Everything You Wanted To Know About Heating Oil Hedging

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september 2014 /

There are about two million rental units in New York City, with the vacancy rate currently hovering around 2.6% (in 2010 it was 3.7%). One of the most significant challenges facing owners of those rental units is managing their energy costs.

According to my research, probably any multi-family construction built within the past ten years or so is heated by natural gas, but conversion to natural gas depends on several factors: for example, not every street in NYC has access to natural gas. Another reason many prefer oil us that until recently and due to the shale gas boom in Texas, North Dakota, and Canada, heating oil was usually cheaper than natural gas. On a macro level, energy prices are falling, with natural gas futures touching six-month lows on July 10th, 2014. Similarly, many large apartment buildings in NYC are dual fuel; that is, they can burn either oil or gas. But natural gas generally prevails over oil because there is nobody needed for delivery of the natural gas and no fuel tanks are required for storage. This convenience factor is an important consideration. And as the federal government puts more and more pressure on electric power plants and utilities to phase out coal in favor of natural gas, this is also going to create a huge incremental demand for natural gas.

September, Everything You Wanted to Know

By way of background, when I was devising hedge programs for real estate owners/operators, approximately 15,000 buildings in NYC were burning what was acknowledged to be the cheapest, heaviest, and dirtiest forms of heating oil known as No. 6 and No. 4 heating oil. Then, under a 2011 city law, No. 6 was banned completely, effective as of July 1, 2015, and by 2030 all buildings in the city are mandated to use cleaner fuels, namely No. 2 oil or natural gas.

However, based on the bitter experience of the aforementioned building owners, converting a building’s boiler to a lighter oil can run between $50,000 or higher and switching to natural gas can cost upwards of several hundreds of thousands of dollars. Significantly, buildings that burn No. 6 after the 2015 deadline could be forced by the city to convert. This is because the heavier heating oils, No. 6 and No. 4, probably contain sulfur and nickel, which don’t burn completely and enter the atmosphere as soot, which could lead to respiratory illness.

Lastly, sufficient natural gas supplies may not exist in some parts of the city, forcing some landlords who want to switch to natural gas to switch to No. 4 oil instead. Statistically, Consolidated Edison has switched 1400 hi-rises from heating oil to natural gas but Con Ed’s own plan to expand its natural gas network won’t even be completed until 2020 at the earliest.

So where does all of this leave you? Trying to sensibly manage your energy costs. Based on the above analysis, you will still be dealing with heating oil in the foreseeable future. One solution is the use of futures contracts. A futures contract for heating oil obligates the buyer of the contract to buy the underlying heating oil a the price at which he/she bought the futures contract, and obligates the seller of the contract to sell the underlying heating oil at the price at which he/she sold the futures contract.

For example, No. 2 heating oil futures contracts are traded on the New York Mercantile Exchange (NYMEX). You, Mr. Building Owner, want to ensure that your fuel costs do not exceed your budgeted fuel price so you want to fix the price of your anticipated fuel consumption which, for argument’s sake, is 42,000 gallons of fuel oil slated for October of this year. To hedge your exposure, you purchase one October No. 2 oil futures contract. Come September 28th, the expiration date of the No. 2 Oil futures contract, you sell back the futures contract at the then prevailing market price. If the futures price at that point is greater than when you originally bought it, the gain on the sale will offset the increased cost (over your budgeted cost) you pay when you actually purchase the 42,000 gallons from your regular suppliers. The reverse is true if the futures contract is sold for less than what you paid for it: the loss is offset by the reduced price by your paying less for the 42,000 gallons from your regular suppliers.

This example indicates that purchasing a heating oil contract provides you with the capability to fix your anticipated heating oil cost for a specific period, no matter what the heating oil futures price does between the time you purchase it and when the futures contract expires. The takeaway is you purchase a futures contract on heating oil to hedge your exposure to potentially rising fuel prices; and if you need to hedge your exposure to falling fuel prices, you can do so by selling a futures contract.

 


Ron Spurga
United Metro Energy Corporation
P: 718-383-1400
C: 347-406-1389
ron@umecny.com
 

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Ron Spurga By Ron Spurga

Ron Spurga

Ron Spurga

Best-selling financial author, Wall Street investment banker, social commentator, award-winning poet, energy consultant, off-Broadway producer, and community organizer in Robert Kennedy’s presidential campaign, Ron Spurga is the ultimate Renaissance Man.

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