There’s nothing like an incident to spark price movement. Thursday morning’s suspected attack near the entrance to the Persian Gulf have stoked, not only fears of a military confrontation between the U.S. and Iran, but also the oil price, up as high as 4.5% on early trades. This just seems a few hours after all the talk was about oil prices sinking 4% on the back of faltering demand. It made me think about flat price trading, which had grabbed the industry pre-derivatives, but I thought surely it was a thing of the past.
This was borne out when I asked a younger member of the trading team what the FEI price was for today, he shrugged his shoulders and said he didn’t really follow absolute prices, but he could tell me where all the FEI spreads were trading. That made me think hard, he was right, do we really need to know the various flat prices in the world of LPG?
I think we read in most trading company brochures that they do not speculate on movements in the levels of commodity prices. I do see them temper this a little by saying, “as a rule”, they hedge these flat price risks, while taking on risks related to price differences and spreads, something the industry calls ”basis risk”.
I remember taking cavern storage in the summer, filling it up with what we assumed was relatively cheap LPG, then holding 80,000 Mts at fixed price, waiting for the winter to begin, and prices to skyrocket. We rarely thought, what if the crude oil price was to drop $5/Bbl, and whilst winters were not a guarantee, the banner of global warming had not even been thought of. We survived because the markets felt far less volatile and monthly prices were still the rage. Without doubt, flat price trading, as it was, is hardly used today.
Today’s trading is all about managing risk. There is no question that oil price volatility has increased over the last twenty years, and with it the wide array of risks. Therefore, we have seen the proliferation of risk management groups, deemed as a “must have” part of a commodity or financial trading firm. These groups not only quantify and monitor daily portfolio risk, they also define the risk boundaries, controls and punishments for violating these parameters. Margin calls, stop losses, the works! But have they managed to eliminate flat price risk?
The reason I ask this question relates to the LPG market in the last twelve months, where we have endured two major, very major, market cliffs! I believe we might all think we are hedged, or we are only taking on the basis risk, but there still exists flat price exposure that can start to punish trading companies at the margin. The graph above shows that from October last year the FEI price fell over $250/Mt in under two months, and yet again a similar drop, from before the end of April through to today. For this to happen twice in just over six months is pretty extreme, even in our business.
So where does the trader get caught out with flat price?
While hedging the ARB, it’s nearly impossible to exactly balance U.S. barrels (Bbls) to Metric tons (Mts). Assuming a VLGC is roughly 575,000 Bbls, this equates to just about 46,334 Mts. But you have to transact in 1,000 Mts lots, therefore you are either 334 Mts or 666 Mts under or over hedged, dependent on whether you buy 46 or 47,000 Mts. With a $250/Mt drop, this could expose the trader to a $166,500 loss, given the worst scenario. Then when the ship is chartered and nominated it might load 47,000 Mts. Again, flat price exposure. In this scenario, and real-world situations, the trader is “forced” to speculate on the unhedged imbalance portion.
The other danger is during the pricing out of a hedge. This is both an issue of divisibility and timing. Cargoes are not all standard sizes, and spreads require unwinding the forward month as the current month prices out. Likewise, the months themselves are not all “standard sizes” either, some even include holidays, which means a price will not be published on that day, let alone how many weekends fall within the month. So, a 46,000 Mt cargo could be priced out in a 20-day pricing month, giving 2,300 Mt/d to unwind each day. Again, this leads to flat price risk as the market doesn’t trade 300 Mt lots.
From a timing perspective, liquidity can be influenced by sudden moves in the crude market causing bids and offers to vanish or at least widen. Gap risk, where prices open higher or lower outside the previous days’ range, is another issue facing LPG markets, since these markets, unlike crude oil or natgas, do not trade on what is essentially a 24-hour/day, weekday cycle. If daily pricing cannot be transacted or bid/offer spreads are significantly wider than normal, then flat price risk again surfaces and small volumes can quickly become costly – today’s oil price spike is a timely reminder.
Although there is a growing capability to use the freight swaps to hedge shipping, it only currently applies to the Baltic index, and liquidity is poor. Given the increasingly dominant position U.S. LPG exports command in the global supply/demand balances, the freight swaps market needs to also cover the main U.S. to Chiba route. I will explore this more in a later ARB blog I’m currently writing. However, a number of traders are happy to take on fixed rate time charters over periods of one year and longer. Unless their system offers a hedge between FOB and CFR contract levels this is again flat price exposure.
Traders always believe in calling price direction and the ultimate test is the movement in the flat price. They recognize that the LPG market can be quickly influenced by factors associated, but outside of the market itself, i.e. crude oil, while also being cognizant that the flat price risks are often unavoidable – or at least they will quickly learn this fact once bitten by it. Trust me when I say, we all will sleep better minimizing the flat price exposure.