Counting Chickens and Other Operational Forecasting Risks

Fast moving information is unremitting in the downstream refined fuels industry, a complicated business where price is just one component in an ocean of data critical for real-time operations. Artificial Intelligence is now being deployed in the industry that will increasingly require laser-like focus on efficiencies to capture margin.

But AI is only as good as the data it processes.

AI has different meanings, with algorithms commonly used in trading futures and options contracts in the energy complex an early and simpler form of applying machine learning. Humans are at a distinct disadvantage when trading in real-time in response to known events, such as an announcement by the Federal Open Market Committee of their decision on the federal funds rate. Energy Information Administration’s Weekly Natural Gas Storage Report published on Thursdays is another illustration of the challenge for human traders where they just can’t compete in speed against algorithmic trading. Let the dust settle, look for an overbought or oversold market frequently accompanying algorithmic trading, and make your trade.

It’s more than just speed, with algorithms designed to uncover market anomalies that afford greater profits and to then pounce with a trade. Or to quickly identify a change in trend. All signs show algorithmic trading will continue to expand, capturing an increasing share of the daily trade volume for futures and options in crude oil and refined products, and along with it, greater price volatility.

Gasoline marketers need to hedge risk in this environment, timing their financial trades with transactions in the physical market. Both buyer and seller encounter an identical backdrop even as their intent in the physical market is opposing, which is, of course, the reason for the relationship. Still, the party with better information might eke out more margin.

Fuel contracts negotiated in the physical market are tailored to varying distinctions such as location, product quality, volume, and timing, so don’t have the fungibility of futures contracts, at times blurring market visibility. Gasoline and diesel fuel spot values increase clarity, reflecting trades in bulk wholesale markets with fungible characteristics in real-time, namely on common carrier pipelines. Trade size on key pipelines is 25,000 bbl, with trades conducted in a basis value against the RBOB and ULSD futures contracts on the New York Mercantile Exchange. The spot value then floats with the more heavily traded futures contract through the trading session.

This relationship diminishes the risk of broader market influences on cash price since it’s captured by the futures contract, while the basis value trades at either a premium or discount to the futures contract, adjusting to the supply-demand disposition in the spot market’s regional geography.

Likewise, a negotiated fuel contract is frequently indexed to a spot price assessed by a price reporting agency. Hereto, the transaction might include a premium or discount against the assessment that finetunes the price paid and received to capture the uniqueness of the market. Against this market structure, parties negotiate terms to transfer fuel from seller to buyer, and a transaction occurs.

Spot markets are price setting markets, with the spot value a cash market price for fuel that is available for immediate delivery. Suppliers use spot price assessments to guide their decisions on where to set their posted price at a distribution terminal for the following day, sometimes the same day when markets are volatile. A buyer uses the spot market to guide decisions on when to dispatch trucks to lift supply, sometimes delaying a lifting to the following day if the spot price is falling sharply knowing the next day’s rack posting will be lower.

Both seller and buyer have a limited time window when transacting to sell or buy fuel for the same or following day. Most transactions are structured so fuel is delivered over a specified timeframe. To be successful in these transactions, you must have real-time data. Rack and spot market data are critical, as is knowing your supply position. Selling or buying fuel for immediate delivery serves multiple purposes, sometimes allowing a supplier to capture greater margin if the market is in short supply. A buyer might look for a bargain if they know the market is well supplied. Fuel transactions for immediate delivery help clear the market, while offering valuable market information for all buyers and sellers.

Just like futures, spot prices can be extremely volatile, and might unearth a profit opportunity. A selloff could provide an opening to buy more fuel and hold in storage, while a supplier can raise his or her offer price in a rallying market to fatten margin.

In either instance, not knowing your inventory position could lead to a costly mistake. Consider a supplier with ratable customers that oversells his or her supply at the terminal that leads to a fuel runout, and angry customers unable to lift. Or a buyer committed to a purchase, yet unable to pick up the load because his or her driver’s certification to lift from the terminal has expired.

In an extreme case, the May 2020 West Texas Intermediate futures contract on NYMEX went negative on April 20, 2020, trading at a minus $40.32 bbl, and settling the session at minus $37.63 bbl because some buyers did not properly understand the logistics of the trade. Following a six-week market share war between Saudi Arabia and Russia that exacerbated a global surplus in oil, demand was crushed by government lockdowns in response to the COVID pandemic. This led to a super contango, with the WTI futures contract nearest delivery trading at a steep discount to deferred delivered futures contracts. A buyer of the nearest delivered contract could profit by simply rolling the contract forward into the following month.

A feature of the WTI contract (and also the RBOB and ULSD contracts) is having an underlying physical delivery location that requires the delivery of the commodity if the futures contract is held to expiration. RBOB and ULSD futures delivery locations are located at approved terminals in the New York Harbor, and WTI futures at the tank farm in Cushing, Oklahoma. Most contracts are financially settled, avoiding the delivery requirement. The May 2020 WTI futures contract was scheduled to expire on April 21, 2020, yet those still holding the futures contract on April 20, 2020, struggled to sell out of the position, meaning they would need to take delivery of 1,000 bbl of WTI specified crude oil from Cushing per futures contract.

These contract holders had no capacity to take ownership of the crude oil, while storage tanks at Cushing were nearly full. They sold at a steep loss. While infrequent, oil prices, as well as electricity and natural gas prices can turn negative if there’s no place to park the commodity.

Commerce in the downstream fuel industry is exceptionally competitive. Situational awareness is critical, and the only way to improve operational efficiencies. If an organization does not have real-time data and an accurate analysis of their markets, they will, at best, leave money on the table. Organizations will also struggle to take advantage of opportunities if they lack real-time market visibility or fail to recognize their pain points. Agility is vital, and not only to capture a market opportunity, but to solve problems that inevitably crop up in a business with so many moving parts.

Blending data from multiple sources is yet another dynamic that organizations must consider in improving their market position. How is weather data integrated into fuel buying and selling decisions? Major weather events can certainly have a big short-term impact on operations, but what about more nuanced weather such as a rainstorm during commuting hours that shifts the consumption pattern?

Increased awareness across your business ecosystem can only add value. Catalog your operational intelligence capabilities and fill the gaps with the data you need in an industry quickly moving towards digitization.

Consider the four questions Ray Dalio, founder of Bridgewater Associates, asks when investing:

• What do I truly know?
• What don’t I know?
• What do I need to know?
• How do I learn what I need to know?

Founded in 1975, Bridgewater Associates has posted the second highest gains of any hedge fund since its inception.

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About the author

Brian L. Milne

Brian L. Milne is a 28-year veteran of the energy industry, and served in multiple roles at DTN, including editor and analyst. Milne delivered dozens of presentations on a wide range of topics discussing the energy markets and has been quoted widely in the media, including the Wall Street Journal, Barron’s, USA Today, Newsweek, CNN, National Public Radio, and major regional news outlets. He has authored numerous articles for international magazines, exploring market dynamics and providing forward-thinking commentary and analysis. Milne graduated from Monmouth University in New Jersey with a Bachelor of Arts in history and an interdisciplinary in political science (magna cum laude).