The Fall is an exciting time of year for fuel distribution companies. After a slow Summer, it’s time to get busy and make money. However, this excitement is often accompanied by trepidation about the uncertainties of the upcoming season.
Many companies use the end of the heating season to assess and address issues. Yet, in a mature industry like ours, it often feels repetitive: What if it’s warm again? What if there is more than the usual number of runouts in the fall? Will my seasonal drivers return? Do I even need them?
The list of concerns can be long, making it hard to prioritize. Here are a few things that can be addressed now, pre-season as it were, to sleep a little better at night.
Excess/Surprise Service Calls
The first cold snap each year is challenging, often requiring a reactive approach. However, it doesn’t have to be this way. A business operating system is full of service data. By sorting customers by call frequency, business owners might identify those with unreasonable expectations, equipment needing service or upgrades or under-performing service techs.
Creating an “Excess Calls Report” (example below) can help proactively reduce these annual issues.
Liquid Product Goals (Budgets)
Early in the season, it’s crucial to define what success looks like. Is it total gallons delivered, total margins, product mix? Setting up monthly budgets for volumes and margins by product allows for better course correction. Finding out a few months later that margins were “off” can be very difficult to recover from. Reviewing these budgets on a weekly basis early in the season (then twice a week from December onwards) can help avoid surprises later. (See example below)
Additional Concerns
Some other matters that business owners might want to take into account include:
• Accurately tracking margins, including inputting bill-of-ladings, identifying contracted vs. non-contracted supplier bills and posting inventory movements correctly.
• Delivery efficiency, such as reviewing deliveries, delivery Ks and “forecast-to-actual” delivery sizes.
• Having accurate baseline data for operations, such as miles and hours, that are often neglected but crucial for cost calculations.
While the Fall is an exciting time of year, it’s also early enough to identify and address key issues. Many companies face similar challenges, but not all share the same level of concern. Identify your firm’s biggest worries, find people to help you through the process, and you’ll sleep better at night. ICM
Sales price pressure from the top and operating expense pressure from the bottom is what Angus Analytics Managing Partner Bob Levins refers to as “the squeeze play.”
Per-gallon profit margins have started to normalize after several seasons of high margins due to extreme volatility. While margins have not gone back to where they were in 2018, they are well below the levels of the past three years. At the same time, we’ve come off of our second consecutive warm winter and are still facing an inflationary environment that is driving up nearly all operating costs. We cannot hide from our realities: expenses must be managed in a way that doesn’t impact the customer experience. This is a difficult challenge and one we work on with our clients every day.
Listening Tour
At Angus Energy, we recently spent a significant amount of time on a “listening tour,” trying to identify “local” challenges in addition to global ones caused by the squeeze play. What we learned was:
• Some companies are misaligned internally, generally without even knowing it. There could be a mandate to make very efficient (aka “large”) deliveries, or another to deliver “x” gallons per month that leads to “pulling gallons early.”
• Other companies recognize the need to manage delivery costs but don’t understand the balancing act of the many moving parts (drivers, trucks, routing, excess capacity, K-factor review automation, etc.) well enough to make changes, so they simply continue as before.
• Then there are the companies in a perpetual state of improvement; this group deserves applause. These improvements can take many forms, such as building a new bulk plant, making an acquisition or moving to a new business operating system. Each initiative can be well planned, yet too often pushes all other needs to the back of the line.
Despite the various approaches of what should be done in the short run, there was a clear consensus that companies must either:
Deliver current gallons—spending less
OR
Deliver more gallons—spending the same
When & How
The only true questions related to that were “When?” and “How?”
For “When,” it should only be when you are willing and able to take on the changes that will be required to accomplish your goals; and yes, you will need to establish a clear set of goals. Simply stating that you need to lower overhead in the next heating season is not a plan—it’s an aspiration. While “When” is very important since later is usually easier than now, “How” is the key to succeeding and it must start with a plan and commitment.
Gaining Delivery Efficiency
While there are numerous variables in our businesses, when it comes to being more efficient in delivering fuel, here are some guiding principles to consider:
1. Pushing deeper into the tank allows for larger deliveries, but also increases the possibility of run-outs. How you dial up delivery sizes (which customers, which Ks, which months, which tank sizes) is not an activity you can rely on instinct to implement. You have the answers already based on the deliveries you’ve already made. One-size-fits-all thinking—i.e., treating all 275-gallon tanks the same way—will severely impede your ability to operate more profitably.
2. Delivery truck utilization is often an unfortunate afterthought. Do you have as many trucks as you need for your busiest delivery day, or do you manage your busiest delivery day to match your fleet size? Making select small deliveries to some tanks can cost your company less money over the course of the year than always targeting your “optimal” delivery size.
3. Every delivery needs to teach you something—and the time to review those deliveries is every day, not just when you have downtime in the Summer. Your back-office system does a spectacular job of telling you what you ask it based upon a finite set of data points (such as, “When will the tank level get down to x?”). When that delivery size does not match the intended size, you need to learn from it. Automating a process will yield incredible benefits.
Marketing, customer support, service departments and the like are all meant to solicit customers, engage customers, keep customers and earn the right to charge customers a fair price. Most companies are good at those things and have adapted over time from mailing postcards and advertising in the Yellow Pages to implementing search engine optimization and TikTok marketing. However, if the delivery operations (generally where you earn all your profits) are still in the age of the Yellow Pages, you have fallen behind. If you recognize that, perhaps you are already catching up. If you don’t recognize it, you have some thinking to do—but avoiding the challenges will not make them go away. ICM
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you considering your financial condition. In considering whether to trade or to authorize someone else to trade for you, you should be aware that you could lose all or substantially all your investment and may be liable for amounts well above your initial investment.
The saying “customers on a price program are the most loyal” has certainly survived the test of time.
Many of us grew up in this industry that revolved around “churning” customers; while some left each year, they were hopefully replaced by others the following year, and dealers were forced to absorb all the associated costs. The way that many companies accomplished real growth was through a different form of customer acquisition—acquiring other companies.
Although today’s homeowners average the same age as homeowners of a decade ago, their behavior is noticeably different. Homeowners today are tethered to their phones looking for good deals and the latest influencers to tell them what to do. Loyalty has been replaced by “likes.”
As operating costs have increased, the main way to offset those and to still make a reasonable profit has been to increase margins on fuel as well as equipment sales and service. We are fast approaching a collision of dealers who want/need to charge more with customers who want/need to pay less (and are often armed with online information allowing them to do so). Replacement costs for lost customers continue to increase, rendering customer retention that much more important.
Operating a truly efficient business is no longer optimal; it is absolutely required in today’s competitive, information-overloaded marketplace. This means:
• Significant overtime expense in peak months needs to go away.
The good news is that there are tools available to make all this happen right now—with an immediate return on investment (ROI)—not one premised on waiting for customers to hit their third year and have a stable Delivery-K. You need to operate more efficiently, and you need to investigate it now. In addition to the basics of operational efficiency, keeping customers can be as simple as offering them the right pricing program—one that inherently dissuades them from looking for another company while scrolling through social media.
Customers with price caps pay a lower price if retail prices spike, and prices drop if retail prices drop. Free lunch? Certainly not. The cost to provide that flexibility is generally shown in the form of a “premium.”
Given the volatility of ultra-low sulfur diesel (ULSD) futures prices over the past few years—ranging from a pandemic low of 61¢ per gallon in 2020 to a high of $5.13 per gallon in 2022 (an 841% increase) —customers are seeking price protection more than ever. In addition, dealers are seeking customers on price caps more than ever.
How to accomplish this can get a bit complicated. Obviously, you need customers to sign up for the cap, which can be done through existing or new marketing channels including snail mail, email, WhatsApp, bill stuffer, text, auto-dialer, websites, etc. For new enrollments, the message (we have helped many dealers create them) should be simple, straightforward and comforting. For renewals, the communication should include the cap price (the maximum a customer will pay) details.
Hedging can be intimidating, sometimes due to a lack of understanding, the perception that hedging is speculating, or by a preconceived notion/belief of what the markets will do. Does “it won’t go up, the economy is so weak,” or “it can’t drop, there is so much inflation” sound familiar?
Understanding hedging basics:
As mentioned, it is not necessarily easy or intuitive, but there are experts who can walk you through it.
An important note for those offering a pricing program and not protecting against the risk to the profit margin: If you are not hedging, you are speculating.
Track sales/hedges/risk while offering the cap
Your business operating system should allow you to track the “short” side of the price cap (the volumes you have made a promise on). Reporting on this can be done through a business intelligence offering (such as Angus Analytics’ BRITE software), or through an internal report generating system. In addition to tracking the customer (short) side, you need to track the hedged (long) side of the price cap. These positions need to be reviewed on a regular basis, and an overall hedge plan in place determined ahead of time (not based on your gut feeling on a particular day).
While “role playing” of future prices might not be a normal part of your process, it is good to know what will happen if prices make an extreme move higher or lower, or if the weather is vastly different from historical averages.
Points to remember:
• Managing and executing hedge transactions takes a certain amount of expertise and planning and can eventually be mostly on “auto-pilot.”
Don’t let the complications scare you away; we are here to help. ICM
*Please note that there are many details involved in delivery optimization and efficiency and your company will vary somewhat from the industry average. In addition, an increased cost savings is often achievable by shifting around the timing of certain deliveries using AI/ML (artificial intelligence/machine learning) focused on individual data points.
You have data, we have data, and, wow, that’s a lot of data! There is data about trucks and service vans; driver’s wages and dispatcher’s wages; deliveries, stops per hour, miles per stop and costs per stop; costs per delivery, gallons per Heating Degree Day (HDD) and costs per delivered gallon. So much data.
In the realm of residential retail deliveries of fuel, all this data, and the metrics it leads to, are much more similar from one dealer to another than you might think. Yes, driving more miles between stops in a rural area will increase fuel and other delivery costs. However, rural areas typically pay lower wages than urban areas—so these two factors usually offset one another.
With operating costs heading only in one direction (up), unless you can be more efficient, the only way to maintain profits is to increase your margins.
As mentioned, most fuel marketers are within a similar range of efficacy, so many are turning to their pools of data to understand their metrics and then make plans to improve them. Here are some simple points to consider:
Delivering more per truck, which allows you to get trucks off the road, is one of the top goals of some new solutions in the marketplace. These solutions lead to setting achievable goals in coordination with management and dispatch to lower the costs to deliver your product. With a lower cost structure, operators can either run the current business with fewer transactions and moving parts, or (as we have seen in several cases) enabling growth without the necessity of enlarging your fleet or finding new drivers.
However, sometimes there is a disconnect. Helping a dispatcher increase average delivery sizes into 275-gallon heating oil tanks from 150 gallons to 180 gallons is great, and we’ve witnessed this success many times. As exciting as it might be for the dispatcher, and as nice as it is to reduce overtime costs in January, what is the true benefit? What does ownership see?
Ultimately, owners are concerned with the bottom line. In any given year, a host of outside factors can impact the bottom line. Would owners attribute the increase in delivery sizes to an increase in profitability? Perhaps it was a cold winter and consumption was up 10%. Alternatively, if equipment sales slumped because of higher interest rates, the increase of 30 gallons per delivery would be lost in the shuffle. However, the benefits of those increases are imbedded in the company’s profits, but they must be recognized.
Using “industry averages,” it costs approximately $65 to make a delivery, not including selling, general and administrative expenses (SG&A—which includes the cost of the fleet, fleet maintenance, insurance, wear and tear, dispatchers and driver wages with overtime and benefits)*. If you have 6,000 retail customers averaging 900 gallons of consumption and are averaging 150 gallons per delivery, your “base” is ~36,000 deliveries per year (900 / 150 = 6.
The only thing worse than not enough data is too much data. That can be true while trying to assess the concrete benefits, costs and priorities. Ultimately, at your core, you are a delivery company and if you can improve those costs, you will have a clear and definable set of benefits. The benefits will be in terms of costs per gallon, saved deliveries, gallons per HDD, etc. However, most importantly, they will be clearly defined by extra dollars of profit. ICM
*Please note that there are many details involved in delivery optimization and efficiency and your company will vary somewhat from the industry average. In addition, an increased cost savings is often achievable by shifting around the timing of certain deliveries using AI/ML (artificial intelligence/machine learning) focused on individual data points.
We all know the basic reasons for getting tank monitors:
Regardless of the reason, tank monitors are meant to take away the uncertainty of asking yourself, “How much will I deliver to this tank today?” Better put, tank monitors put an end to the challenge of relying on questionable K-factor consumption calculations. If you know how much you will deliver to a particular tank, you can achieve the two most important improvements imaginable: increased delivery size and optimal fleet management.
You’ve gone out and purchased monitors. Now what?
The decision to buy was likely a combination of economics and emotions. The economics pushed you towards the goals of delivering more efficiently and saving money, while emotion triggered the actual purchase. However, once that decision is made, there is still a lot of work ahead of you. How do you install the monitors? Who installs the monitors? What do you do with the information collected? How do you track value, savings, return on investment (ROI)? How do you know whether your decision was the right one?
We can start with some easy answers. If you don’t install monitors, you will simply have expensive inventory collecting dust on a shelf. If you don’t train your dispatchers and plan how the monitors will improve your results, the investment will not have been worth it. Lastly, if you don’t have an organization that can learn from the data, the purchase was not a good decision.
What should you do?
As with all desired improvements—weight loss, more income, better grades—you need to start with a baseline or a reference point. Do you know your numbers now, before you start with monitors? Knowing your average delivery size is better than not knowing it, but there is a lot more you must know:
Those are some of the questions that you need to ask yourself to successfully plan for the physical deployment (prioritization) of your monitors and the tracking your monitors’ benefits.
If you purchased monitors just to avoid run-outs, it wasn’t worth the investment—you don’t really have that many run-outs. If you purchased monitors just to avoid those frustrating 40-gallon deliveries… well, you don’t have too many of those either. However, if you bought monitors so that you can manage the optimal time to make deliveries for every tank and for every month of the year, then you have the right frame of mind.
Adding monitors without changing your mindset will not achieve your goals. You need to start thinking in terms of days instead of gallons. In addition to considering when a tank has room for a certain sized delivery you must also consider whether that delivery makes sense in the context of the time of year, staffing, overtime and fleet capabilities.
My main point is that monitors are not the solution; they are part of the solution. Monitors are a tool. When coupled with historical data, ongoing reviews and a well-executed operational plan, monitors can (and do) yield fantastic results. We are happy to share some of what we have learned during the past seven years of implementing, tracking and optimizing tank monitor solutions. ICM
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS
The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. In considering whether to trade or to authorize someone else to trade for you, you should be aware that you could lose all or substantially all of your investment and may be liable for amounts well above your initial investment.
There is an old joke about some guys sitting together talking about their “best” insurance scam escapades that ends with the line, “So, how do you make a flood?” (If you don’t know the joke, you’re likely under age 40!) While it is true that you cannot make a flood, it is also true that we cannot make the weather cold. However, we need to recognize the growing need for our industry to be protected against winters that are not exactly wintery.
The economics of our industry are fairly straightforward: Gross margins are charged per gallon delivered. The number of gallons delivered is based on the number of gallons consumed. The number of gallons consumed (or at least 80% for space-heating customers) is based on the weather. You may not be able to control the weather, but the weather definitely controls you and your profits.
This past winter could have been an absolute financial disaster. Prices were up anywhere from 50% to 150% from the prior year. Interest rates were rising, putting a crimp on all spending, and after a reasonably normal October, the weather in November was warm, and the lost Heating Degree Days (HDDs) never recovered—leaving us with a double-digit percentage loss in HDDs and in sales volumes for heating fuels over the winter.
I said it could have been a disaster, but along with the warm weather in November came moderating prices. Though volumes were light, prices were still relatively high (see Chart 1 for historical ranges over the past five years), allowing per gallon margins to remain strong—in many cases at record highs. If you can manage to sell with record per unit margins, some lost volume might not be that big of a deal. However, if the lost volume were more frequent (see Chart 2 for the weather over the last 10 years, Oct−Apr, at BOS [Boston, MA] weather station), profits would become much less predictable and the operating model would have to change.
The economics in the residential heating fuels industry are mostly fixed—salaries, equipment payments, rent, etc. While there are variable expenses relating to deliveries, you need to keep a fleet of trucks, drivers and dispatchers available to deliver your “normal” number of gallons. It is estimated that to simply break even, sales need to be between 85% and 90% of “normal.” This illustrates why a year that is 1–3% warmer (or colder) might not have a major impact on your bottom line, but once beyond 5%, it can be painful (or, if cold, enjoyable). Further, once we are beyond 10% warmer, we hear about layoffs, deferred capital expenditures, and sometimes uncomfortable conversations with banks and suppliers. In the last eight years, we have had three winters that were 5% warmer and two that were more than 10% warmer.
Prices will vary up and down. Supplier basis will jump about. If you sell your product at rack-plus, these gyrations do not have a major impact on you. If you sell your product—as most do—with the offer of a pricing program, you are familiar with the ways to hedge your offerings to make your per-gallon margins more predictable. You cannot control the weather, but you can control the impact the weather has on your business.
We don’t have opinions on the weather—other than that it is unpredictable. If it is not cold, we won’t make enough money. Risk management (hedging) is exactly that: managing a risk. Your trucks are insured. Your life is insured. Your service techs in someone’s basement are insured. How about your revenue? Is that insured? ICM
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. In considering whether to trade or to authorize someone else to trade for you, you should be aware that you could lose all or substantially all of your investment and may be liable for amounts well above your initial investment.
This article is being written in March, almost a year to the day from the first of a series of price spikes that has plagued the world, the U.S. and our industry since Russia attacked Ukraine. Futures prices spiked to almost $4.70/gallon in March 2022. They spiked again to $5.85/gallon in April 2022. In June and then again in October, prices spiked up to over $4.50/gallon (note that we are talking only about the price on the Merc, not the “spot” price in the Harbor or the local rack prices). During that same time period, from March 2022 to March 2023, not only did prices reach highs of almost $6.00/gallon, but they also traded as low as $2.50/gallon (a 240% increase from low to high!).
I do apologize if the prior paragraph gave you flashbacks to last Spring and Summer and the associated sleepless nights as you tried to navigate the extreme price volatility, lack of supply, uncommunicative suppliers and banks, and (mostly) the need to offer comfort to your customers.
Typically speaking, we see pricing programs as among the most certain ways to retain customers (along with service contracts). Within the world of pricing programs, price caps usually do the best job for retention and they continue to grow in popularity. To answer an oft-asked question, “If we don’t offer a cap, is offering a fixed price better than no offer at all?”, I would say that usually the answer to that question is “Yes,” but (as with everything) it is case-specific.
As you learn in Hedging 101, capped and fixed-price offerings need to consider the weather (volume), the price (Merc and basis) and—only in the case of the cap—the “premium” for the protection, usually in the form of a “call” or “put” option (again, case-specific). Generically speaking, the difference between a cap and a fixed price is in the flexibility and the cost. Cap offers are more expensive, but more flexible (prices can’t exceed a certain level, but they can go down—given certain market circumstance, like falling prices). Fixed offers are just that, fixed. They do not have the added cost of the premium for the option on the price of oil, but they also do not have the flexibility to take advantage of falling prices. As the premium for the cap protection is typically passed along to the customer (either as a cap fee or embedded into the delivered price of the cap gallons), dealers got fairly comfortable with the costs and the process. Then came last year’s quandary.
In the Spring and Summer of 2022, caps were very expensive. With spiking prices, record-challenging volatility and extreme basis uncertainty, options prices practically doubled; they often reached levels of more than 50¢ per gallon. The costs to offer a cap became so expensive that some reverted to offering fixed as the “suggested” approach. Ouch.
For example, if a dealer had a choice of offering a fixed price of $5.999/gallon (as insane as that sounded then —and now still!) versus a cap offer of $6.499/gallon, the fixed price might sound more attractive. However, there was a reason for the expensive premium and if/when prices fall more than $2 per gallon, it makes the 50¢ worth of “protection” make a lot more sense. When there is a group of customers paying $5.99, while another group is paying $3.99, some customers in the former group might not be all that happy!
As infuriating as 2022 was to most companies, the ability to capture full margins (and in many, many cases to widen margins) was the result of the extreme price volatility and a far less competitive (dealer versus other dealer) market environment. If you sold product to customers who bought as part of a cap program or to customers who just paid your “street” price, the odds are that on a per-gallon basis, you did very well this past winter. However, the fixed-priced customers did not allow you to increase your margin and many of them felt slighted by being “stuck” with those high prices. When you factor in the warm weather and the extra fixed price gallons that you probably own, fixed price offers were very expensive this year—to the dealers.
Going forward, you need to react, not overreact. You need to hedge, not speculate. Mostly, you need to plan, not guess. The volatility in the market is not something that hardly ever happens. It occurs with regularity and the only thing that we feel is predictable is the unpredictable nature of the business. Consumers want stability—not just your customers, but all customers.
Often, we make things far too complicated, and we don’t have to. If you want to cut down on attrition, offer a program. If you offer a program, offer a cap. If you offer a cap, hedge the risk. If you hedge the risk, consult with a professional so that you will fully understand what you (and your customers) can expect. ICM
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. In considering whether to trade or to authorize someone else to trade for you, you should be aware that you could lose all or substantially all of your investment and may be liable for amounts well above your initial investment.
The changes that we have seen over the past several years can no longer be considered an unlucky string of one-time events. The last few years have presented a new set of realities that must be considered for you to continue to build the legacy of your family or your business.
Prior generations were extremely skilled at dealing with the challenges of their day. The current generation is no more or less skilled, but does need to recognize that the challenges of today are different than those of the past.
1. Price volatility: Although we have had our share of extreme movements in the past, such as the Gulf War and the impact of the real estate bubble in 2008, the past few years have made the extreme seem normal. Be it the COVID-19 pandemic, negative interest rates, runaway inflation or the Russian incursion into Ukraine, we have seen a lot of unpredictable price gyration.
a. Flat Price: Simply put, the effect of world events on the actual and perceived demand for oil and the resulting counterbalance attempts by the world’s oil producers.
b. Basis differentials: We have never witnessed both the size and the longevity of the swings we have seen over the past few years, from the pandemic’s negative numbers leading to an extreme dearth of storage, all the way through last year (continuing today) and the heavy carry costs of oil due to the economics of carrying inventory that is worth less as time passes by (negative forward basis).
2. Electrify everything: Rational thinkers worldwide, and certainly those with working knowledge of what it takes to power and heat the people of our planet, recognize that “alternative energies” such as wind and solar power do have niche applications. Those same thinkers understand that, even if it were proven that there was a compelling case to limit or lessen the use of fossil fuels (I would be preaching to the choir if I gave my full thoughts on the subject), it can’t and shouldn’t be done by political fiat in response to activism that does not consider the potential results of their demands.
3. Delivery logistics: Sure, there isn’t much you can do to change the political winds—the bloodlust of some current world leaders or the activism of some famous 20-year-olds—but if there is one thing you know, it is delivery planning and logistics. Prices might go up and down, but your core customer with the K-factor of five will still consume 900 gallons in a normal year with 4,500 HDDs, right? Not any longer. Those Ks have become 5.5s and 6.2s. You need to anticipate and work with those changes.
The world has changed, realities have changed and challenges have changed. Your role is to do what prior generations did: accept the realities, learn from them and adapt to them.
I mentioned earlier that today’s generation is no better skilled than prior generations. That might be true as far as human brainpower, but not true as far as the ability to recognize and adapt much more quickly than prior generations.
We deal with hundreds of companies that serve over two million residential customers. All of our clients are challenged by new realities, and we spend a good amount of time working with them—not to predict the future, but to work with the present.
The new world can be scary. You don’t have to do it on your own. Many professionals can help you with banking, supply sourcing, risk management/hedging, BI (stop “running those reports” and have them automatically done) and delivery efficiency and optimization. Those who will be successful are those who address the challenges head-on. Assess the challenges that apply to you, and don’t be afraid to “phone a friend.” ICM
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
The risk of loss in trading commodity interests can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. In considering whether to trade or to authorize someone else to trade for you, you should be aware that you could lose all or substantially all of your investment and may be liable for amounts well above your initial investment.
For the past 30 years, companies have been offering pricing programs (fixed and capped) to give their customers peace-of-mind, maximize company sales margins and minimize customer attrition. The methods to offer caps have usually centered around a combination of Merc-related hedges, often locking in “supplier diffs,” and sometimes using physical inventory and/or weather hedges.
The key issue being hedged was generally the price of oil on the Merc, as everything seemed to flow from there. Basis differentials (the spread between the Merc and the price charged by suppliers) were always on the radar, but they were generally stable and were hardly anything that kept people awake at night—the “diffs” did move, but the movements were generally small, just the matter of a few cents per gallon in either direction.
Last February, Russia did the unthinkable and attacked Ukraine. Since that time, the world’s economies have been in flux, the political landscape has become untethered and oil prices have overshadowed all markets (except for cryptocurrencies) in terms of volatility and unpredictability. ULSD futures prices went from a low of $2.00/gallon to a high of almost $6.00/gallon in the late Winter/early Spring—and then fell to $3.00/gallon and rose to $4.70/gallon in the Fall (see Figure 1).
That record-setting volatility drove hedging costs (options premiums) to record highs. Who wants to spend $.50/gallon to cap the price of oil? However, the real issue was not the Merc price or the high cost of Merc-related options. The real issue was something that we had never seen before: a basis blowout so extreme that it restructured all that we know about inventories, futures contract spreads and supplier basis-diffs.
Once the prices spiked last April (see Figure 2), the combination of (a) supply uncertainty and (b) a belief/wish that “all this would soon go away” drove “spot” prices (spot prices, such as those in the New York Harbor physical markets are truer indications of suppliers costs, and accordingly, rack and basis-diff costs) up dramatically and left futures prices at a discount to the spot markets, but not by a few cents. Not by a few dimes, either. The NYH-Merc basis moved out to $1.25 per gallon, well different from the historical average of less than a penny. Ever since the Spring of 2022, we have had futures prices in “backwardation,” where each successive month is less expensive than the one before. In plainest English, it means that physical supply is expected to consistently drop in value over time. That is a recipe for low storage inventories. Who wants to own/hold an asset that is losing value? You need to think deflation as opposed to inflation.
While we had this backwardation over the Summer (see Figure 3), we also had suppliers that were quoting, if at all, seemingly egregiously high basis-diffs for their clients (the heating oil dealers) who wanted to lock in diffs. If there was any good news over the Summer, it was that the basis blowout—spot versus Merc—seemed to have reverted back to its normal boring self.
And then October came! In October, the basis spread moved up to about $.75/gallon and then in November it moved up (again) to $1.25/gallon (see Figure 4).
The hope that it was just a one-time occurrence was quickly dispelled. Inventories remained bare, backwardation remained in place and supplier-diffs were still very pricey (note that this article is being written at the beginning of December 2022).
In the future, when the oil market insanity of 2022 is debriefed, there will be a lot of finger-pointing at Moscow and Vladimir Putin. However, a closer look will reveal a lot of other things that have been bubbling up over the past number of years, finally reaching a boiling point—the anti-fossil fuel lobby has led to declining investments in oil production and an absolute curtailment of the building of refineries, all while demand for energy has been increasing. Mixed messages from the U.S. administration about pipeline approvals and the need for more oil production don’t help matters. Worldwide political struggles will always overwhelm the myopic position that the U.S. is a self-sustaining energy producer.
Inventory, suppliers, Greenification, politics, etc. We didn’t start the fire; it was always burning since the world’s been turning. Perhaps we have been lucky that we didn’t have basis blowouts until now.
The three takeaways that we have from this past year are:
1. If you want to keep your customers, you need to protect them from extreme price movements.
2. The larger the swing in prices the more important it is to offer caps rather than fixed prices.
3. Basis protection is no longer a “nice to have” but something that you must have.
You can hedge the basis with supplier diffs (if you can find fair ones), you can hedge with paper hedges (either fixing of capping the basis) or you can pray that 2022 was a total one-off any won’t happen again. What you can’t do is be surprised again. Fool me once, shame on you. Fool me twice, shame on me. ICM
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
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