Wednesday, March 9, 2016
By JD Buss . . . More market volatility. We see that in both market fundamentals and in market prices. From the fundamental standpoint, the surge in export volume from the United States has now made our domestic market both heavily intertwined with, and susceptible to, other international conditions. A major view now is that exports will continue indefinitely. But a change in the demand in China, or a narrowing of prices in South America or another region, will generate decisions that could leave more—or less—propane within our domestic borders. 
Exports have already had a huge impact on propane prices. One impact has been a lengthening of the propane price curve. Price curves now go out to 2020, and it’s not unusual to hear quotes for two-plus years out on a daily basis. Increased export volume has also generated more trading partner interest in hub-based financial products. And all of these items—more export growth, longer-dated trading, and more players in the market—have contributed to more volatility to the market.
So how do you handle these changes? One major way we are handling this change is to provide our clients with more advanced financial hedging and trading options. And we’re doing that by setting up a Commodity Trading Advisory (CTA) firm. A Commodity Trading Advisory firm is a member of the National Futures Association (NFA) and is licensed by the Commodity Futures Trading Commission (CFTC). The specific goals of our CTA firm are to help our clients improve their hedging decisions by providing a larger group of trading partners and access to a much more liquid trading market. In addition, clients know they are getting service from a firm that meets all of the current legal requirements for firms providing hedging advice.
The Reason Is Prices
But why a commodity trading advisor? Three major reasons. First, from 2005 to 2014 we’ve seen Belvieu prices that have averaged 110 cents/gal. (Conway averaged 106.75 cents/gal.). We also have seen some decent up and down price movements that have generated margin concerns for anyone with a trading account. During that time period, a client could have been actively involved in bilateral transactions that didn’t incur the same level of margin calls. From 2015 forward, however, Belvieu has averaged 40 cents/gal. (Conway averaged 35.5 cents/gal.). The probability of strong margin calls has diminished and opened the door to a lower cash-flow risk related to margin calls.
The second reason centers on the many changes and heightened scrutiny that have been taking place since the Dodd-Frank Act was passed and implemented. One large impact on the energy sector from the Dodd-Frank Act was heightened scrutiny and reporting for financial transactions. The goal with these regulations was to help bring additional transparency to the market and limit the amount of transactions that could be hidden from review. As more and more trading firms have adapted to the Dodd-Frank regulations, this means the retail propane community also needs to make similar changes.
Counterparty Risk
Our last reason has become more pronounced as we’ve moved through the first part of 2016. Declining energy and equity markets have reintroduced an old term to the trading vocabulary: counterparty risk. Standard & Poor’s downgraded 25 oil E&P firms’ debt to junk status in early February. In the energy industry, one only needs to harken back to 2001-2002 to recall when the previous counterparty risk was so prevalent. Many may also recall the demise of a little company named Enron that generated a huge amount of overall counterparty risk. A similar scenario seems to be playing out 15 years later. A CTA firm can help direct clients to set up relationships with brokers who will run transactions through a clearing process, or help them identify credit-worthy firms to do business with during these uncertain times.
Isn’t a CTA firm, though, like running a hedge fund? There are several CTA firms that do operate in a manner similar to hedge funds, with the express goal of achieving a stated return on capital for their investors. However, our goal is not to be a traditional CTA/hedge fund. Our goal is to advise on timing, market information, trading counterparties, and to implement a strategy that operates as a genuine hedge for retail margin protection.
A CTA may help eliminate some risks, but won’t this increase cost levels for propane retail firms? What has been most surprising, and exciting, over the last several years has been the fact that the majority of the time, even nine times out of 10, our clients have been able to realize cost savings. Merely increasing market liquidity has been known to add anywhere from a penny or more of cost savings. Throw in a concerted and focused effort on the market, and a CTA firm can clearly bring benefits to a propane retailer.
Longer-Term Market View
With prices currently so depressed, what’s your longer-term market view? I break this into two separate categories. Crude fundamentals do not appear to support any form of reversal in the current trend. I’ve heard speculation that crude could see a strong recovery, with references made to the 2009 surge. With the current glut of product, the surge by multiple nations to push for market share, and the questionable financial status of many oil firms, the longer-term price scenario could be much more range-bound and have more similarities to the 1990 era than the 2009-2012 timeframe.
Looking at propane, however, we have a different view. Underlying fundamentals are drastically shifting as U.S. inventory levels start to decline due to the ongoing and anticipated export volume increase. In addition, we have failed to see the same surge in propane production that took place in the 2014 to 2015 period. With no other changes, these shifts generate a more bullish future view for propane.
However, there is one interesting twist for propane that our market has never experienced. All of the increase in propane exports has been predicated on two items: strong global demand and wide arbitrage values. At this time in 2016 the demand appears to be going strong. However, the arbitrage values are shrinking rapidly. How negative will arbitrage values need to go in order to stop or slow the flow of product from the U.S.? A rising propane value in the U.S. will only speed up the narrowing of the arbitrage spread. This unknown will bring definite volatility and could counterbalance some of the future bullish changes that we mentioned earlier.
So how should propane retailers prepare for this year? Same advice we’ve had for many years. Plan, plan, plan, and plan some more. One thing we are modifying this year is to do supply planning much earlier than the prior years. On the hedging/risk management side we advocated patience through much of the winter, advised looking at both this year and next winter for protection, and supported futures and swaps over options for this year.
JD Buss is an adviser to independent propane retailers at Twin Feathers Consulting (Overland Park, Kan.). He previously worked in risk management, marketing, and trading at Koch Industries and Enron.
Exports have already had a huge impact on propane prices. One impact has been a lengthening of the propane price curve. Price curves now go out to 2020, and it’s not unusual to hear quotes for two-plus years out on a daily basis. Increased export volume has also generated more trading partner interest in hub-based financial products. And all of these items—more export growth, longer-dated trading, and more players in the market—have contributed to more volatility to the market.
So how do you handle these changes? One major way we are handling this change is to provide our clients with more advanced financial hedging and trading options. And we’re doing that by setting up a Commodity Trading Advisory (CTA) firm. A Commodity Trading Advisory firm is a member of the National Futures Association (NFA) and is licensed by the Commodity Futures Trading Commission (CFTC). The specific goals of our CTA firm are to help our clients improve their hedging decisions by providing a larger group of trading partners and access to a much more liquid trading market. In addition, clients know they are getting service from a firm that meets all of the current legal requirements for firms providing hedging advice.
The Reason Is Prices
But why a commodity trading advisor? Three major reasons. First, from 2005 to 2014 we’ve seen Belvieu prices that have averaged 110 cents/gal. (Conway averaged 106.75 cents/gal.). We also have seen some decent up and down price movements that have generated margin concerns for anyone with a trading account. During that time period, a client could have been actively involved in bilateral transactions that didn’t incur the same level of margin calls. From 2015 forward, however, Belvieu has averaged 40 cents/gal. (Conway averaged 35.5 cents/gal.). The probability of strong margin calls has diminished and opened the door to a lower cash-flow risk related to margin calls.
The second reason centers on the many changes and heightened scrutiny that have been taking place since the Dodd-Frank Act was passed and implemented. One large impact on the energy sector from the Dodd-Frank Act was heightened scrutiny and reporting for financial transactions. The goal with these regulations was to help bring additional transparency to the market and limit the amount of transactions that could be hidden from review. As more and more trading firms have adapted to the Dodd-Frank regulations, this means the retail propane community also needs to make similar changes.
Counterparty Risk
Our last reason has become more pronounced as we’ve moved through the first part of 2016. Declining energy and equity markets have reintroduced an old term to the trading vocabulary: counterparty risk. Standard & Poor’s downgraded 25 oil E&P firms’ debt to junk status in early February. In the energy industry, one only needs to harken back to 2001-2002 to recall when the previous counterparty risk was so prevalent. Many may also recall the demise of a little company named Enron that generated a huge amount of overall counterparty risk. A similar scenario seems to be playing out 15 years later. A CTA firm can help direct clients to set up relationships with brokers who will run transactions through a clearing process, or help them identify credit-worthy firms to do business with during these uncertain times.
Isn’t a CTA firm, though, like running a hedge fund? There are several CTA firms that do operate in a manner similar to hedge funds, with the express goal of achieving a stated return on capital for their investors. However, our goal is not to be a traditional CTA/hedge fund. Our goal is to advise on timing, market information, trading counterparties, and to implement a strategy that operates as a genuine hedge for retail margin protection.
A CTA may help eliminate some risks, but won’t this increase cost levels for propane retail firms? What has been most surprising, and exciting, over the last several years has been the fact that the majority of the time, even nine times out of 10, our clients have been able to realize cost savings. Merely increasing market liquidity has been known to add anywhere from a penny or more of cost savings. Throw in a concerted and focused effort on the market, and a CTA firm can clearly bring benefits to a propane retailer.
Longer-Term Market View
With prices currently so depressed, what’s your longer-term market view? I break this into two separate categories. Crude fundamentals do not appear to support any form of reversal in the current trend. I’ve heard speculation that crude could see a strong recovery, with references made to the 2009 surge. With the current glut of product, the surge by multiple nations to push for market share, and the questionable financial status of many oil firms, the longer-term price scenario could be much more range-bound and have more similarities to the 1990 era than the 2009-2012 timeframe.
Looking at propane, however, we have a different view. Underlying fundamentals are drastically shifting as U.S. inventory levels start to decline due to the ongoing and anticipated export volume increase. In addition, we have failed to see the same surge in propane production that took place in the 2014 to 2015 period. With no other changes, these shifts generate a more bullish future view for propane.
However, there is one interesting twist for propane that our market has never experienced. All of the increase in propane exports has been predicated on two items: strong global demand and wide arbitrage values. At this time in 2016 the demand appears to be going strong. However, the arbitrage values are shrinking rapidly. How negative will arbitrage values need to go in order to stop or slow the flow of product from the U.S.? A rising propane value in the U.S. will only speed up the narrowing of the arbitrage spread. This unknown will bring definite volatility and could counterbalance some of the future bullish changes that we mentioned earlier.
So how should propane retailers prepare for this year? Same advice we’ve had for many years. Plan, plan, plan, and plan some more. One thing we are modifying this year is to do supply planning much earlier than the prior years. On the hedging/risk management side we advocated patience through much of the winter, advised looking at both this year and next winter for protection, and supported futures and swaps over options for this year.
JD Buss is an adviser to independent propane retailers at Twin Feathers Consulting (Overland Park, Kan.). He previously worked in risk management, marketing, and trading at Koch Industries and Enron.
