is hedging right for you

Minimizing risk is key to maximizing fuel profitability.

The post-Hurricane Katrina era is presenting a flood of challenges for uneasy marketers at the most inopportune time. Competition from multiple retail channels has never been greater, credit card fees are eating away store profits and fuel supply is being called into question forcing pump prices to record highs.

Unbranded marketers are feeling the worst of it. The problem is branded stations have contracts with their parent refineries that refiners have to honor. So the branded stations get first pick. Whatever is left is sold to on spot market or to a middle market where the nonbranded station gets their gas. When supply is tight, the branded stations still get first pick, but there may not be any product left for the middle market let alone the spot market, as evidence by the post-Katrina shortages and overlifting surcharges.

And it’s only getting worse.

For example, just two years ago, a load of fuel cost about $6,000. Today, the same load could cost $30,000 or more. This increase is tying up vital capital that marketers are slowly recouping in $10 and $20 increments at the pump, leaving a serious strain on a station’s ability to buy additional fuel loads and stay viable.

Combined with rising fuel prices, fixed costs are also jumping. Utilities and real estate prices are hovering at historic highs for station owners, making expansion difficult and reducing opportunities for achieving favorable economies of scale.

So while a load of fuel is nearly four times higher, marketers are forced to make drastic decisions to overcome these financial obstacles. Hedging to manage the petroleum investment risk remains a solid option—if it’s done right.

Retailers have two areas of risk as it relates to petroleum: the risk of margin decline that accompanies price increases, and the risk that purchased fuel will decline before it can be sold, said James Burr Vice President of FCStone, one of the largest commercial hedging firms in the nation.

“Everyone in the retail business agrees that margin decline is linked to increases in price. But this correlation is not linear—in other words, if the price of gasoline goes 20 cents higher, your margins will not decline 20 cents,” Burr said. “There are various methods to go about protecting against this price induced margin decline, and determining which is right for you necessitates that you do a little soul-searching.”

FCStone offers a “Structured Trading” program in which the retailer knows that the maximum risk each month is approximately 2 cents per gallon. If the market moves higher, there are predetermined levels at which positions are liquidated with gains. If the market does not go higher, the maximum risk was known in advance.

For those retailers that are willing to take on a greater degree of risk, FCStone’s HedgeSmart offers a more aggressive program that lets market conditions combined with computer models dictate the use of a combination of long and short options, swaps, futures and crack spreads.

“Risk/reward is a very simple concept; the more you put at risk, the more potential for gains—and for losses,” Burr said. “Should you be protecting your retail outlets against margin decline? Absolutely, however you need to select the program that is right for you.”

The second area of risk for retailers is on priced purchases. Any purchase in which the price is established has risk of loss until that purchase is sold at a set price. “This is not only true for the inventory you own at your combined stations, but also any gallons that you have purchased on forward contract,” said Burr. “You may have never purchased any gallons on forward contracts, but suppliers cannot continue to assume the financial risk that posting a traditional rack price places them in.”

Another strategy the high-volume fuel retailers are exploring is buying space in the pipeline, which is expensive and risky because the ship time on these purchases is usually four to six weeks in advance. If there is a significant shift in prices, one mistake could be disastrous on the bottom line.

“Many retailers think they can add to their margin simply by becoming a pipeline shipper,” said Burr. “But the majority of the profits made by pipeline shippers comes from correctly timing, and hedging, their purchases in the forward contract market.”

Branded suppliers have historically been the most reluctant to offer forward contracts, but any branded retailer can take advantage of the profits of forward contracting by using the swaps markets in place of purchasing physical forward contracts.

“Changes in how you do business are not just coming—they are here,” Burr said. “In order to compete in this new world you must know how to protect your company using the tools available to you.”

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