4) The Money Margin (Fuel Gross Margin)

Part 1: Where’s the Money?

Fuel gross margin or FGM is the money margin for fuel retailers. It is the common measure of fuel sales profitability. FGM minus net operating cost (NOC) equals a station’s net fuel profit margin. Given that most retail stations have an NOC of 10 ¢/g or more, FGM must exceed 10 ¢/g for a station to profit by selling gasoline or diesel fuel.

The equation for fuel gross margin is:

Fuel Gross Margin (FGM) = Retail price – Delivered Cost – Taxes

Delivered Cost = Rack price + Transportation

Rack price = Spot Price + Rack/Spot differential

Spot Price = Futures price + Spot/Futures differential

(The Spot/Futures differential is referred to as the Basis.)

Bringing all the components together:

FGM = Retail price – Futures – Basis – (Rack/Spot differential) – Transportation – Taxes

Fuel retailers control their retail price, though the retail price is affected by factors outside the retailer’s control (competitor prices, fuel sales volumes, convenience store sales and traffic). Fuel retailers have no control over the other components of FGM – futures, basis, rack/spot differential, transportation costs, and taxes. Retailers are at the mercy of the market for those other components. So, in effect, retailers have very little control over their FGMs and, therefore, little control over their net fuel profit margin.

Given the significant volatility in futures prices, some degree of volatility in basis, and little (but some) volatility in the rack/spot differential, transportation, and taxes, it is not surprising that data over the last five years show a wide range in FGMs. This wide range is exhibited in the following histograms (frequency distributions) based on U.S. average data and is representative of areas across the country.

 

As indicated on the charts, the 5-year average FGM for regular gasoline is 18.4 ¢/g (median 16.7 ¢/g) and the 5-year average FGM for diesel fuel is 22.5 ¢/g (median 20.2 ¢/g). In 2009, the average FGM for regular gasoline decreased to 14.9 ¢/g.

California shows a similar pattern:

With NOCs of 10 ¢/g or higher, the net profit margin in 2009 on regular gasoline in the U.S. is less than 5 ¢/g, and less than 4 ¢/g in California.

Will average FGMs improve on their own? Not likely, given increased competition in retail fuel marketing from big-box retailers and grocery stores, whose primary objective is profitable store sales – not profitable fuel sales. Add a weak economy and political pressures to keep retail prices down and you have a recipe for FGMs averaging 12 to 17 ¢/g for the foreseeable future.

So what’s a fuel retailer to do? Most have decided to make the best of their C-store sales and hope for the best with FGMs. Will C-store sales make up for low margin fuel sales? For some, yes. For others … that’s a big gamble and, as the casinos in Las Vegas can attest, few gamblers win.

Well informed and creative fuel retailers will also make the best of their C-store sales, but they will go on offense to improve their fuel sales profitability. Going on offense entails understanding and utilizing currently available tools to manage futures prices and basis, and thereby actually set forward FGMs – not just hope the competition disappears or the market magically gets better.

Which type of retailer are you?  Do you want to just hope the market takes care of your business, or do you want to take care of your business?

Next …
Part 2: Making Money

3) “Mini-Futures” Make Hedging Easy

U.S. Commodity Funds

Transactions in the futures market can be costly and a bit of overkill for some fuel retailers who own or operate only a few stations or whose stations sell less than 100,000 gallons per month. Futures can also be intimidating, even for the “big guys”. In addition, the requirements for opening and funding a futures account to enable futures transactions – and then deciding who has authority to execute and who’s going to track & report the transactions – can be a hassle. Nevertheless, since the futures market is the market driver (see Post #2), a fuel retailer should put him or herself in a position to use the futures market to their and their customers’ advantage. That’s going “on offense” and just smart business.

Fortunately, U.S. Commodity Funds are now available (UGA and UHN for gasoline and heating oil, respectively) that make futures transactions simpler and less costly, but equally effective. UGA and UHN are “mini-futures” that trade like stocks. More precisely, they are exchange-traded securities “designed to track the changes in the price of gasoline [heating oil], as measured by the changes in the price of the futures contract on gasoline [heating oil] traded on the NYMEX, that is the near month contract to expire. UGA’s [UHN’s] units may be purchased and sold on the NYSE.” A copy of the Prospectus for UGA may be obtained here.  A Prospectus for UHN is available
here.

The effectiveness with which UGA and UHN track their futures counterparts is evident in the charts below. The correlations between the funds and their futures counterparts are essentially 100%.

Another advantage of the commodity funds is that they are not month-specific like futures contracts. In effect, owning a commodity fund is like owning “the forward curve” in the futures contract. Buying futures or futures options first involves choosing the futures month, which, of course, eventually expires. At expiration, owners of futures contracts must either liquidate or roll their positions to the next month or thereafter. While rolling futures contracts is not difficult, it is an “administrative” activity that is not required with the commodity funds.

Volume Conversions

One futures contract is 42,000 gallons or 1000 barrels. Calculations show 5.9 shares UGA is roughly equivalent to 100 gallons of RBOB (gasoline) futures and 6.7 shares UHN is roughly equivalent to 100 gallons of HO (heating oil / diesel fuel) futures. That’s why the commodity funds can be called “mini-futures”.

2) Futures Market & Retail Fuel Prices

The futures market is the “driver”

Retail gasoline and diesel prices are linked to futures gasoline and heating oil prices.  The futures market is the “driver”.  This is clear from high correlations (over 96% [1]) over the last five years between retail and futures prices in areas throughout the United States.

 

 

 

 

 

 

 

Even in “remote” California …

 

 

 

 

 

 

 

Data Source: Energy Information Administration

The high correlations between futures prices and retail prices are not coincidental. They result from spot prices in all markets “trading off” futures prices. Spot prices set rack prices that, in turn, set retail prices. Therefore, futures prices set retail prices —

Futures à Spot à Rack à Retail

That fact offers significant opportunities to achieve higher margins & sales (and happy customers) for fuel retailers who are willing to take advantage of it. Is anyone taking advantage of those opportunities now? Gulf Oil is working on it. Pricelock and Petrofix are actively trying. But any fuel retailer can take advantage of the link between futures and retail prices — whether a single C-store owner or a major oil company.

[1] A 96% correlation means 96% of the change in the retail price is due to the change in the corresponding futures price.

1) Higher Margins & Sales (and Happy Customers)

Achieving all three – regardless of the number of retail sites

Retail gasoline and diesel fuel margins are volatile, unreliable, and sometimes unprofitable.  All fuel retailers know that, but most are unaware (or unwilling) to take advantage of opportunities in the wholesale markets to improve fuel margins.  They focus instead on increasing sales of profitable merchandise from C-stores; i.e. they take a “Costco-lite” approach to their fuel margin challenge.
 
Why are fuel margins so tight?  Competition, of course, but equally (or maybe, more) important is the fact that fuel retailers react to the market (rack and delivered prices, competitor prices, existing sales volumes) when setting pump prices.  In such a reactive mode, fuel margins are a hope-for-the-best proposition.  Fuel retailers are at continual risk of fuel sales being marginally profitable, and sometimes unprofitable.  (Statistics show gasoline fuel gross margins are below net operating costs roughly 25% of the time).

What to do about fuel margins?  Raise pump prices?  No, that drives sales down and customers away.  Focus on merchandise and food sales?  Ok, but that masks the problem and forces C-store owners onto big-box retailers’ and grocery store chains’ turf.  Hope you outlast the competition and then raise pump prices?  Everyone else is doing that, and how long is that going to take — assuming you make it to the “promised land” of less competition?
In order for fuel retailers to capture higher fuel margins (and achieve other benefits) they must go on offense.  The best defense is a good offense.  Offense against what?  The futures market where gasoline and diesel prices (among other commodity prices) are set.  Evidence is overwhelming — statistical and behavioral — that the futures market sets spot prices which set rack prices that, lastly, set retail prices.  In short, the futures market is the driver.  And it’s going to stay that way.  The good news is tools are available that enable retailers to control their “margin destination” and, at the same time, the “price destination” of their customers.  Friendly tools.  Today.