July 2010 Hedging Extra Feature
Just When You Thought You Were Fully Hedged…

By Antonius Van Wijngaarden and Ryan Hosie, Boston Oilheat Financial

In the July 2010 issue of Oil and Energy in our column Price Protection 2.0, A new hedging era: turning the tide for retailers, we discuss the benefits of rack-plus hedging and how dealers can protect themselves from the price risk of capped protection programs.

Rack-plus hedging offers numerous advantages over traditional hedging methods, which include supplier forwards and puts. Most significantly, it does not force dealers onto heating curves, allows dealers to protect 100 percent of program volume, and carries no penalties for under-lifting and/or shifting volume. Furthermore, when combined with the proprietary hedging and trading models developed by Boston Oilheat Financial, it enables dealers to lock in a guaranteed operational margin.

Because of their reliance on heating curves, traditional hedging creates far more risk than most dealers realize. For this reason, Boston Oilheat Financial has developed a free risk assessment, which quantifies the risk of supplier forwards and puts as a hedge to capped protection programs.

The process is simple: dealers submit the general parameters of their hedging methods, and we run our proprietary simulation model using 10 years of Heating Degree Day data from Massachusetts and NYMEX heating oil futures price data.

Based on the risk assessments that we have provided so far, it is clear that traditional hedging exposes dealers to a great deal of price risk. On average, dealers who requested our risk assessment were exposed to a 25 percent probability of losing over $74,000 during the heating season. This shows that even when dealers are properly hedged by traditional standards this risk does not disappear.

The Dealer’s Dilemma
An inherent risk of traditional hedging is that dealers are forced to commit volume on a heating curve. With winter temperatures varying unpredictably from year to year, this curve is merely a proxy for average oil consumption during the heating season. It is rarely accurate in predicting oil purchases, and discrepancies between prediction and reality result in supplier penalties for under-lifting or shifting volume.

In addition, to protect against a mild winter, dealers frequently hedge only 65 to 70 percent of their anticipated program volume. This leaves dealers at risk for the remaining volume in the event of a regular or cold winter. In combination with high heating oil prices, this can lead to substantial losses.

This is exactly the type of dilemma that our risk assessment model quantifies for dealers. Take, for example, a dealer with 500 capped customers, who on average use 800 gallons during the season. Let’s assume that this dealer faces a $.10 per gallon penalty for moving volume on the curve, and only hedges 70 percent of program volume.

His anticipated program volume is 400,000 gallons, so he decides to purchase seven supplier forwards (with a fixed price based on the current NYMEX futures price curve plus a supplier differential of $.10) and seven at-the-money put option contracts.

As of the writing of this article, the August, September and May futures closed trading at $1.98, $2.00, and $2.12 respectively. Because this dealer is aiming for a $.65 operational margin, he sets his capped price at $2.88: the May futures price plus the supplier differential and his budgeted margin.

Calculating Exposure
The first step in calculating the exposure is to allocate the protected volume to the heating season using a heating curve. In effect, based on the seven contracts that he purchased, he is committing 294,000 gallons to his supplier. Using a 10-year average heating curve for Massachusetts, this Boston-based dealer decides to allocate his volume as follows (rounded figures):

Program Volume Allocation based on 10-Year Average Heating Curve

To capture the uncertainty of the upcoming winter season, we randomly simulate a historic heating curve from the last 10 years. The heating curve below represents the distribution of heating degree days during the 2002-03 heating season (rounded figures).

At 6166 HDDs, this winter was exceptionally cold, compared to the 10-year Massachusetts average of 5479. Under this scenario, all consumers who bought into the cap would have used all of their protected gallons, and our example shows that the full 400,000 gallons would be used. However, the dealer only bought 294,000 gallons of protected wetbarrels, leaving him exposed for the difference.

Program Volume Needs based on 2002-03 Heating Curve

In addition, we simulate monthly price fluctuations based on a random sample from 10 years of historical NYMEX heating oil price data. In our scenario, prices rapidly rise by 5.2 percent to $2.08 in September, and continue their climb to $3.35 in May (up 74.4 percent from the current near-month trading level of $1.98). The simulated price levels faced by this dealer are as follows:

Simulated Heating Oil Price

Simulation Results
Because of the high number of heating degree days, the dealer’s committed volume on the curve is smaller than program volume needs of capped customers. As a result, this dealer has to purchase the remaining volume off the rack at high market prices (this example assumes a rack basis of $.10: equal to the supplier differential on the forwards). In this simulation, the dealer would have incurred a loss of approximately $53,500 over the heating season.

This scenario helps to exemplify the significant risks of using traditional methods to hedge the exposure of capped protection programs. Dealers should be aware of these risks, so that they can be fully informed when making hedging decisions.

To receive a free assessment of the price risk of your protection program, please visit www.bostonoilheat.com to download and complete our form or contact Boston Oilheat Financial Corporation at (877) 700-6454 or info@bostonoilheat.com.

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