon, why would you NOT want to hedge that exposure.
Important note: the notion of the “hedging of that exposure” is not to say that you could not do better if “x, y and z” happened. It is just a way of bringing in predictability to a business that inherently has more than enough unpredictability.
Again, locking in the old spec versus new spec differential (and we can help you with that—either by arming you with enough ammunition to work with your suppliers, or by looking at a simple paper transaction) is not to speculate on the direction of where that spread will go—back to 15-under or back to 1-under, but to take away the ability for that unknown to be something that you need to live with. It is a necessity for fixed and capped sales (assuming that they have been sold and hedged properly), and will go a long way towards making those spot (or variably priced) sales more predictable. We have seen this coming for the past year, and now it is here. Ignoring it will not make it go away.
If you are a dealer in NY, thanks for reading, and enjoy the fact that you DO have one less thing to worry about than many of your oil selling brethren. ICM