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Trader's Corner
This week’s Trader’s Corner looks at the use of call options in these uncertain times.
In this Trader’s Corner, we want to look at using call options to manage risk with our supply. Anytime there is a lot of uncertainty, we should think of options. Options allow us to transfer risk, which is never a bad idea in uncertain conditions as long as the company assuming the risk is not charging too much to take on our supply price risk.
Options are very much like insurance. We pay a premium to an option writer, just like we pay a premium to an insurance company. The premium we pay for the option becomes an expense item, and we must include it in our costs when determining our sales price, just like we do for any other expense item.
The premium we pay is a known, which we can manage our business around in contrast to being subject to market prices. The option allows us to identify our highest cost of supply for a given period, while giving us the flexibility of lowering our price. This flexibility is the key reason we would consider using an option rather than a pre-buy or a swap.
Very simply, if we knew prices were going higher in the future, we would not consider a call option. We could own the swap or pre-buy and avoid the premium expense. It is when we see viable scenarios for prices to move in either direction that we like options.
What has already transpired this winter heating season with propane prices is a perfect example of why assuming risk is not always the right move. You may be among the many propane dealers who used pre-buys and swaps to protect from higher prices this winter. It seemed like a very good move in September or October, with propane prices relatively low compared to the rest of the energy complex and the inventory surplus coming down.
Yet, in November, we watched Belvieu propane fall 16.375 cents and Conway 10.75 cents. Even with the rebound this past week, Belvieu is down 10 cents and Conway 8.625 cents in December. Keep those declines in mind as we look at the premium costs of a call option.
Perhaps you look at the declines above and think very little downside price risk remains at these low levels. Indeed, we are beginning to see propane trying to put in a price floor. So if you had that thought, it is a very good one. If you believe that the bottom is in, then don’t consider the options we are discussing. If the bottom is in, we are back to wanting to own swaps and pre-buys.
However, one thing we have learned over the years has been that anytime we say the price can’t go any higher or it can’t go any lower we have generally been wrong. So let’s attempt to make a case for why prices could go lower.
Such an attempt needs to begin with the uncertainty over the U.S. federal budget. If the “fiscal cliff” of mandatory tax increases and cuts in federal government spending take place, commodities and equities markets are likely to fall. On the other hand, if a deal is reached, we could see a rally in both during January, thus the conundrum that favors the option.
The second factor favoring the option argument would be propane fundamentals. The fact is we have not seen much draw on propane inventory this winter heating season. Inventory is holding at levels that are setting new five-year high marks. Though inventory is declining, the rate at which it is declining has been less than normal in most weeks. As of the last EIA report, U.S. inventory was 20.8 percent above the five-year average.
Last week’s inventory draw was an exception to what has been happening in 2012 as it exceeded the five-year average for week 49 of the year. What made the draw particularly impressive was it came with a sharp jump in imports. Imports averaged 256,000 bpd last week compared to 160,000 bpd the week before. While the drawdown on inventory was impressive given the imports, the imports themselves make one realize there is a lot of propane from Canada to the Gulf Coast looking for a place to go.
Even though inventory is high, providing a weak fundamental backdrop for propane, the extremely low current relative valuation of propane means it will likely take very little pressure on inventory to move propane prices higher. Belvieu and Conway are trading at historically low levels for this time of year, at 36 and 33 percent of WTI crude, respectively.
At these levels, just a little winter will probably go a long way to moving prices higher. But as we all know, if winter doesn’t happen, like it didn’t happen last year, propane prices can really fall off the table at the beginning of a new year.
Okay, so where does that leave us? Prices are most likely dependent on what Washington politicians do and what weather does. If we had to pick which of the two is the least predictable, it would be a tough choice. That uncertainty makes options a supply management tool we want to consider.
Below are the call option current strikes and premiums to cover January or January through March at Belvieu and Conway:
Here is how the option works. If the month average exceeds the strike price above, you will receive the difference from the option writer. So if prices are higher than the strike, you will pay your normal supplier the higher market price, but the option proceeds will offset that cost and bring your actual supply cost back to the strike.
This insurance has a premium or expense. When we add the premium to the strike, we get the max supply cost. You can look at max supply cost as the breakeven point for owning the option. Any monthly average above the breakeven means you made a good decision to use the call. If we were going to pre-sell gas to our customers, we could use this max supply cost, which is FOB Conway or Belvieu as the basis to calculate what our sales price needs to be.
If Washington comes through by avoiding the fiscal cliff and winter comes in like gangbusters over the next few months, then the option has us covered. But if Washington doesn’t avoid the fiscal cliff and winter doesn’t happen, then the real beauty of the option is revealed.
If prices fall, then our option is going to expire without a payment to us. We often say the option expires worthless, but we hate to use that term. It is when the price falls that options truly show their worth. We are able to lower our sales price because the premium represents our total exposure to lower prices. That certainly isn’t the case with a pre-buy or a swap.
It is true that we will be priced the amount of the option above our competitors, assuming they did nothing in a falling market. The premium is an expense we can’t ignore. The decision on whether to buy an option or not often comes down to deciding if can we hold our retail price the amount of the option premium above our competitors in a falling market without getting pushback from our customers.
Using the January Belvieu call as an example: If we buy the option and pay 4.75 cents and prices move lower during January, can our retail price be 4.75 cents above our competitor and our customers not leave us for the competitor? If the answer to that question is yes, then the decision on the option is made much easier.
If you would like to discuss how options might work in your particular situation, don’t hesitate to call us at the number below. We would be glad to take the time to answer your questions.
Call Cost Management Solutions today at 888-441-3338 for more information about how Client Services can enhance your business, or drop us an email at info@propanecost.com.
WEEK IN REVIEW
Improved manufacturing activity in the U.S. and China helped crude churn out a modest gain.
Propane got a boost from a larger-than-average draw on inventory and possibly buying from speculators playing the crude/propane spread.
We go into this week bullish as the four-day increase in propane prices gained momentum on Friday.
LAST WEEK'S DAILY HIGHLIGHTS
Monday: A drop in Chinese exports kept crude markets under wraps. Propane prices continued lower in the wake of weak fundamentals.
Tuesday: Propane prices rose for the first time in December, with Belvieu seeing the most buying pressure. Crude was able to break out of its recent downtrend as threats to Middle East supply and a gain in German business sentiment encouraged risk taking by investors.
Wednesday: The rebound attempts by propane and crude extended into a second day. The data from the EIA was supportive for propane as the draw on inventory was higher than average for week 49 of the year. The EIA data was bearish for crude and refined products, but crude gained on an announcement by the Federal Reserve it would be increasing its stimulus measures to support the U.S. economy.
Thursday: Propane continued to rebound as Belvieu posted its third 0.7 percent rise in as many days and Conway gained as well. Crude could not extend its rally into a third day as traders took profits despite supportive economic data on retail sales and jobless claims. Lack of progress on the U.S. federal budget negotiations remained the key headwind.
Friday: Crude was back in recovery mode after China and the U.S. reported improvements in their manufacturing activity. Propane extended its rally into a fourth day as traders reacted to last week’s above-average inventory draw.
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