While most city-folk have natural gas these days, there are still millions of people in the Northeast U.S. and eastern Canada who heat with No. 2 fuel oil. While the reasons for sticking with oil are varied, most oil heating customers today don't have access to natural gas. Its important to note that before 2008 there were times when oil heat was actually less expensive than natural gas and its not out of the question that it won't happen again. Many fuel oil distributors will also be quick to remind you that No. 2 fuel oil has never blown up a building. Despite this, fuel oil distributors are seeing their routes shrink each winter as the natural gas utilities pick-off their customers. In Connecticut and Maine, the State is actively encouraging customers to switch to natural gas and even subsidizing the expansion of natural gas infrastructure.
Towards the end of the summer, many heating oil customers are asked by their distributor if they'd like to "Lock-in" their oil price for the coming winter. This may seem like a daunting and opaque transaction for the average residential or small commercial consumer. There are several elements and risk factors that are included in any fixed priced offer for oil.
The first and most obvious risk is the price. Heating oil is a refined petroleum product that is nearly identical to diesel fuel. The price is largely determined by the input cost of the oil into the refinery and the supply of refined heating oil in the marketplace. East coast refiners make adjustments each fall to build stocks of heating oil and the relative supplies are determined by the degree to which refiners calibrate their plants to produce refined product (e.g., gasoline, kerosene, jet fuel, asphalt, etc.). Heating oil futures are traded on the NYMEX under the symbol HO and each month has its own contract. The contract size is 42,000 gallons (1,000 barrels) and the delivery point is New York Harbor. After May 2013, the specifications for the NYMEX heating oil contract will require a sulfur content of less than 15 ppm and heating oil and diesel will be one and the same insofar as the NYMEX contract is concerned. Heating oil with the higher sulfur content will persist for a while in physical markets as some Northeast US states don't mandate the switch to low sulfur until 2018.
No one takes delivery in New York Harbor so there is a basis differential in the price between the settled NYMEX heating oil contract and the local spot market. The graphics below show the current NYMEX heating oil futures curve as well as recent spot prices for heating oil in Boston as reported by the Oil Price Information Service. Note that heating oil futures are backwardated just like Brent futures (generally speaking, going long into backwardation is a bad move). For most customers, the delivered price of oil to their tank will be anywhere from $0.30 - $70/gallon higher than the spot prices reported here since the fuel oil distributor needs to mark up the fuel to pay for delivery costs.
The second risk factor is usage since it represents a volumetric risk. In a cold winter a customer will use a lot more oil than in a warm winter. As a result, the volume of oil in any fixed price deal is a moving target for the counter-party offering the fixed price. Some "price lock" offers will include a limit on the volume of oil offered at the fixed price to help mitigate this risk. Although the customer will use oil continuously during the heating season, the fuel oil distributor will need to make discrete purchases and deliveries of oil to the customer's tank. As an example, the oil that a customer consumes in December would likely have been purchased and delivered in November. As a result, the November oil price is relevant to December's usage.
Many people falsely presume that by locking a price per gallon for heating oil that they will attain budget certainty. While fixing a price per gallon will hold one variable steady, absolute budget certainty will still prove elusive. The column bars in the graphic above represent fuel oil deliveries to a medium size commercial customer in Eastern, MA during the 2012-2013 heating season. The fuel oil distributor makes an oil delivery approximately every 10 days during the heating season. Since actual consumption varies with the weather, there is a significant difference in delivery volumes and as a result, the total cost of each delivery varies widely. The red squares represent the total cost of each delivery with the most and least expensive deliveries costing $2,791 and $1,179, respectively. The number and size of deliveries is based on consumption which is based on the weather which can be highly unpredictable.
So what is a fuel oil user to do? At ETE, we generally offer two pieces of advice. The first is that "locking in" a price for oil for residential or small commercial seasonal quantities is an extremely inefficient transaction with multiple middlemen . The second is that if a customer feels strongly that they need to be able to contain some of the budget risk in their fuel oil spend and they can "lock in" a price at an acceptable level, they should do it so long as they know they are paying a premium to do so and that the actual spot price could be lower when winter comes. The graphic below helps illustrate this choice.
If your facility is struggling with a decision to lock in an oil price, call us. We can probably help.