Controlling your budget: hedging energy price & volume.

It is not news to note that over the past 8 years, the price of energy has skyrocketed.

The wholesale cost of heating oil has gone up 7-fold since early 1999 (from $.30 per gallon to over $2.10 per gallon), over 4-fold since 2001, and over 3-fold since 2003. As a purchaser ("end-user") of energy products, the volatility of prices, as defined by the actual annual swings in price, has also exploded.

During the decade of the 90's, it was rare to have a year that saw more than a $.20/gallon swing from low to high. Since the start of the new millennium, the annual swings have been approaching $1.00/gallon from low to high.

As consumers of oil (or natural gas, propane or electricity), the per unit cost of the commodity that you need to purchase is not the only factor that has kept your budgets out of kilter. Depending upon your level of attention as it pertains to space heating, the actual volume that is needed acts independently from the cost of each unit (gallon). Consumption in a cold winter can exceed "the norm" by as much as 15%, while warm winters' benefits show less consumption of up to 15%, as well. So, demand from one year to the next, depending upon Mother Nature can swing by as much as 30% (note that monthly swings in demand regularly exceed 25% from "the norm"). The adage in the oil markets is that weather can definitely affect prices, but prices cannot affect the weather. In other words, the correlation between cold weather and high prices, and warm weather and low prices, which is logical, does not always work out that way.

Energy prices move, seemingly on a whim, without much in the way of warning.

Geopolitical, military, economic and weather events all coincide on a daily basis, and the world markets (it is important to note that energy is truly a world commodity, and what happens in one, perhaps remote, location, can and does have a ripple effect through the rest of the system) interact to set the cost of oil. While these events will definitely impact pricing, the question will always be asked as to how much of an impact, and for how long.

Bringing this all down to the local level, your cost to heat a building is simply the number of gallons (or therms) that you purchase, multiplied by the weighted average delivered cost of those gallons from your supplier. The cost is generally a differential (for the supplier's profit) over a local price-be it a "rack posting", J.O.C. Index, NYMEX price, or the like. The differential should be pretty steady, and the real variable in the cost of the oil is based upon what is happening to the "spot" price of oil, much more so than in shopping around from one supplier to another in an effort to save a penny or two per gallon. Although there may be a tendency to raise the thermostat a degree or two when it gets too cold outside, the volume that you consume is much more strongly related to the weather outside (as calculated by Heating Degree DaysHDD's) than by attempts at conservation. The bottom line is that when we have a colder than normal winter, you will exceed your budgeted volumes. A warm winter will have the opposite effect.

In addition to the simple "posting-plus" method to buy oil, many companies have looked to "fix" or "lock" the cost per gallon with a supplier, in an effort to manage their costs. This effort should be applauded, although there are still two issues that will be unavoidable. The first is the simply human nature. After locking in costs, and being able to budget (at least the per unit cost) for the expense, too many are nervous about what will happen if prices happen to drop. Even though logic would say that the budgeted number (per gallon) was achieved, the simple desire to pay "the best price" often gets in the way. The other issue goes back to the simple parameters of the weather. When you lock in the price, how do you know how many gallons to lock in, and how do you budget for the cost of additional gallons during a warm winter? As is often said, some hedging is better than no hedging, but price uncertainty often leads to increased indecision.

All of us have read articles over the past few years about how certain airlines (Southwest, in particular) benefited tremendously by hedging the cost of their jet fuel, to protect against a price increase. We are also familiar with the hedging needs of shipping companies, as they try to keep away from "fuel surcharges" and other variable costs that need to be passed through to their customers.

The natural inclination for many is to say, "Sure Southwest Airlines can hedge, but my volumes are too small". It is interesting to note that in addition to large corporations, many--actually millions--of individual homeowners hedge the cost of their heating fuels, as well.

Through their suppliers (home heating oil dealers, or independent natural gas marketers), these homeowners control the cost--either by fixing or capping their price--of their heating fuels. Many control prices on as few as several hundred gallons per year.

The premise for both the large corporations all the way down to the small local heating oil dealer delivering oil to homeowners is the same.

The notion behind hedging is to shift the risk--in the case of a building owner who is paying the bills for the heating fuels--of the cost of the oil, as calculated by units times price.

If you buy on a floating, or variable, price basis, you stand to pay less as prices and volumes drop.

Conversely, as we have been seeing for the last number of years, as prices increase-both with warm weather, and (even more) with cold weather, the cost of heating will rise.

Uncertainty reigns supreme in a world where profit margins can be this, and other expenses (management fees, taxes, debt service, etc.) and incomes (rent rolls) are hoped to be very predictable. Some, as mentioned earlier, will fix the per gallon cost of their deliveries. Although, we would prefer to see this per gallon cost indexed to a certain number of gallons -as a means to control the TOTAL cost of oil, it is certainly a way to bring more stability and predictability to the expense side of your ledger.

There is a third way to approach the costing of heating buildings that is used by several thousand heating oil distributors, in order to offer a "capped price" to several million homeowners. The way that a cap works is that it allows the price of delivered oil to float up and down with the market, BUT has a set limit as to how high prices can go (the cap level). As an example, a homeowner may have a cap from his distributor that guarantees that if prices were to spike higher ($3.50, $4.00, $4.50 per gallon), that the delivered cost would not exceed $2.699/gallon.

While in the event that retail prices fell significantly, the delivered cost of the oil would fall with the market price.

As an example, let's assume ABC Management Company requires 750,000 gallons of oil per year to heat their buildings and they have contracted to pay 25 [pounds sterling] over NYMEX which we will say is at a present price of $2.20.

If there was no movement in price or weather, ABC would have to budget approximately $1.85 million dollars for their oil. However, with a 15% volatility in weather and prices moving close to $1.00 in either direction, as mentioned above in this article, ABC can not be sure if they will pay $600,000 or $1.85 million or possibly $2.9 million for their oil budget.

By hedging and capping their budget they would be able to guarantee that their budget would never go above $2.1 million but would still be able to benefit if prices move down and we have a warm season. This is clearly a much safer and risk averse way to operate and budget their buildings.

Skeptics out there will immediately point out that there is no free lunch, and that is quite true. The mechanics of offering (or owning) a capped price -whether a cap on the per gallon price, or a cap on the total heating costs (price times volume) require an additional cost-or premium. In concept it is a form of "price (or cost) insurance".

The additional cost of the premium allows for the pricing flexibility that caps the cost, and allows for the "participation" in a low-cost market.

As mentioned, the no-free lunch approach does come at a cost, but given that variable prices can spike against you, and that fixed prices can "hurt" if prices fall after being fixed, this approach may well be worth investigating.