I know, I know! You’re tired of reading and talking basis blowout! Relax, I’m not here to discuss blowouts at the rack. Basis is the standard expression for the relationship between two indexes in a commodity. In this case it’s the spread between the spot ULSD contract on the CME exchange and your local supplier’s rack price. This spread, the so-called basis, is a critical piece of information in the rack equation needed for negotiating a supply contract or a wet barrel for hedging. It is also important to understand the basis when buying oil.
If you are not monitoring and learning the basis relationship in your oil purchasing, you are likely missing opportunities to improve what I call your purchasing score. The purchasing score, simply put, is a grade on how well you are doing in managing your oil buying these days. We’re not talking about fractions of a penny here. We’re talking whole pennies per gallon. This can be a significant number you are leaving on the table. I can make a solid case for this data having as much impact as any other metric you might be tracking in your business.
There are 3 critical areas you should be looking at regarding the basis relationship .
• Hedging : Wet barrels or paper hedging
• Supply contracts
• Spot purchases
All three areas are simple to monitor and track. You can do it on a spreadsheet. You’ll want to record the following every day: the spot month settlement of the ULSD contract, your low rack price, your daily sales volume and the retail price. This task should not take more than two minutes and should be sourced to an admin person; NOT you (as the owner/manager you wear too many hats and will never keep it up). This ensures that it gets done every day. I highly recommend that you also record every one of your suppliers’ prices, including any spot deals offered. The more that this data ages out the higher the value; likely reaching a plateau at about three years.
Since it’s that time year when there’s a lot of hedging going on for the price protection programs next heating season, let’s start here.
Let’s say you are hedging a cap program. There are basically two structures for hedging a cap price. You can buy wet barrels and put options, or you can buy call options. The call option covers any increase in the price while the downside component is realized at the rack. In the other structure, the wet barrel contract covers any increase in the price while the put option is used to pay off any downside risk. They both perform the same task, so why choose one over the other? This is where the basis comes in. Let’s say you are looking at covering the month of December’s gallons and are offered a wet barrel contract priced at .10/gallon over the December futures contract. Before you take that offer, you review the rack basis data over the past 3 years for December and find that the average spread is .02 over the spot contract. That’s a whopping .08 per gallon more than you are paying for the privilege of buying a wet barrel contract in advance. Instead of buying a wet barrel with a put option you opt for buying the call option knowing that your rack basis is averaging just .02 per gallon. This hedging structure will lower your COGS significantly. This scenario plays out time and again in almost every marketplace. The wet barrel contract typically demands a premium from the supplier. And for good reason; sometimes. The supplier, who must turn around and hedge the wet barrel contract on paper themselves, is also tasked with carrying the margin requirements on your behalf for the time between the day you lock the prices in and the actual delivery months. Does this mean you should not use the wet barrel/put option structure in any part of your strategy? No. The wet barrel/put option hopefully offers you supply certainty and basis certainty. However, when over utilized it can add up significantly. Pennies per gallon in most cases.
Summary of the impact that basis has on hedging: A well thought out hedging structure that analyzes historical basis can significantly lower the cost of hedging your price protection program.
It’s presumable that the last time many of you heard the term supply contract articulated was while sitting around the office or garage with your father or grandfather. There was likely considerable musing about the good ol’ days when the supplier painted (branded) the oil trucks with the Texaco star or Exxon logo and credit lines carried on for months!
Supply contracts are gradually finding their way back into logistics portfolios today. At Hedge we have been negotiating supply contracts since the late 1990’s. Most of these were based on an index like Platts back then and were not as lucrative as they are (or can be) today.
Why reconsider this old relic for purchasing a portion of your oil supplies? The supply chains in the Northeast and Mid-Atlantic regions are slowly degrading and have us living on a knife’s edge even in the mildest of winters. One
only needs to look at the diminished storage and refining capacity over the past 15-20 years to come to this conclusion. PADD 1 inventory data reveals a chronic shortage of supply every winter. Yet we seem to dodge that bullet (major supplier outages) most years. This is likely due to the
equally anemic demand for heating oil, caused mainly from its loss of market share to other fuels. This correlation will likely disconnect at some point. Terminals are expensive to keep up. The considerable curtailment in storage and contraction in the number of suppliers to the marketplace makes logistics challenging, particularly when trying to meet a demand curve that packs 80% of the call for supply into just 90 days. There are no signs of abatement here. One prominent supplier recently closed a terminal in Connecticut. That same supplier also closed a terminal recently in New Jersey. Tertiary storage has been and contines to shrink thanks to the enviromental regulations. Meanwhile, as the industry trasisitons to renewables it will continue to suppress the demand for storange.
Having a supply contract can offer both security of supply as well as advantageous pricing when done correctly. It is absolutely essential to run historical back testing of any supplier offers. You’ll want to see when and how often the index beats your normal rack basis! If you don’t supply your own data, it would mean using another source like OPIS. OPIS has great data, but it is expensive and it’s not organic to your own company’s purchasing history. Think of it this way; a year of OPIS data along with the supplier ’s likely index (Argus) data can cost between $2,500.00 and $5,000.00. So, it makes sense to make the effort and implement your own data collection!
Lastly, though certainly not least important , is what we call your purchasing score. Just how well are you doing in purchasing your oil these days? What can the data tell you about this and can it improve profit margins? The data can tell you plenty, and it certainly can improve profit margins. The same four data points in our discussion here can produce several very critical views of how you are doing in purchasing the oil and its impact to your daily margins. We use our proprietary software called MarginTrak2. There are a couple of reports that have become invaluable tools to our clients that produce clear visuals into how their purchases are impacting their daily margins.
One report in particular yields insights into day counting margins and can motivate you to change the way you purchase oil as well as how you set your rack to retail margin. The simple histogram below (chart A) shows how many days the client is spending at various margin levels. This is a picture that is truly worth a thousand words because it both illuminates as well as exposes the flaws in the industry’s business model: The majority
of heating degree days are packed into a very limited time period. Hence the importance of how many days you are spending at your desired margin levels. In other words, every day counts. Because every day is volumetrically weighted, it is vital that margins are optimal at the optimum times. Another way of looking at it: for every day you miss your target margin in January, you need three days in April to make up for it due to the smaller sales volumes. Once the client is aware of this, they are motivated to correct their course. This is the power of data in a visual format.
Another example below (chart b) shows the client’s margins as the retail and rack price changes day to day. What becomes clear over time here is the accordion effect on margins and the obvious lag in pricing as the rack price moves up and down. This behavior is ubiquitous across the industry. Energy marketers are typically slow to move prices up when necessary; but also tend to drag their proverbial feet on the way down. Just another example of pricing trends and how changing both purchasing habits as well as pricing can dramatically improve margins when it becomes clear
what the cause and effect is. Please feel free to reach out to me with any questions or comments.
Rich Larkin is president of Hedge Solutions ( www . hedgesolutions . com ). He can be reached at rlarkin @ hedgesolutions . com .