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

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”.