futures market segued into significant backwardation last summer , when typically , we would see a contango structure . This made it difficult for suppliers to bring in inventory ahead of the winter . But it was the backwardation in the extreme that presented hedging issues we ’ ve never had to deal with before . The wet barrel differentials offered by suppliers spiked to what seemed like prohibitive levels . They were certainly historical and this is where the basis risk as we understood it , morphed to a very different kind of risk .
Suppliers were offering wet barrels for the following heating season at nymex differentials as high as . 60 cents per gallon over the futures prices . This meant that anyone hedging a cap program had to consider the risk of buying wet barrels at a differential of . 60 only to arrive in the delivery month to see rack basis normalize to much lower levels . The put option , like the call option , only covers the nymex component in price movement . Therefore , just as the call option will not cover the rack basis “ blowing out ”, the put option did not cover the wet barrel purchased at plus . 60 “ contracting in basis ” to say , . 05 cents over .
Example : A dealer last June went to the supplier and bought a wet barrel winter strip at $ 4.00 plus the supplier ’ s . 60 differential to get a cost of $ 4.60 . The dealer then buys a put option covering the same winter strip at a strike price of $ 4.00 to cover the downside risk . Come winter , the oil price drops to $ 3.00 per gallon which puts the supplier ’ s rack price at $ 3.05 . The option return is $ 1.00 per gallon , netting the wet barrel strip to $ 3.60 , which nets the cost to . 60 cents per gallon higher than the local rack . Assuming the margin at $ 1.00 per gallon over rack , or $ 4.05 , this would leave the dealer with a gross profit margin of just . 45 cents per gallon , well short of the expected margin of $ 1.00 .
Had the dealer covered the risk with a call option strip , they would have simply gone to the rack at $ 3.05 and realized the forecasted margin of $ 1.00 per gallon . However , this would have left them exposed to the very opposite risk of the basis blowing out .
30 MAY 2023 | FUEL OIL NEWS | www . fueloilnews . com