Silicon Productions

How to hedge residential propane prices.

As of January 2009, crude oil prices are low relative to where they were in September 2008

If you're concerned about propane rising in price again you have the opportunity to hedge the price of propane while the prices are low.

Propane seems to track crude oil prices (more or less), which makes sense, so if you buy 'oil' in advance then you can sell 'oil' later at a profit and that profit will offset the price you will be paying for propane in the future.

To buy and sell 'oil' you can buy and sell the Exchange Traded Fund called USO

USO uses crude oil futures to set a price for a USO 'share'. Using the USO ETF takes all the stress out of hedging the crude oil commodity

Here is my formula. It fits the historical data. Provided the relationship between crude oil and propane and the fuel tax situation remain the same, then I expect the formula to hold.

Residential cost of propane per gallon = price of crude(in dollars)/40 + 75cents

Here's a table of crude oil price and expected price of propane per gallon

Oil ($ per barrel) Expected retail propane ($ per gallon)

20__________________1.25

40__________________1.75

60__________________2.25

90__________________3.00

120_________________3.75

180_________________5.25

The price of USO is not the price of crude oil. The formula that looks right for USO to crude oil price per barrel is :

price of oil($ per barrel) * 0.70 = price of USO

So, if oil is $37 per barrel the USO should be 37 * 0.70 = $25.9 per share

How many USO shares do you buy?

Let's say you use 1000 gallons of propane per year. You will be paying this much money :

crude oil price/40 * 1000 + 0.75 * 1000 dollars for the whole tank

(Note that regardless of the price of oil you will be always be paying that 75 cents per gallon for every tank.)

Now, let's say that the price of oil is $34 per barrel when you decide to take out your hedge position. Then you must spend :

34/40 * 1000 dollars (that's $850) for every tank you want to hedge into the future

$850 will be 850 / (34 * 0.70) = 36 shares of the USO ETF

If you wanted to hedge 10 years worth of propane then you need to buy 360 shares of USO

When your tank is empty and you need to buy your 1000 gals of propane. You pay the retail price for the propane to the supplier (you dont have much choice!) but then you go and sell 36 shares of USO. The profit you make on the USO shares should offset the difference in the price of propane compared with when you hedged it (when the price of oil was $34 in this example).

Note : the number of USO shares you buy is dependent ONLY on the number of gallons of propane you need to hedge. It is not dependent on the price of oil or the price of the USO stock. If your tank holds X gallons, the number of USO shares you need to buy is X/28

To see where the 28 number comes from, using the above example : (34/40 * X) / (34 * 0.7) where X is 1000 in the example, = X/28

Using the 1000 gallon tank example above, the number of USO stocks to buy is : 1000/28 = 36 (approx)

OK, full example : (I'm writing this in Jan 2009. The oil prices below are just guesses/examples)

Date : Feb 2009, your tank size 750 gallons, price of oil $33 per barrel (whoohoo!)

Calculated : estimated price of residential propane at this $33/barrel oil is 33/40 + 0.75 = $1.58 per gallon. Happy with that price for the next 10 years? Good:)

Go to your brokerage account and buy : 750gallons/28 * 10 years = 268 shares of USO (lets buy 270 USO shares). The price of USO shares will be $23.10 each

Time passes, the economic situation improves, oil goes up...

Date : Oct 2009, price of oil = $55/barrel, propane will be 55/40+0.75 = $2.13per gallon

Buy your 750 gallons at $2.13/gal = $1598

Sell 27 shares of USO (27 is one tenth of the 270 USO shares you bought)

The price of USO will be 55 * 0.7 = $38.50 per share

The profit you make on the USO shares is 38.50 - 23.10 = 17.87 * 27shares = $415.80

Therefore the net price you paid for your 750 gallons of propane is 1598 - 415.08 = $1182.20

This $1182.20 is approximately the price of your 750 gallons at $1.58 per gallon ($1185)

Date : Oct 2011, price of oil $160/barrel (!)

Buy your 750 gallons at 160/40 + 0.75 ($4.75/gallon) = $3562.50

Sell another 27 shares of USO (price will be 160 * 0.7 = $112)

Your gain from the USO shares = 112 - 23.10(your buy price) * 27shares = $2400.30

So your net price you pay for 750 gallons is 3562.50 - 2400.30 = $1162.20

$1162.20 is approximately your hedged price for 750 gallons

Warning, warning : you will probably be paying capital gains tax on your gains on the sale of USO stocks. I have not taken this into account for these calculations.

In the graph above the purple line (adjusted price of oil) is mapped to propane using my formula (oil price/40 + 0.75) * 100 (in cents/gal)

Also, USO (yellow) is adjusted to map on to the price of oil using my 0.7 multiplier

mike

As of January 2009, crude oil prices are low relative to where they were in September 2008

If you're concerned about propane rising in price again you have the opportunity to hedge the price of propane while the prices are low.

Propane seems to track crude oil prices (more or less), which makes sense, so if you buy 'oil' in advance then you can sell 'oil' later at a profit and that profit will offset the price you will be paying for propane in the future.

To buy and sell 'oil' you can buy and sell the Exchange Traded Fund called USO

USO uses crude oil futures to set a price for a USO 'share'. Using the USO ETF takes all the stress out of hedging the crude oil commodity

Here is my formula. It fits the historical data. Provided the relationship between crude oil and propane and the fuel tax situation remain the same, then I expect the formula to hold.

Residential cost of propane per gallon = price of crude(in dollars)/40 + 75cents

Here's a table of crude oil price and expected price of propane per gallon

Oil ($ per barrel) Expected retail propane ($ per gallon)

20__________________1.25

40__________________1.75

60__________________2.25

90__________________3.00

120_________________3.75

180_________________5.25

The price of USO is not the price of crude oil. The formula that looks right for USO to crude oil price per barrel is :

price of oil($ per barrel) * 0.70 = price of USO

So, if oil is $37 per barrel the USO should be 37 * 0.70 = $25.9 per share

How many USO shares do you buy?

Let's say you use 1000 gallons of propane per year. You will be paying this much money :

crude oil price/40 * 1000 + 0.75 * 1000 dollars for the whole tank

(Note that regardless of the price of oil you will be always be paying that 75 cents per gallon for every tank.)

Now, let's say that the price of oil is $34 per barrel when you decide to take out your hedge position. Then you must spend :

34/40 * 1000 dollars (that's $850) for every tank you want to hedge into the future

$850 will be 850 / (34 * 0.70) = 36 shares of the USO ETF

If you wanted to hedge 10 years worth of propane then you need to buy 360 shares of USO

When your tank is empty and you need to buy your 1000 gals of propane. You pay the retail price for the propane to the supplier (you dont have much choice!) but then you go and sell 36 shares of USO. The profit you make on the USO shares should offset the difference in the price of propane compared with when you hedged it (when the price of oil was $34 in this example).

Note : the number of USO shares you buy is dependent ONLY on the number of gallons of propane you need to hedge. It is not dependent on the price of oil or the price of the USO stock. If your tank holds X gallons, the number of USO shares you need to buy is X/28

To see where the 28 number comes from, using the above example : (34/40 * X) / (34 * 0.7) where X is 1000 in the example, = X/28

Using the 1000 gallon tank example above, the number of USO stocks to buy is : 1000/28 = 36 (approx)

OK, full example : (I'm writing this in Jan 2009. The oil prices below are just guesses/examples)

Date : Feb 2009, your tank size 750 gallons, price of oil $33 per barrel (whoohoo!)

Calculated : estimated price of residential propane at this $33/barrel oil is 33/40 + 0.75 = $1.58 per gallon. Happy with that price for the next 10 years? Good:)

Go to your brokerage account and buy : 750gallons/28 * 10 years = 268 shares of USO (lets buy 270 USO shares). The price of USO shares will be $23.10 each

Time passes, the economic situation improves, oil goes up...

Date : Oct 2009, price of oil = $55/barrel, propane will be 55/40+0.75 = $2.13per gallon

Buy your 750 gallons at $2.13/gal = $1598

Sell 27 shares of USO (27 is one tenth of the 270 USO shares you bought)

The price of USO will be 55 * 0.7 = $38.50 per share

The profit you make on the USO shares is 38.50 - 23.10 = 17.87 * 27shares = $415.80

Therefore the net price you paid for your 750 gallons of propane is 1598 - 415.08 = $1182.20

This $1182.20 is approximately the price of your 750 gallons at $1.58 per gallon ($1185)

Date : Oct 2011, price of oil $160/barrel (!)

Buy your 750 gallons at 160/40 + 0.75 ($4.75/gallon) = $3562.50

Sell another 27 shares of USO (price will be 160 * 0.7 = $112)

Your gain from the USO shares = 112 - 23.10(your buy price) * 27shares = $2400.30

So your net price you pay for 750 gallons is 3562.50 - 2400.30 = $1162.20

$1162.20 is approximately your hedged price for 750 gallons

Warning, warning : you will probably be paying capital gains tax on your gains on the sale of USO stocks. I have not taken this into account for these calculations.

In the graph above the purple line (adjusted price of oil) is mapped to propane using my formula (oil price/40 + 0.75) * 100 (in cents/gal)

Also, USO (yellow) is adjusted to map on to the price of oil using my 0.7 multiplier

mike