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

5) The Truth About Margins

On July 24, 2009, ABC’s 20/20 aired a special program titled “Over a Barrel: The Truth About Oil“.  You may download and watch the segment of the program dealing with gasoline stations and margins here or here.

In the context of retail gasoline margins, some notable quotes from the program:

“The average retailer makes 10 cents or less on a gallon of gasoline. There’s a better profit margin in convenience stores.”  Sal, station owner

“That corner gasoline station has never been able to make a profit on gasoline.”  Sal, station owner

“Intense competition among local gas stations is what keeps profit margins on gasoline low.  After all, people will drive miles just to save a couple of pennies a gallon.”  Charles Gibson, ABC News

“It is time for smart, entrepreneurial, and customer-friendly retailers to utilize the tools available to them (see Posts 2 & 3 below) to improve their profit margins on gasoline and diesel fuel while saving people more than a couple of pennies a gallon“  Tom Langan, WTL Trading