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				“Futures Trading: The Fine Art Of Managing Risk, Or Shooting Craps" National Petroleum News By Phil H. Shook Itís called the New York Mercantile Exchange, the Merc, the NYMEX, the energy futures market ‚ but during periods of big price swings, heating oil marketers, refiners, crude oil producers and jobbers call it a lot of other names. A growing number of petroleum marketers that trade energy futures make the case that the Merc is an essential tool for doing business. Others argue that it remains a breeding ground for price volatility and a playground for opportunists whose notion of a sound investment extends to the green felt of craps tables. "We are very pleased that the Merc came along and gave us a method of managing risk," says William S. Kenny III of Meenan Oil Co., Syosset, N.Y., a company that sells almost 200-million gal.of fuel oil annually at wholesale and retail. "My feeling is that the futures market is probably one of the biggest enemies that this industry has," says Roy Patterson with F.C. Haab, one of the largest fuel oil marketers in the Philadelphia area. Since 1978, when heating oil took its place among the silver and gold, soybeans and pork bellies traded on U.S. futures exchanges, companies that sell petroleum have found a variety of ways to make use of the market. Today, a small marketer with a tanker fleet in Texas, can use the Merc to protect the cost of a big gasoline purchase long enough to complete a sales transaction. An East Coast fuel oil marketer who has large volumes of product moving by barges between a half dozen harbor terminals needs the futures market to manage risk. In recent years, at least two well-known oil company chief executives have used the futures market as a hedging and investment vehicle with spectacular results. Amerada Hess Corp. chairman Leon Hess, a critic of the futures market, admits that his company chalked up $329-million in hedging profits in 1990. Mesa Limited Partnershipís T. Boone Pickens justifies his $1-million annual salary by reminding unitholders that he has added $84-million to company coffers over the last five years trading oil and gas futures. Hedging Against Volatility By definition, the operation of the energy futures market seems fairly easy to grasp: it is designed to allow commercial entities ‚ producers, refiners, marketers and end-users ‚ to purchase and sell specified quantities of particular grades of commodities: crude oil, fuel oil and its derivatives, unleaded gasoline and natural gas, for delivery at a specified location and time in the future. The price that the buyers and sellers pay and receive is determined through competitive auction-style bidding and offering on the floor of the exchange. NYMEX officials say the process provides for open access to all segments of the marketplace and prices of actual transactions are instantly and widely disseminated throughout the world. Producers, marketers, resellers and end-users use the market to reduce their price risk, or hedge. In hedging, futures contracts are sold to reduce the risk of price declines and bought to reduce the risk of price increases. According to NYMEX president R. Patrick Thompson, transactions on the futures market are essential tools for commercial entities to manage their supplies, inventories, distribution and marketing. "The oil industry uses thes transactions to minimize its costs, and through competition, these cost savings are passed along to customers," Thompson says. In one sense, the exchange is a perfect market because at the end of each day there are an equal number of buyers and sellers, explains Robert Greenes. Currently executive vice president of the New York Oil Heating Assn., Greenes ran one of New York Cityís largest heating oil distributorships for 40 years and helped set up futures trading for No. 2 heating oil. Greenes and others point out, however, that when it comes to the dynamics of supply and demand, the futures market is not always so perfect. Thatís because of psychological factors that affect any commodity business, Greenes says, noting that there doesnít have to be a freeze in Florida to sent up the price of oranges, only the threat of one. The effect of the weather on Floridaís citrus crop doesnít move energy markets, but in the last two years some other things did, most dramatically a heating oil crisis during the winter of 1989-í90, the Iraqi invasion of Kuwait and a failed coup in the Soviet Union. When crude oil pirces climbed above $40/bbl. following the Iraqi assault on Kuwait in August 1990, Saddam Hussein was not the only one that got the blame. Some people pointed a finger at the futures market structure for the ensuing violent price movements in petroleum products. Although he admits the last two years have provided the greatest challenge to energy commodity and futures markets since their inception, the Energy Information administrationís (EIA) Calvin Kent says there was no reason to lay blame on the NYMEX. A former economics professor, Kent says that, despite claims by critics that the rapid run-up in prices was caused by the failure of the energy markets and the activities of speculators, the exchange operated efficiently during thse periods. Savvy Traders A good way to understand how the futures market works is to look at the experiences of petroleum marketers experienced in using the NYMEX. After the major oil producers, independent fuel oil marketers are among the most savvy traders of energy futures. Santa Fuel Inc., a retail fuel oil distributor in Bridgeport, Conn., has been using the futures market to hedge its inventory, to purchase inventory outright and to offer price protection to customers. Tom Santa says the company uses the futures market to hedge its inventory, to purchase inventory outright and to offer price protection to customers. "Our experience in listening to our customers has indicated that price volatility is one of the most disconcerting aspects of the fuel oil market," Santa says. "We have tried to limit that through the commodities market." Meenan Oilís Kenny says using the futures market is the only way the company can handle large volumes of oil and minimize the risk of a price collapse. Operating in three states, Meenan sells about 100-million gal. Of fuel oil at retail and another 90-million gal. At wholesale each year. Meenan has six terminals on the water that are fed by barges from New yuork and Philadelphia harbors. In addition to the product stored in those terminals, the company often has oil being transported on the water between those points. Companies like Meenan can look at the amount of oil in its tanks, the amount being transported on the water and the amount being transported on the water between those points. Companies like Meenan can look at the amount of oil in its tanks, the amount being transported on the water and the amount committed for sale and calculate a "days of sale" figure. Kenny says that if a company was not comfortable handling product that represents 20 days of sale, for example, it could go the futures market and sell the number of contracts necessary to bring down its risk to more like eight days of sale. "If the [oil price] went up, we would make it on oil and lose it on the futures market, but if the market went down, we would make it on the futures market," Kenney says. "In essence we are locking in our costs." A Tool For Fleets Once ignored by fleet managers as being too risky, futures contacts are now being used as a risk management tool by many motor carriers that distribute diesel fuel. Vera Haskins, vice president of Mauger & Co., a regional heating and diesel oil distributorship based in Malvern, Pa., says 160 of the companyís 2,000 trucking customers are allowing Mauger to trade on the NYMEX in their behalf to hedge their fuel costs. The objective is not to get the lowest price for fuel, but to minimize the risk of price spikes, Haskins says. Maugerís trucking clients are reluctant to discuss their futures market strategies. "They donít want anyone else to know about it because they think itís a tool of the future," Haskins says. "It gives them a competitive advantage." Haskins says one of Maugerís customers, using the Merc to hedge, paid only 50 cents/gal. Last year for diesel fuel at a time when the market price was more than $1 and most fleets were adding fuel surcharges to their freight bills. After using the futures market as a tool to help its motor fuel customers, Mauger, a company which has never stored product, began offering the same option to its residential fuel oil customers this year. "The two price spikes brought to mind that this was a tool that we should carry over to that part of our business to protect our customer base," Haskins says. About 1,200 of Maugerís 4,000 heating oil accounts have opted for a firm priced program, backed by Maugerís use of the futures market. Haskins says the alternative to using the Merc for hedging would be to put product in storage, and that option is no longer cost effective. She says petroleum marketers are doing the same thing by using the futures market. "The only difference is that itís not going into a hole in the ground in the back of the building." Providing price protection through the futures market requires a disciplined approach from the market and end-user alike, Haskins says. "Everybody thinks they know what the price is going to be next week," she says. "Some customers decided to participate, but never did because they always thought the price was going to get better. You cannot effectively doing that." A marketer providing priced protection to customers must decide what a good price is in a particular market, Haskins says. And when the price gets to that point, she says you must begin setting up the framework for hedging that price on the futures market. Petroleum marketers who manage futures programs also must maintain a discipline when prices go up, Haskins says. "When prices become inflated, there is a tremendous amount of cash potential building up in your position. Many a fuel dealer has been in serious trouble because they have turned from a hedger to a speculator." Protection From Price Spikes Despite having a low opinion of the futures market, F.C. Haabís Patterson says the company also uses futures contracts to protect itself and its customers from price spikes. "The bottom line is that as long as you have severe fluctuations in the marketplace, you have to protect your customer base from those fluctuations." The futures market allows a company to offer the set price programs that now have vecome popular in the market, says Doug Woosnam with Sinkler Inc., a 13-million gal./yr. fuel oil marketer based in South Hampton, Pa. Providing this price stability to a customer is necessary to compete with utility companies, Woosnam says. "The biggest thing that the utilities are throwing at our industry is the bolatility of the market especially in light of [the events] in the last few years," he says. Using the futures market to provide price guarantees to customers is not a way to attract bargain hunters, although some marketers mistakenly try to use it this way, says John Santa of Santa Fuel. "The basic thrust of this tool is to preserve your good conservative customer from the ravages of price gouging," Santa says. "It is not to give them the lowest price in the world." Greenes estimates that as many as 40 percent of fuel oil distributors now offer some kind of price protection to their customers. "You really canít do that, not with a modicum of security, unless you are involved in the market or use the market yourself," Greenes says. Because of changes in supply agreements, Woosman says Sinklar also uses the futures market to manage risk. "We contract for the products to take delivery of the wet barrels and then go out in the options market and do what we have to do [to protect the price]." Marketers who wish to avoid margin calls, a possibility with futures contracts, can purchase options on crude oil, heating oil and gasoline. With an option, if the market moves against a position, and a trader holds on to his option, the maximum cist is the premium paid for the option. On the other hand, if the market moves in favor of a position, the virtually unlimited profit potential of an option is parallel to a futures position, net of the premium paid for the option. In this way, protection from unfavorable market moves is achieved at a known cost, without giving up the ability to participate fully in favorable market moves. Ram Oil Corp. of San Antonio, a 168-million gal./yr. distributor of gasoline and diesel fuels is among the companies now taking a hard look at ways to expand their participation in the futures market. Ram Oil has used the market on a limited basis and is now looking at ways to use it as a risk management tool, says J.D. Marek, a co-partner. He says the company would trade contracts in gasoline and diesel fuel.. "Our goal is to make a better profit margin," Marek says. "That is the driver." Lucky Lady Oil Co., a Dallas-based marketer, uses the NYMEX on a limited basis to manage risk. Rick Canady, who heads the companyís wholesale and freight operations, says he occasionally works through a brokerage to buy a contract on the futures market and lock in a price on a load of fuel for future delivery. Canady uses an example of a customer who offers to pay a certain price for a load of fuel. "I might have a customer who would say he will pay a certain price for 20,000 bbl. But, if he can buy it a little cheaper, he knows I already have my margin locked in." Like the major oil companies, Diamond Shamrock, Inc., the San Antonio-based refiner/marketer, uses the NYMEX to trade crude oil contracts. Unlike the majors, Diamond Shamrock is no longer part of a companyh with an exploration and production arm so it must depend on crude markets for supplies. The company buys 60-million bbl. of oil annually or 160,000 b/d. The companyís strategy is fairly straightforward, according to Robert Ayres, Diamond Shamrockís manager of hedging and trading. "Our whole game is to try to buy crude as cheap as we can," he says. Owner and operator of about 750 service stations throughout the Southwest, Diamond Shamrock occasionally uses the NYMEX to trade gasoline contracts. "When we do trade gasoline futures, we would be a seller of product futures as a hedger because our company makes money on the spread between products and crude," Ayres says. Diamond Shamrock and other marketers in the Sun Belt states they would be bigger participants in the gasoline and heating oil markets if there was a Gulf Coast contract. Presently, the delivery of gthese commodities is based on a New York Harbor contract. "If the difference was only transportation costs, you could factor that out of there." Ayres says. "But in New York you get [price] squeezes and the local market situation often bears little resemblance with what is going on [in Texas]." Bill Billings, senior trader with Phillips Petroleum Co., Bartlesville, Okla., says the company would be active in trading gasoline futures if a Gulf Coast unleaded contract is established. "The [New York Harbor ] gasoline contract is OK, but there are too many periods each year when it bears no relationship to the Gulf Coast value," he says. Billings says he also uses the futures market as a form of price discovery for petroleum products. For an increasing number of oil companies actively trading energy futures contracts, futures have become a standard for valuation in cash market contracts. Spot prices for refined products and crude oil are now so linked to their respective near month futures prices that the two markets function interchangeably. According to NYMEX officials, price discovery permits a concrete determination of market expectations, enabling producers, refiners and marketers to hedge their perceived risks, market more competitively and conceivably increase their profits. Resistance Although many marketers use the futures market for a variety of reasons, many others, concerned that the NYMEX serves to drive up prices, criticize it frequently or shut it entirely. "Thanking the futures market for offering you protection against price fluctuations is to me like thanking the Mafia for selling you a contract to keep your business from burning down," says F.C. Haabís Patterson. "There has been quite a bit of resistance to it," says Santa of Santa Fuel. "Many of our peers have their established way of doing business and the Merc is not part of that." Patterson says he doesnít think products like fuel oil and natural gas belong on the futures market. Trading agricultural commodities makes sense, trading crude oil doesnít, he says. "You have hundreds of thousands of farmers out planting a wheat field," Patterson says. "People take their bets, lay down their money and it is up to god and nature to affect the supply side of the quotient." On the other hand when you are dealing with oil, the supply side is directly under the control of a very few individuals, Patterson says. "So you really donít have a free floating marketÖyou have a market that can easily be manipulated by the producers or any one of a number of people along the line." Maugerís Haskins says the effect that perceptions have on the market as opposed to reality is what bothers people the most about the Merc. Haskins argues, however, that perceptions play a role in every industry. "The futures market does respond and react, but so does the stock market," she says. In June 1990, EIA issued a report on performance of energy markets during the heating oil crisis in the winter of 1989-í90. the analysis concluded that the major casual factors of the price movements during that period were supply and demand fundamentals, not trading or speculating on spot or futures markets. ëIt was our finding that the activity which took place during that periodÖwas legitimate commercial activity as providers of heating oil struggled to meet the unexpected demands created by the coldest spell of weather seen by the United States in some 60 years," says EIA administrator Kent. He says a "series of factors" exacerbated the well-below normal temperatures including problems in transportation and production as causes for the price movements. Following the Iraqi invasion of Kuwait, there was again considerable discussion, within the industry and before congressional inquiries about the futures market and whether it contributed to higher crude prices. Kent says the NYMEX performed efficiently during the period and should be commended for action it took to allay fears of potential wartime profiteering. He noted that the Exchange took appropriate action to set new trading rules and expanded price limits in crude oil and products on the two nearest futures contracts. Instead of $1.50/bbl. limits on crude oil in the first back month, the two nearest months were given limits of $7.50/bbl. If the contracts stayed locked on the limit price for five minutes the market would close for one hour and reopen with new $7.50/bbl. limits for all contract months. When trading opened on Thursday, Jan. 17, 1991, after the start of Desert Storm, there was speculation that crude and product prices would go through the roof, some predicting $100/bbl. oil. Instead, the nearby February 1991 crude oil contract opened down $7.50 to $4.50. the price stayed at that level for five minutes, the market closed for one hour and reopened with new limits for trading. Those price limits were not reached for the rest of the day, and the February 1991 crude oil contract closed at $21.44, down $10.50 from the previous dayís quote. "The new limits worked as anticipated, and the temporary closing had served the purpose of permitting traders time to assess the situation and respond accordingly," Kent says. Kent says trading activity throughout the entire period of the Gulf War indicates that spot and futures crude oil prices moved together, indicating that it was market fundamentals, and not speculation, that led the market. He says trading in heating oil showed a similar relationship. Energy markets in New York and worldwide also functioned normally during the failed coup in the Soviet Union, Kent says. Even though heating oil trading reached record high volumes on Tuesday, the day before the coup collapsed, Kent says the appropriate balance between holders of long contracts who must ultimately take delivery of the commodity and holders of short contracts who will ultimately deliver it, remained. Meenan Oilís Kenny says the large numbers of non-industry players that have access to the futures market probably do make it more volatile today but it doesnít mean speculators control the market.. "Volatility means that which goes up, comes down," Kenny says. An example of the marketís ability to adjust came last September and October, Kenny says, when heating oil came back down to around 59 cents/gal. After climbing as high as 70 cents/gal. "It had no business being at 70 cents, but it went up just because of the emotional effects of the unrest in Russia and concern over Iraq coming back," he says. "The fact it came back means it canít sustain a false market for very long." While the company uses the NYMEX to minimize its risk, Kenny says marketers should be aware that energy futures are far less mature and more politically driven than most other commodities. He also notes that there are fewer alternatives available to traders and end users of petroleum products. "If you donít like the price of wheat, you go and buy some rye. But if youíve got to heat your home, you donít have any other choices," he says. "[With heating oil] I canít say I donít like the price so I am not going to buy any, because I would lose my customers." Kenny says the bottom line for Meenan and other companies like it that store and sell significant volumes of petroleum products is that they could not manage risk nearly as well without futures market. Says Kenny: "There would have to be something else, and righ now I donít know what that would be." February 1992