9) Roads to Higher Margins: Storage

The Classic Way

Storage is the “classic” (and simple) way for retailers to achieve higher margins and offer the cheapest gas among their competitors. It is classic in the sense that many businesses, traders, and consumers utilize “storage” in different ways with different products to their economic and strategic advantage.

Suppose you own a gasoline station (and convenience store) with sales volume of 100,000 gallons per month. You have several competitors within a 5 mile radius, including a big-box retailer that promises the “lowest prices” around. So your gasoline margins are tight and likely to stay that way. You focus on your convenience store products and margins because you think there’s nothing you can do about gasoline margins, right? Wrong. Let your competitors think that.

Now suppose you have an opportunity to install a gasoline storage tank at no cost on your property – no construction, environmental, operating, or any other costs for the tank. It’s free! (It’s also invisible, so you might call it a “virtual tank”.) You can fill the tank with any amount of gasoline at any time (and hold it for as long as you like) to be drawn down at a later date when economically advantageous. Would you install the tank? Do you think having a storage tank filled with, for example, 50% of your monthly sales volume at a price of $1.50/gal or less relative to futures prices that you can draw down at any time will help improve your gasoline margins? Of course it would. That, in essence, is the Storage Road to higher fuel margins.

What exactly do you store in the virtual tank? Futures gasoline – the most volatile and impactful component of retail fuel margins (see Post #6) – in the form of futures contracts or “mini-futures” discussed in Post #3. Why store futures? Because futures drive retail prices, as detailed in Post #2 and as the following chart illustrates:

Mini-futures (UGA for gasoline) track futures and provide effective and less costly alternatives to futures contracts (see Post #3) for small volumes. (One futures contract is 42,000 gallons.)

6 shares UGA ≈ 100 gallons RBOB; ± $1/share UGA ≈ ± 6 ¢/g RBOB

 

Returning to your gasoline station that sells 100,000 gallons per month. Assume it’s January 2009 and you’d like to store 50,000 gallons of gasoline futures in your virtual tank. That’s a little more than 1 futures contract or 3,000 shares of UGA. Assume you store (buy) the 3000 shares of UGA at $22/share. Your virtual tank is “full” – and now you wait for the summer driving season. [This is what makes the strategy “classic”. It’s parallel to a buy-and-hold strategy in the stock market, though the potential holding period is shorter.)

It’s now June 2009 and you sell your 3000 shares of UGA at $30/share. You may decide to keep the profit on your mini-futures or share some of the profit with your customers at the pump. You choose the latter, still achieving higher margins with your mini-futures transaction by pocketing some of the profit, but also scoring points with your customers by truly having the “lowest prices” around (lower than the nearby big-box retailer) and – with the increased traffic to your location due to your low pump prices – racking up more sales in your convenience store.

Specifically, how might you share the profit?

1. UGA gain: 3000 shares x ($30 – $22/share) = $24,000
   
2. Share 50% of your gain with customers = $12,000
   
3. Existing monthly volume = 100,000 gallons; assume monthly volume increases 20% due to discounted pump price à new monthly volume = 120,000 gallons
   
4. Allocate $12,000 over July & August à pump price discount (relative to your price without the storage gain) = $12,000 ÷ (2 months x 120,000 gals per month) = 5 ¢/g
   

Increase your fuel margins, sales, and customers (and customer loyalty) with the Storage road. Offer the cheapest gas “in the neighborhood” and confound your competitors. As Charles Gibson of ABC News said (see Post #5) “… people will drive miles just to save a couple of pennies a gallon.” They may drive twice as far to save 5 ¢/g at your station — and visit your nice convenience store when they arrive.

Next … Options to Protect your Virtual Storage

6) The Money Margin

Part 2: Making Money

As discussed in Part 1 (Post #4), fuel gross margin must exceed 10 ¢/g for a retailer to profit on fuel sales. Given that, history shows retailers actually lose money on gasoline sales 25% of the time (see the cumulative frequency line on the chart). Weak and unprofitable margins are likely to continue given increased competition and other market pressures.

Fuel retailers leave themselves at the mercy of the market for fuel margins. They react to the most volatile component of fuel cost (i.e. the rack price), their own sales volumes, and what the competition is doing. Is that any way to run a business? Retailers try to make up for low fuel margins with high margin C-store sales. But that “strategy” just masks the problem; it doesn’t solve it. Is the primary business of gas stations to sell gas or store items? Is the reason most people stop at gas stations to get gas or something in the store?

How can retailers directly solve the problem of low fuel margins; i.e. how do they make money on the money margin? As discussed in Post #1, retailers need to be proactive about their fuel margins. Essentially, that just means retailers need to control their rack prices. The easiest and most effective way to control rack prices is to control futures. Remember from Post #2, futures prices set spot prices that, in turn, set rack prices –

Futures prices à Spot prices à Rack prices

Returning to the equation for fuel gross margin:

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

If the Futures price is locked or limited, the retailer controls the most volatile and heaviest potential drag on fuel margins. The futures price may be locked with futures contracts or commodity funds (see Post #3); it may be limited with futures or commodity fund call options. On balance, locking the futures price with a commodity fund (UGA for gasoline, UHN for diesel fuel) is the simplest and most economic choice (e.g. 6 shares of UGA is equivalent to 100 gallons of gasoline futures). A commodity fund may be held indefinitely (like a stock) without the need for “rolling” the position like a futures contract. The fuel retailer may then easily hold the commodity fund until an advantageous time to sell. (More on that “advantageous time” in Post #9.)

The Basis is an important component but less volatile and less of a potential drag on fuel margins. For example, since 2005, the Basis for U.S. gasoline has averaged 4.1 ¢/g with a standard deviation of 8.2 ¢/g. Over the same period, gasoline futures have averaged 195.2 ¢/g with a standard deviation of 56.3 ¢/g.

The Rack/Spot differential is a relatively stable and predictable 1 to 3 ¢/g. It reflects the cost of moving product from spot locations to rack locations, plus the cost of operating a rack.

Transportation is the cost of trucking product from a rack to a retail station. It is also stable and predictable and averages 2 ¢/g.

Lastly, Taxes are a combination of federal and state taxes and are stable enough (though too high!). Taxes by state and product are shown here http://www.api.org/statistics/fueltaxes/.

What’s the bottom line? Control futures and you control the money margin. Control the money margin and you make money selling fuel – consistently and predictably. Even better, control futures and you may increase sales and customer loyalty, and achieve other benefits. That’s called a Fuel Price Protection Program.

Next …
The Roads to Higher Margins: Fuel Card or Storage

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.