Monday, February 23, 2009

Is there too much HOPE in that Propane or Heating Oil Hedge?

Speculation. Its a dirty word for businessmen. A word reserved to describe ex-Enron employees and others of their ilk. Certainly the word "Hedger" makes bankers happier and balance sheets more balanced. Ideally, the two words are as opposed as Black and White. Oil and Water. Don Henley and Glen Fry (in the 1980's).

But there exists some overlap - some gray area inside which the difference between speculation and hedging begin to become difficult to discern. Some call it "hedgulation" or "specuhedging." In these scenarios, the applications of the words begin to look similar. Like Plymouths and Dodges. American Pilsners. Don Henley and Glen Fry (in the 70's & 90's). Allow me to explain:

A hedge can be defined as a transaction entered in to for the purpose of avoiding risk. Often, the position is equal and opposite to another intended transaction. Typically it locks in some type of (positive) margin, which is expected to occur sometime in the future. Propane and heating oil marketers buy fixed price product to offset future fixed price sales and lock in a margin just as cattle farmers sell live cattle futures to offset the price risk associated with cattle that are getting ready to go to market.

A speculation is a transaction entered into for the purpose of taking on risk. It does not exactly match the entity's price exposure or it creates a completely new position in addition to the original price exposure. An example might be a dairy buying some coffee futures. There is really no good reason for this trade - other than to roll the dice.

But let's take a look at three transactions that have made the news lately:

1) Southwest's Gasoline Hedges - Southwest was heralded as a forward thinking company that aggressively managed thier costs of jet fuel (June-July 2008). About two months later, the case was made that they were overagressive and hamstrung by bad trades (October 2008).

2) Suncor's Producer Collar - Suncor (One of the biggest players in the Alberta Tar Sands) entered into an options collar structure to ensure a minimum price for some of the crude oil they produce.

3) Atlas Pipeline's Crude to Propane Spread - In Early 2008, Atlas Pipeline Partners entered into a crude-to-propane hedge to hedge the liquids in their pipelines. Although the last 20 years of data demonstrates a floor in the price relationship between propane and crude, the relationship of the two commodities trend as they had historically, and the partnership lost $116 million.

Which of these was a true hedge? In its purest definition, I don't know whether any of them are. Instead of eliminating price risk, they each just shift price risk on a piece of the company's overall exposure.

The speculations work as hedges for the first two companies, though, because of the unique context that the companies found themselves in. I can imagine that Southwest thought "We can make money and keep low rates at these prices...if fuel prices continue to go up, that might not be possible." Similarly, Suncor probably said "We can sell crude at a breakeven at these prices but if the market price for crude continues to fall we will begin to risk our company." Considering this context, I feel like the term "hedge" is appropriate, because the firms mitigated the risk associated with bad price outcome in exchange for limited benefit should a "good" price outcome occur.

The Atlas Gas scenario is different. The management team that considered this hedge clearly "hoped" for an outcome similar to the historic price pattern. They "hoped." And that hope was a tell-tale sign that their transaction was more a speculation than a hedge. In my mind, the more Hope is involved in a position, the more the position is likely to be a speculation. It is a great acid-test to ask oneself before a transaction is entered into - "How much hope is involved here?" In the case of covering a pre-sale program at target margins, there is none. In the case of entering a cross-commodity hedge (as Atlas Gas did), there is plenty!

Barry Ritholtz, over at The Big Picture, has a great quote in a recent article. It is about investing in the stock market, but can be applied to hedging in commodities. He says:
"In investing, Hope is a four letter word. It reflects wishful thinking, not sober analysis. It is a function of your book, not an objective read of reality...And its killing many investors."

As you contemplate pre-buy for next season...are you considering doing so because you "hope" prices will rise? Or are you considering doing prebuy because it works for your retail customers and creates a price they find desirable? The former is a hopeful, potentially expensive speculation. The latter is closest to hedging. Let's keep HOPE out of our HEDGES to minimize negative outcomes.

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