Hedging 101 – Part Two: Identifying Risks
We started our Hedging 101 series by defining a “hedge” as a way to mitigate or protect against risk (Part One). With that basic building block in place, we can move on to the next step – identifying what risks a business needs to protect against.
Margin erosion is a major risk for most businesses
What is margin erosion?
Almost every business has the same major risk – margin erosion. Sticking with our plan to “keep it simple,” let’s define this risk.
- Every business sells something (a product or service).
- Every business has costs (the cost of making and delivering the product or service).
- The difference between the sale price and cost is called the margin.
Most businesses want that margin to be as large and steady as possible. However, margin erosion occurs when costs are higher than expected or when the sales price drops more than expected.
An example of margin erosion in fuel distribution
For those in the fuel distribution business, margin erosion can often occur due to market prices rising more than expected, which increases your costs. Here is an example.
A propane distribution firm sells a future delivery of 1,000 gallons of propane to one of their customers at a price of $2/gallon. That firm desires a margin of $1/gallon and that can be achieved at current market prices. However, three months in the future propane costs increase by $.30/gallon and the distributor’s margin has dropped 30%.
Two risks that can create margin erosion
The example above demonstrates two major risks that can create margin erosion.
1. Fixed Price Risk: defined as selling a product or service to a customer for a future delivery at a fixed price that has a margin determined by costs that fluctuate in the open market.
2. Market Risk: defined as a cost that is subject to daily fluctuations of a trading market (such as gasoline, diesel, oil, and propane).
How do you avoid margin erosion in a business that has fixed price and market risks?
We mentioned earlier that most businesses want a strong and steady margin, but how can this be achieved in a distribution business that often has fixed price and market risks?
One way to achieve that goal could be to simply not provide your customer with a fixed price future sale. In this industry, that approach tends to reduce your number of sales, so another solution is necessary.
That other solution is to hedge (protect against a risk) your fixed price and market risks. We will describe how that process works in future posts. Today however, we want to make sure we can clearly identify risks.
Where can we see fixed price and market risks in fuel distribution?
Both the fixed price and market risks can be seen in many aspects of a fuel distributors business.
- In multiple customer price programs (Prebuy, Budget, Cap).
- In large commercial accounts.
- In Autogas accounts attempting to show the benefits of propane over traditional gasoline or diesel.
- In supply coming to their facility via rail car and supply being stored for future usage.
All of these situations can (and DO!) exhibit both fixed price and market risks. Stay tuned for future posts where we will outline the next steps in “how” to hedge these two major risks to protect against margin erosion.
Hedging 101 – Part Two: Identifying Risks
By JD Buss
