Currently the United States produces 10.9 million barrels per day of crude and other liquid hydrocarbons. That may seem like a remarkable amount but when Americans consume over 18 million barrels per day it falls short of domestic autonomy from foreign oil. However, with the discovery of new shale plays, the U.S. has the potential to become the world’s leader in oil production. As these finds will change the energy business, we felt that a short refresher will help you in your future decisions.
 
The Utica Shale Play
The Utica Shale was discovered recently by the U.S. Geological Survey (USGS) and although it ranks third in size when compared to the Marcellus Shale in the eastern United States and the Green River Formation found in Colorado, Wyoming, and Utah, the Utica Shale is estimated to have larger reserves of natural gas, oil, and other natural gas liquids. In fact, the USGS estimates the Utica Shale contains close to 38 trillion cubic feet of natural gas, 940 million barrels of crude oil, and nine million barrels of gases such as ethane and propane. However its size isn’t the only thing driving up speculation regarding the U.S.’s potential of becoming the leader in oil production.
 
What is special about the Utica Shale?
The Utica Shale is unique because of its location to the surface. Although the Utica Shale is located directly under the Marcellus Shale which sits at approximately 5000 feet below the earth’s surface, in areas such as New York and Ohio, deposits are found at a mere 2000 feet below the surface. This means lower drilling and production costs which has a major impact on the United States ability to produce more oil.  In addition, the quality of some test wells suggest that the crude oil products will be a premium light sweet crude.

What is the U.S. overall potential?
The U.S. has five other Shale Plays aside from Marcellus and Utica. They are: The Bakken Formation, Barnett Shale,  Eagle Ford Shale, Haynesville Shale, and Niobrara Shale. 
The Bakken Shale extends from eastern Montana into western North Dakota. It is estimated to have 3.65 billion barrels of oil, 1.85 trillion cubic feet of dissolved natural gas, and 148 million barrels of natural gas liquids.

[Source: Geology.com]

The Barnett Shale, located in northeast Texas has been a major source of oil production for over 50 years and until recently was thought to be tapped out. However over the last few years, the Barnett Shale has produced more natural gas than any other shale play in Texas. It produces 1.5 billion cubic feet per day of natural gas and is expected to increase over the next decade as more wells are being drilled.

[Source: Geology.com]






The Eagle Ford Shale, located in southern Texas, produces both natural gas and oil. A 2012 report from the USGS estimates that there is a mean average of 1 billion barrels of oil, 52 trillion cubic feet of gas, and 2 million barrels of natural gas liquids undeveloped but recoverable from the Eagle Ford Shale.

Centered on the borders of Louisiana, Arkansas, and Texas is the Haynesville Shale. Until the Marcellus Shale was discovered, Haynesville Shale was deemed the fourth largest reservoir in the world with an estimated 160 trillion cubic feet of natural gas. The only downside to the Haynesville Shale is that deposits are found at 22,000 feet below the surface making drilling a costly venture.

[Source: Geology.com]

The Niobrara Shale extends through five states; Colorado, Wyoming, Montana, South Dakota, and Nebraska. At one point Niobrara was being compared to the Bakken Formation in regards to its undeveloped resources. The Niobrara consists of three major basins; North Park, Powder River, and Denver-Julesberg (D. J. Basin). USGS estimates for just the Powder River basin include 16.5 trillion cubic feet of gas, 1.5 billion barrels of oil, and 86.5 million barrels of natural gas liquids.

[Source: OilShaleGas.com]

Location, location, location. 
Many of these new reserves are not in the traditional location of earlier oil and gas reserves.  The midstream infrastructure will change significantly as these resources are developed.  Just some examples are the plans to change direction in the product flow of Enterprise's Seaway crude oil and TEPCO propane pipelines. Other significant projects to tap into these new locations will come on line in the next two to ten years.  The Utica Shale is perhaps the most interesting as it is very close to the highly populated Northeast Corridor.

Can the U.S. Compete with Saudi Arabia?
The United States is sitting on close to 200,000 trillion feet of undiscovered gas, over 1,000 billion barrels of oil, and close to 2500 million barrels of natural gas liquids. So why is Saudi Arabia currently the world's leader in oil production?  It's in the cost of production. The cost of drilling is far cheaper in Saudi Arabia than the cost of drilling domestically in the United States. This begs the question whether the United States can supplant Saudi Arabia and become the leader in oil production. But the recent Shale discoveries, especially the Utica Shale discovery puts the United states closer to that goal and even closer to domestic autonomy from foreign oil. 

What does this mean?
The benefits for the U.S. will be significant. Some economically depressed areas of the country will become affluent. Cheaper energy will drive down costs in every business and household budget. The country's economy will have a greatly reduced balance of payments deficit. And most importantly, there will be many unanticipated business opportunities in the changing energy landscape. 

Sources: 
Geology.com: Utica Shale - The Natural Gas Giant Below the Marcellus
CBS Money Watch: U.S. May Soon Become World's Top Oil Producer
Investment U: The Utica Shale: Get Ready For a Spout of Potential Gains
USGS.gov: Assessment of Undiscovered Oil.....

What does this mean for your business?

We have many tools to help you evaluate this trend in the petroleum markets as it applies to your business opportunities.
 
Here are but a few of our tools:
  1. Mergers and Acquisitions
  2. Succession Planning
  3. Growth Initiatives
  4. Restructuring, Turnaround, and Business Process Improvement
  5. Finance and Development of Emerging Businesses and Industries.

Call or email one of our team:
Sean Cota:
Industry champion… Chief, cook, bottle washer! Sean has more than 34 years of experience in the retail fuels industry, serving as President of his family businesses in VT and NH until 2011.  Sean is resident in our Washington, DC and Bellows Falls, VT Offices.
email: [email protected]
Phone: 802-380-1571

Bill Overbay:
Conductor…Mediator…and Referee! Bill has over 15 years of corporate financial experience ranging from venture backed start-ups. Bill is resident in our Providence, RI office.
email: [email protected]
Phone: 401-286-4883

As reported in the Boston Globe on New Year's Day, Brown’s Oil and Air Conditioning of Needham, MA, was acquired by MacFarlane Energy in Dedham, MA.  Their story tells an important lesson for retail heating fuel marketers in the Northeast.

Brown’s Oil has suffered what the heating oil, and to a lesser degree the propane gas business has experienced in recent years.   The heating oil market in certain regions has been suffering an accelerating loss of gallons, and customers.  Brown’s Oil is typical of the Northeast urban and suburban heating oil marketer.   This decline is due to high commodity prices, poor weather, customer conservation, natural gas distribution pipeline expansion, structurally constrained low natural gas prices, and tough bank lending restrictions. These factors have nothing to do with the excellent talent and tenacity of the heating oil marketer.  For marketers outside of the natural gas marketing regions, keep an eye on the family businesses who compete there.  These companies will feel the impact first and worst.

A Changing Energy Market in the Northeast:The decline in market share is evident in the U.S. census data.  I've attached some charts on household change in energy sourcing for the last 5 year ending in 2011.  Even without seeing 2012 numbers, these changes are illustrative.  

According to the New Year's Day, 2013 Boston Globe article, "decade ago more than 40% of homes where heated by oil, that number has dropped to 31.8%." This translates to a loss of 1/4 of the entire Massachusetts market in 10 years. Consumer conservation has dragged fuel sales even further. Massachusetts has lost 350 million gallons in sales.  Despite these losses, there still exists roughly the same number of retailers in this market. The market capacity demand just for Massachusetts would suggest there should be several hundred fewer marketers operating there.

STRATEGIES FOR SUCCESS BY CHANGING YOUR BUSINESS:Here are just some of the strategies you MUST implement to succeed over the long run. Many of these strategies will take the next three to ten years for the payback to justify their effort.  If you are not willing to go all out, then get out.

•    Increase Margins!  As product prices increase, and sales decline, both for reasons out of your control, you must increase your margins to help make up for the total lost gross profit.
•    Markup on a Percentage!  Heating oil marketers are one of the very few industries who don't.  In the late 1940's my Grandfather bought number 2 heating oil for 8¢ per gallon and sold it at 12¢!  Using that same percentage markup today, you would be selling heating oil around $4.80 a gallon.  Look into your past for your appropriate margin.  Look at 2004, which was in general a good year for the industry, and determine your margin as a percentage.  Apply that number to today's costs.  As surprising as it will be, it's where you need to be today.  Don't fight your competition to the bottom.  I've seen many companies who have reduced their margins to increase sales, and the total gross profit declined!
•    Sell More Stuff!  Increase total gross profit by focusing on the value added sales with the least increase in costs. Here are some ideas.  This list is just a start, and remember that all markets have a slightly different need and perception.
    -> Service Contracts.  If it needs to be fixed in the home, offer a service contract to do it.  Always link the program to other purchases the customer can get from you. Introductory rates are okay, but you must link them into long term agreements, as most of the expensive deferred maintenance is done at the beginning of a service contract.  Service contracts also have the cost advantage of smoothing out your labor costs by decoupling the service time from the time it is billed.  It's a lot easier to get a customer to allow you to service their heating equipment during your slow period in the spring, when you tell them that they've already paid for it in their service contract.
    -> Sub-contracted work that relates to your business.  Instead of giving away work that you don't do, you bill the customer for sub-contracted work (and Mark it up!). If you don't do plumbing on a boiler, and your customer needs that work done, you are the general contractor who controls the relationship. Likely your staff will have to coordinate the plumber and your service technician anyway.  Make money while doing it. Other similar items are: chimney cleanings,  chimney linings, air conditioning services, heating system installations, bath and kitchen remodeling. etc. If these sub-contracted services build into larger businesses you would increase margins and reduce costs.
•    Increase your cash-flow without reducing margin.  
    -> Sell budgets to all your accounts and start them in June.  You know what the consumer is going to burn more than they do.  Take the time in this slow time of the year to calculate what their needs will be and auto enroll them into a budget where they have to opt-out to not be on it. People take the path of least resistance.  Remove them from the budget by fall if they've never made a payment.
    -> Avoid fixed price pre-buys.  Although these programs advance your cash-flow, if these are fixed price programs, they are dangerous speculative instruments.  First, they reduce the valued added components of your business to a single dollar per gallon number. Consumers become price conscious. They will chase that one number forgetting all the other great stuff that you do.  Second, the consumer has too many government and legal protections in a volatile market where they can bail on their agreements if the market turns against their position. This happens, and it happens a lot.  The risk is then borne by you.  Option based capped price programs are fine, but make sure the consumer pays for the option cost with a markup.
    -> Make it easier to pay. There are many vendors who provide on line payments.  Many utilize smart phone applications for billing and easy payments from ACH debiting of your customer checking or savings accounts. You get paid electronically without credit card companies like Amex getting a 3% ($.10/gallon +) vig.  It's easier for the consumer, and easier for your staff.  
    -> Don't just give away cash discounts.  Turn this electronic prompt payment into a customer points system to sell them some of your new services they have not yet used at a reduced rate.  
•     Act on business expansion.  For increased gross profits and top line growth, be prepared to deploy and leverage your capital to expand your business.
    -> Acquire competitors. With volumetric declines, there are too many competitors.  Customers if handled properly tend to stay with the business they have been with.  These companies are worth buying, and in general it is far cheaper and takes less effort than to plan elaborate and expensive marketing campaigns to get customers.       
    -> Add capital intensive business lines with higher margin.  Things like propane gas, LNG, CNG, and natural gas retailing.  These are big dollar items that will drive you out of business even faster if they are pursued under capitalized.  These expansions need a plan that includes a return on the capital investment in addition to an increased gross margin over the items that you currently sell.
•    Get rid of assets you don't need.  Sell off unrelated businesses if they are not adding to your total gross profit. Sell the extra trucks, but sell them out of the region or convert them to a different use before you sell them as they may reemerge as a new competitor. Sell your unproductive real estate. Sell parts of the business that are under performing and you don't have the resources to fix.  I'd say sell the boat or the vacation house too, but you are all likely so stressed out, that you'll need to get away.

MODEST CHANGE STRATEGIES END IN FAILURE:
I've seen many companies fail or destroy years of their retained earnings by half-hearted attempts at change. This reminds me of the Pearl Jam song, Elderly Woman Behind the Counter in a Small Town: "So I changed by not changing at all, small town predicts my fate."  A lack of significant effort in making a hard turn in your business direction when the world is changing around you, leaves your business in the worst position.

I've seen many examples of halfhearted efforts that leave you worse off.  Here are a few:  
    -> Entering into the propane business with only a truck and making the customers buy the tanks, only depletes your resources while not producing long term margin improvement.
    -> Bait and switch marketing techniques like offering the first delivery sold under cost.  This leaves the customer with the expectation that they should always get a special deal or they will change. (Oddly enough electric heat's recent growth is from the customer perceptions that they were getting the same rate as everyone else and hadn't missed out on a deal that they neighbor had received.)
    -> Cutting customer service.  The customer is with you because you know the details of their home.  If they are just a number, then they might as well be with a utility.
    -> Converting your service department into sub or independent contractors.  Yes, service techs require hand-holding, but they sell you to the customer.  If they are working for themselves, they'll sell utility programs to your customers in order to get the conversion kickbacks.
    -> Laying off long term employees with the hope you will get them back seasonally.  You will likely not get them back.  If you do, your business is no longer their focus. If they don't return you'll spend an entire season training their replacements.
    -> Increasing cash discounts to advance cash-flow.  You undermine your overall profits.  Your customers will perceive your company like a discount oil company only you charge a lot more.
    -> Selling unhedged prebuys for cash-flow today, hoping the market will decline enough to lock in your position later. This is like playing the lotto.  There are a lot more losers than winners, and heaven forbid your bank finds out.
    -> Cutting membership in the trade associations and not going to their meetings.  This is where you will find either the new ideas that will save and grow your business, or the competitor who may later be a potential buyer.

GO BIG OR GO HOME.

The energy market is changing, and for most heating oil companies, not in a good way.   Each day without a new business model means a day that your business is worth less. A value you placed on the business 5 years ago is discounted today.  There are few buyers, and they need to be cultivated to have an interest in your exit.  The family business cycle was described well by Babson College's Ed Marram, as Wonder, Blunder, Thunder, Plunder, Asunder. If you are not willing to double down now for a longer term payout, then you must seriously consider selling your business, and utilize that capital to do something else.  Plundering your asset to get the value out now, may avoid the final stage of going Asunder.

Scott MacFarlane in his business has done most of these strategic changes, and more.  They are set for great success in a difficult market.  Are you and your business ready for this change??

For the full article please click here, "Fuel Oil Industry Feeling the Heat"
What does this mean for your business?

We have many tools to help you evaluate this trend in the retail petroleum markets as it applies to your business opportunities.
 
Here are but a few of our tools:
  1. Mergers and Acquisitions
  2. Succession Planning
  3. Growth Initiatives
  4. Restructuring, Turnaround, and Business Process Improvement

Call or email one of our team:
Sean Cota:
Industry champion… Chief, cook, bottle washer! Sean has more than 34 years of experience in the retail fuels industry, serving as President of his family businesses in VT and NH until 2011.  Sean is resident in our Washington, DC and Bellows Falls, VT Offices.
email: [email protected]
Phone: 802-380-1571

Bill Overbay:
Conductor…Mediator…and Referee! Bill has over 15 years of corporate financial experience ranging from venture backed start-ups. Bill is resident in our Providence, RI office.
email: [email protected]
Phone: 401-286-4883

In my many years of observing the changing landscape of energy, I was often confused by what was being said about energy and what was fact.   While I studied science in the metric system, the world of American energy was in "United States Customary Units".  e.g. BTU's, U.S. Gallons, PSI, Horsepower, CCF (100 Cubic Feet), MCF, etc. In the years before the internet, I needed a way of referrencing and converting energy by knowing the specifications of each energy source. In the link below you will find this set of data that I've been accumulating over the years.  I hope you find the spreadsheet useful. 

This listing although, not complete, does have the most common units.

Will heating oil distillate inventory supplies follow the potential shortages of propane?

Today Consumer Energy Report's, Robert Rapier, published an analysis of the Energy Information Agency's (EIA) This Week In Petroleum which showed distillate inventories for PADD 1A and 1B are at near record lows.  EIA reported:
"For the week ending October 5, distillate inventories in the U.S. Northeast (PADDs 1A and 1B) were 28.3 million barrels, about 21.5 million barrels (43 percent) below their five-year average level (Figure 1). Distillate inventories have historically been used to meet normal winter heating demand but are also an important source of supply when demand surges as a result of unexpected or extreme cold spells. The low distillate inventories could contribute to heating oil price volatility this winter. In addition, outages at several major refineries, notably Petroleos de Venezuela’s Amuay Refinery, Shell Oil’s Pernis Refinery in the Netherlands, and Irving Oil’s Saint John Refinery in Canada, have added to the fundamental market pressures in the Atlantic Basin."


These factors are combining to create a potential basis blowout if the 2012-2013 winter is normal or colder than normal as is the current forecast.  Heating oil dealers should plan for the potential shortages.  Some solutions for this potential event are:

1. Keep your inventories full as cold weather approaches.
2. Enter into supply agreements with product suppliers for fixed differential contracts.  This will ensure that they have your product available to retailers in a similar way to futures contracts.  This would also reduce the basis impacts for dealers.
3. Time deliveries to your automatic customers to avoid filling tanks at peak January degree days.

For more on this potential basis blowout, see Consumer Energy Report at:

http://www.consumerenergyreport.com/2012/10/15/the-potential-for-a-heating-oil-crisis/
 
 
PGANE reports out its "New England Supply & Transportation Outlook for 2012-2015" at its annual meeting Friday, October 12, 2012.
In response to Lake Rudd and Company's newsletter,"Potential of a Massive Propane Shortage this Winter (2012-2013) May Leave You High and Dry", PGANE's board contracted Bard Black to study the supply logistics of propane for this winter through 2015.  This excellent piece came to many of our same conclusions.  In its executive summary it stated:
"Experience over the past 15 years negotiating the supply chain and logistics challenges of the New England propane market clearly demonstrate that this is a unique, sometimes fragile market, susceptible to frequent periods of interruption.

As new companies enter the retail propane business in New England, understanding the supply and transportation infrastructure and developing their business plan accordingly will in large part determine the success of those new entities.

Many are aware of the short term supply issues and concerns facing the propane industry for the winter of 2012-2013, and those are addressed herein as well as a hard look at the next 3-5 year period. The base case of assumptions was developed in conjunction with marketers, suppliers, and through the analysis of the data contained herein.

There is plenty of work needed to improve efficiencies both upstream and downstream of the retail bulk storage facilities. Suppliers need to improve the supply chain and distribution and logistics leading to the retail bulk storage facilities, and retail marketers need to continue to add additional storage and improve distribution efficiencies to their customers.

Many experienced individuals contributed to this study by sharing crucial information to ensure the best possible result for this study. I have attempted to drill down as far into the supply chain as possible to provide background and detail for the reader. I had a lot of fun sharing ideas and talking with some very savvy propane industry veterans who care about the future of the propane industry while completing this study.

The consensus is that the supply chain, distribution system, and logistics of yesterday and today will be dramatically different in the future requiring diligent attention and a willingness to accept change as the industry moves forward in the decades to come."

This excellent report by the Propane Gas Association of New England is worth its weight in gold to propane marketers.  It is an excellent basis for building a supply strategy for retailers.  If you would like to get a copy of this report, it is available to PGANE members.  Contact President, Joe Rose, at 888-445-1075 or visit their website:

http://www.pgane.org/pgane-membership/
 
Forewarned is for armed.Shortages, and supply dislocations are part our the retail heating fuels business.  It's how you plan, and react to dynamic changes that separates a quality profitable marketer from the rest.
 
You are forewarned.  You have the advantage of reading this newsletter and gaining from our years of experience.  Your mistakes in what could be a record supply disruption event, could be very costly. 
 
If you have concerns that we can help with, give us a call.  Learn from us.
 
-Sean Cota

Lake Rudd Partner, Sean Cota, is proud, yet a little embarrassed by the accolades given by CFTC Commissioner Bart Chilton at ICPA/OHIRI's Annual Conference. Commissioner Chilton's speech was very thought provoking with regard to futures and swap trading which effect the retail fuel industry.  We thought you would benefit from reading what he had to say.


Speeches & Testimony
• “Twists and Turns in Tradium”

Introduction: Two Tents

Aquy (ah-quoy)! Or perhaps, háu, is a better known Native American greeting. Anyháu hi, hello, and good evening. Thanks for that kind introduction. I appreciate the invitation to spend some time with you. Thanks, also, to each of you for your participation in these organizations. As groups, you provide needed voices. Understandably, these organizations take time away from your families and your personal lives.

Spending a career making or helping to make decisions about policy issues, it has been invaluable to have organizations express opinions. You help government be more thoughtful, observant and attentive to what is actually going on in the countryside. So thanks to each of you—really, sincerely, thanks.

I also want to particularly thank Sean Cota who has been of great value to the Commission. He has served in advisory capacities for the Agency, but Sean has been a good sounding board for me, specifically. It is hard to adequately describe the overwhelming information we get from large companies and corporations. Finding smaller companies and individuals who are able to provide us with advice and counsel is rare. When you find a good one, like Sean, you hold onto them like a dog with  a bone. Some days I actually feel like that, a dog getting, and holding onto, information. Other days, of course, I just feel like the tree. Either way, thank you, Sean.

Feeling like one day you are “this” and another day you are “that,” and being here on the Mashantucket Pequot Reservation brings to mind the fellow who visits the psychiatrist. He tells the doctor, “Doc, one day I wake up and feel like a wigwam, and the next day I feel like a teepee.” The Doctor looks to the ceiling and thinks, then leans forward and points his finger at the patient and says, “I know your problem. You’re two tents.” Ugh, I know. My point is, let’s not be too tense. Let’s relax for the next few minutes and have some fun and talk about some policy issues that are front and center.

Alternate Worlds

When one comes to a place like this, a hotel casino, it really sort of transports you to another world, doesn’t it? I’m not sure about that “altering the oxygen” in these places stuff. Maybe that’s an urban, suburban or rural legend or myth. I don’t know. Either way, there is unquestionably a dissimilar feeling, a different vision, vibe and sound, right? We look and sense things a little differently. It is, to some degree, an alternate world. Let me prove my point. In this world, right here and right now, they charge $5 to make an ATM withdrawal. It is a different world. More on bank fees after a bit here.

Another thing, in this world you can actually see some marvelous stuff most of us would never be able to come close to in our daily lives. Take the Hard Rock Cafe with that fabulous memorabilia. This one has Tony Iommi’s guitar. Tony, for those that don’t know, is a founding member of Black Sabbath. In fact, he’s the only constant band member. One of his guitars, a black Gibson SG is right here, in this world, at the Hard Rock. Tony used it at Ozzfest in 1997. It’s fantastic to see. There’s also a Bun E. Carlos, Cheap Trick Ludwig drum kit used on the 1979 Dream Police Tour. This place is another world, and it has one cool back beat soundtrack. “The dream police, they’re coming to arrest me, oh no.”

Tradium

There’s yet another world out there, too. I’m calling it Tradium. Times are rough and tough in Tradium. It seems most folks are in debt. Almost everybody lives on credit. And some of the biggest of the big firms are taking advantage of the Tradi-ites—that’s what they call themselves: Tradi-ites.

The other day in Tradium, what’s today? It was Monday. Monday in Tradium, a foreigner comes to visit. He stops at the Tradium Inn and Suites (formerly Howard’s Hotel—he was bought out by a syndicate) and lays down a $100 bill on the counter. But first, he says, he wants to inspect the rooms in order to pick one in which to spend the night. As soon as the foreigner leaves to do his inspection, Howard snatches the money and sprints next door to the Awful House where Butcher Bob is always having coffee and holding court. Howard pays his debt to Butcher Bob. Then, Bob takes the Benjamin. Oh yeah, in Tradium they call $100 bills “Benjamins,” too—weird, right? Butcher Bob takes the Benjamin and passes it across the table to hog farmer Phil, who dashes off to pay his bill at Freda’s Feed and Fuel. Freda races to the bank and pays her debt. The banker, Sterling, grabs the greenback. What? That’s his name: Sterling. It doesn’t have to be alliteration. That’s his name for crying out loud, and I’m not changing it for your amusement. So, Sterling rushes out the door and down the sidewalk. Looking both ways, he gives the 100 bucks to Vanessa Vixen (there ya go, back in the saddle, again)—Vanessa Vixen. Vanessa is Sterling’s for-hire love interest (not that it is really any of our business, but Tradi-ites know about Vanessa). So, right away Vanessa sheds her heels and hurries down the street as fast as she can (in that skirt—if that’s what you call it) to the Tradium Inn and Suites where, with a wink, she hands the $100 bill over to Howard to pay off her room bill. Howard then places the $100 back on the counter so the foreigner won’t suspect anything. Just then, the foreigner comes back, picks up the cash, and says the Tradium rooms aren’t acceptable. “I liked it better as Howard’s Hotel. You don’t even have in-room coffee! I won’t be staying here,” he says, as he pockets his Benjamin and makes like a tree and leaves.

Hang with me gang: during this entire chain of events, no one produced anything. No one earned anything—money for nothing. Nonetheless, all of Tradium is debt-free, (yay for the Tradi-ites!), and a few even envision a future with great optimism, expectation and anticipation . . . and a generation of kids with cooler names. Does some of that circumstance sound familiar? Is that how some systems in our world actually work?

Unfortunately, that’s not all that is going on in Tradium in these dark days. In this bizarre and inexplicable world, the population has suffered due to some of Tradium’s largest financial corporations. Regardless, the “geniuses” of these very firms have received behemoth bonuses—boatloads of those Benjamins. Many of them have put their needs above all else, even their own customers! Many, far too many, have engaged in fraud and even in market manipulation. Some have been involved in complex cons, others in dubious deceptions, and some in straightforward scams.

The Tradi-ites are getting awfully fed up with these dudes. They’ve had enough—and they’ve called them some not-so-nice names (even worse than Sterling). The Tradium Tribunal has gone so far as to pass some new laws and rules to stop the madness (they call them “traws” and “trules” in Tradium, but I don’t want to get lost in translation). The Tradium judges, or “trudges,” are fining the bad guys and even putting some behind bars at Tradium’s Iron City Correctional Facility. By the way, at Iron City, Tony Iommi and Black Sabbath: very popular. One inmate has a tat of Tony’s black Gibson SG. But, (keep hanging) the entire situation in Tradium is all very sad because nothing, not even putting nogoodniks in the Iron City slammer, has stopped the lunacy. In fact, many businesses and individuals have been devastated. The entire Tradium economy is even in precarious peril.

Regrettably, the circumstances in Tradium aren’t taking place once upon a time in a faraway land. You guys are smart. I bet you could see this coming. You! Nope, the things taking place in Tradium aren’t just “inside of my head,” oh no. They are all too real. They are here. It is, Dum - - - de DUM DUM: now.

The Here and Now

In fact, most of us are becoming numb to all of this, in all of the scandals and corruption. Most people can’t even keep track of all the junk going on in our Tradium-like financial sector.

I won’t get deep into the root causes of the 2008—and counting—economic calamity. I’ve spoken many times about it. Andrew Ross Sorkin’s Too Big to Fail is a must read for anyone who wants to know what actually happened. All I will say is that lax laws, rules and regulations led to many of the largest financial institutions in the world being involved in some irresponsible business practices. In turn, those business practices led to hundreds of trillions in a big bank bailout with no strings attached.  There were no requirements that those banks make more loans (which was something sorely needed since folks were losing jobs by the millions, losing their homes and seeing their retirements devastated). Oh yeah, and as the economy suffered the worst frontal blow since the 1930’s and the government provided trillions of bail out buckaroos, firm executives received millions in bonuses. Is that something they teach at business school—tank the economy, get a bonus? Jeez Louise, that takes guts . . . or something Gordon Gekko-ish.

The List Goes On

But still today, even in the last year, it still seems like we are in an alternate world, like Tradium, yet it is here and now. I mentioned ATM fees earlier. Well last November, Bank of America agreed to settle for $410 million for charging excessive amounts on overdraft and debit card fees to over 13 million of their own customers. What BofA did was to program their computer systems to organize customer debit card and ATM transactions from high to low dollar amounts, as opposed to when the purchase was actually made. As a result, customers would enter into a negative balance circumstance quicker. Consequently, they’d bounce more times and incur more fees than they should. The bank collected all of these excess fees. Hence, they agreed to that $410 million settlement. As disconcerting as that was, it took place at roughly 13 different institutions! U.S. Bank settled, this summer, for $55 million for the same sort of thing.

We have also witnessed both Goldman Sachs and Citi establish these fake out funds (Goldman called it Abacus and Citi called it their Class V Funding III Securities) where they coaxed their customers to invest, then once the funds were populated with their own customers funds, the banks themselves took the opposite positions—psych! Did these guys go to school at Screw U and take that ethics class: Business OU812? Goldman paid $550 million in a settlement with the Securities and Exchange Commission (SEC) and Citi’s $285 million SEC settlement was tossed out by a judge as too lenient.

In July, Wells Fargo, the largest home mortgage lender in the country, reached a $175 million settlement (the second-largest residential fair lending settlement ever) with the Department of Justice (DoJ) related to brokers that charged higher fees and rates to more than 30,000 minority borrowers. From 2004-2009, Wells Fargo charged more to minorities than it did for white customers with the same credit ratings. DoJ’s Assistant Attorney General for Civil Rights (Tom Perez) said it amounted to a “racial surtax.”

We also have one of the largest banks in the world, Barclays, trying to manipulate the Libor rates—rates that impact just about everything anybody buys on credit.

Of course we have MF Global in which hundreds of billions in customer funds went missing, and there is Peregrine Financial Group that looks like a $200 million fraud.

And on top of all of that, JP Morgan, who seemed steady as all of this was going on announced a multi-billion trading loss due to a chap dubbed the London Whale. As Mr. Dimon said, “In hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective an economic hedge than we thought.” And, that was a firm some thought was rarely fallible.

Amazing, doncha think? This list of almost things goes on and on . . . unfortunately.

The New Normal—Not

Again, this may all seem like another world—some Tradium-type realm. It isn’t. It is here. Is it the new normal? It can’t be the new normal, right? We wouldn’t last. We’ve got to find a way back to healthier times, more stable times.

We unequivocally should ensure that there is an environment in which businesses can make money and that our rules and regulations aren’t so overly burdensome, costly or restrictive that we do damage to firms, markets or see market migration to other nations. It is all about balance. At the same time, customers, consumers and taxpayers need to be treated with dignity and respect. Given what has been going on, given some of what I’ve spoken about this evening, that hasn’t happened. There is a hefty weight upon us to ensure that rules and regulations are appropriate. We need important protections (some, by the way, we are just about to approve). However, it will require more than just what government can, or should, do. Government can’t mandate business morality and ethics. I’m convinced, however, that there needs to be better business values, standards and, yes, ethics. We need a culture shift, if you will, in the financial sector. I’ll be speaking about this at greater length next week.

From my perspective on the government side, the Dodd-Frank Wall Street Reform and Consumer Protection Act goes a long way toward establishing some important parameters. However, regulators are still working to implement the 2010 law. Of 398 total rules that government needs to finalize, as of the beginning of this month the government has only finalized 131—that’s 33 percent. For the CFTC alone, we do better than all other regulators, having completed 40 out of 59—67 percent.

I’m often asked if we are safer from a financial mess than we were prior to 2008. Sure we are, but until we get all of the Dodd-Frank provisions implemented, and a few more things done that have surfaced since then, we still have important work to do.

Volcker Rule

Let’s talk about just a few specific issues. The first one is the Volcker Rule, named after former Federal Reserve Chairman Paul Volcker. What the Rule says—and this is a law, part of Dodd-Frank—is that banks must not engage in proprietary trading. With some exceptions, they can only trade for their customers. Prior to the repeal of the Depression-Era Glass-Steagall Act in 1999, banks were what we traditionally think of as banks. They have customers and hold their money, perhaps making investments for their customers. But when Glass-Steagall was repealed, it allowed banks to trade for themselves as well as their customers. That’s how Goldman and Citi scammed their own customers because they—the banks—could trade for themselves. So, it created this troublesome duplexity. Were they trading to make money for themselves or for their customers? I suppose the two different motives could go in sync, but they don’t have to, and as it turns out they didn’t. Thus, the need for the Volcker Rule, which essentially reverts, to a large extent, to how banks operated prior to the Glass-Steagall repeal.

That may be all fine and good, although the banks really want to trade for their own accounts. Here is the problem, in my view: there is the possibility of a massive loophole. You see, there is a provision of Volcker that says regulators must allow banks to trade if they are merely hedging their own risk. So, under the law, under Volcker, the banks can’t speculate in the markets for themselves, but they will be allowed to trade in order to hedge their own business risk. However, the difference between hedging and speculating isn’t always so easy to distinguish. What is being urged would create a large loophole—an immense breach—in the Volcker Rule because it could allow almost any trades whatsoever to be considered as a hedge.

Say I work at one of these banks and I place a proprietary trade—a hedge—for some business concern that the bank holds. What happens if that hedge gets into the money? By that, I mean, what if it turns out that the hedging trade was something that did really well, something that looked pretty speculative? If I’m the bank and I get questioned by regulators, I simply say, “Hey, we are allowed to hedge our proprietary risk with trades and that is what we did.” Then, the government would be in the position of going to court arguing that the hedge was speculative and not simply a hedge.

I don’t see such cases going forward. The banks would hire an expert economist; the government would bring in its own—a stalemate whereby the government would have a very difficult time making its case. There would simply be too much litigation risk on the part of the government. You see, the “wide open spaces” that such a large loophole could create would leave a lot of room, as the Dixie Chicks sing, “to make the big mistakes.” We would be pretty much back to where we were without the  Volcker Rule; banks speculating in the market and taking risks like they did leading up to the 2008 crash, and potentially taking advantage of their own customers.

Now, the Volcker Rule is a provision that amended the Bank Holding Act. The Federal Reserve has primary responsibility for that law. At the same time there are four other regulators who have something to say, or should have something to say, about how the Rule will be finalized. I’m concerned that our Agency—which has a lot of good, solid knowledge and experience about what the term “hedging” actually means and how it is used in markets—ya know risk-management markets—has been fairly inaudible on what the final Volcker Rule should look like. That is why in the morning, I’m sending a letter to Chairman Bernanke of the Federal Reserve Board suggesting that a clear, tailored, stick-to-the-law reading and interpretation of hedging is what should be incorporated in the final Volcker Rule.

In my letter, I write the following:

                • The Volcker Rule should be interpreted and promulgated—promptly—so as to protect against the most basic conflicts of interest: that is, prohibiting banks from trading for their own interests ahead of their customers.
                • Any exemptions from this prohibition should be considered in light of clear consumer protection objectives, and should be tailored to ensure that the exemptions do not create loopholes from regulation.
                • Regulators should look to the CFTC for guidance regarding any exemption relating to "bona fide hedging."
                • First, the Rule's definition of "hedging" should ensure that exempt transactions have and retain a risk-management purpose.
B. Second, entities claiming such exemptions should be required to disclose to regulators their risk modeling, to ensure that such calculations are appropriately calibrated.

C. Third, if "hedges" over time result in profits greater than losses on the underlying risk, then there is presumption that the exemption has been improperly claimed. Such willful evasion over time in avoidance of the prescribed oversight should be prosecuted with the full force and effect of applicable laws.

Position Limits

Speaking of speculation, let’s talk about excessive speculation for a bit, shall we? In 2008 we saw energy prices go through the roof. That’s when crude reached its highest point in history in July of 2008 when it touched $147. 27. In fact, through all the talk about gas and oil prices, July of 2008 still stands as the highest price for both. The average gas price then was $4.11. Had anything in the underlying supply issues changed much from earlier in the year when prices were in the low $90s? Nope. What about demand? Was there some big demand, or an expected increase that drove those prices? Nope.

So, what changed? Well, in a three-year period between 2005 and 2008 we saw a massive increase in dollars moving into the futures industry. In fact we saw $200 billion in managed money come in from the likes of pension funds, hedge funds, and exchange traded funds (or ETFs). There certainly isn’t anything wrong with folks putting their money in the futures industry. What we were seeing was an asset class shift. Folks not satisfied with their returns in the equities markets, or simply wanting to expand their portfolio thought, “Hey, why not invest in crude oil, or nat gas, or silver or gold or soybeans?” And, they did.

It wasn’t just the billions that came into the futures markets, though. It was what they (by and large) did with the money. They parked their money and went long. What I mean is that they put money into the futures markets like some of our parents put money into blue chip stocks. They bought and held. If things go right sonny boy, “when  I go over yonder you will gets these” and they will be worth something. And folks invested in Motorola or IBM or RCA. Well, they were doing the same thing, but in futures. Their bet (and some don’t like it when people call making trades in the futures industry a “bet” but that is exactly what it is—perhaps an educated bet, but so is doubling down on 11 with a full deck), is that crude, or whatever, is going to be worth more in several years than it is today. They don’t care much if the price goes down today, tomorrow or after the summer driving season. Nope. They are betting, yes betting, on the price going up in several years. They keep their money in the market and unless something really unusual happens, they keep it there. So, they have a fairly passive trading strategy, and many of them are really massive. I’ve termed these traders “Massive Passives.”

I can tell you that in 2008 most of the staff at the CFTC, and all of the other Commissioners didn’t see a need to do anything to curb what I saw as excessive speculation that was leading to large price swings. Look, if prices go up or down based upon supply and demand, that is the market. Regulators are not price-setters, but we are charged with ensuring efficient, effective, and fair markets devoid of fraud, abuse and manipulation. When prices are moved because of excessive speculation, that’s a problem, and I have witnessed it in several markets. All our citizens experienced it to some degree in 2008 with oil and gas prices.

Dozens of studies confirmed exactly what was, and at times continues, going on. In fact, so many people denied that there was evidence of the impact of excessive speculation that I put a bunch of studies on the CFTC web site. They are still up there if folks are interested. Incidentally, there is one that does date back to 1990, by a fellow named Larry Summers. It appeared in the Journal of Finance. Mr. Summers (along with three other colleagues) repudiated the view offered by other economists that suggests speculators reduce volatility.  Mr. Summers et al. suggested that excessive speculation could increase volatility and that speculators can do so by joining with other speculators—jumping on the Tradium bandwagon, as it were—of irrational price movements.

Calling for limits, position limits, to ensure that no single trader controlled such a large percent of any given market was something that did gain support. In fact, some key members of the U.S. House like Congressman Joe Courtney who represents this Congressional District, numerous Senators, and none other than President Obama called for limits on speculation.

Finally, a provision was included as part of Dodd-Frank. I should also stop for a moment here to thank Sean for his work in this regard. He was a vocal and firm advocate for limits and I thank him.

So, limits were included in Dodd-Frank. In fact, we were supposed to implement position limits on energy commodities in January of 2011. We missed that deadline. The good news (and my enthusiasm is tempered here, but I’ll explain later) is that on October 12 the first set of CFTC speculative position limits becomes effective. These limits on speculation apply to the spot month, which is generally the period right before trading in a contract expires and the obligation to make or take delivery on a physical delivery futures contract applies. Spot month limits are not new. There has been some form of these limits administered by the exchanges (and also by the Commission in the case of the enumerated agricultural commodities). What is new is that these limits will now apply to swaps, whether they're exchange-traded or over-the-counter.

There are three reasons why I temper my enthusiasm on position limits:

1. Limits on speculative positions outside of the spot month won’t become effective until sometime later, probably sometime early next year—once we get enough data on swap positions. These hard limits on speculation outside of the spot month will be something new for the energy, metals, and non-enumerated agricultural derivatives markets. They are important, but again, won’t be in place in October.

2. I’m also not sure that we have reached the correct limit levels. What I have always said is that we should err on the high side to ensure we aren’t doing damage to the markets by syphoning away liquidity. We need to get the levels correct. So, I’m not suggesting that these limits levels are all right on the mark. They may have to be adjusted as we go forward, and our rule allows for that. Under the rule, the position limits change as the size of the derivatives markets and the size of the underlying physical market change.

3. Finally, while position limits should ensure that no one trader holds a concentration so large that it could manipulate prices, that doesn’t mean that a group of traders acting in concert couldn’t impact prices—as Larry Summers and his colleagues suggested. I’m not even talking about something that would obviously be a violation of law if they did something in collusion. I’m saying, what if a bunch of the Massive Passives simply decided to invest in a market, say heating oil, and all go long? What if there was a herding mentality and once a few did it, a bunch of others followed—regardless of supply and demand?

Remember that glorious footage of the buffalo—the Native American’s tatanka—herds running through the South Dakota grassland in Dances With Wolves? When the herd shifted, it left a path of damage because hundreds followed hundreds of animals.

The fact that all of the Massive Passives—like the tatanka—have an identical herding-type trading strategy could, in and of itself, since they have size and weight, push prices around.

That reminds me of my favorite sign in South Dakota, which is where Dances with Wolves was filmed. There is a hand painted tourist sign that reads:

“EXIT HERE—SEE THE ONLY HORSE IN SOUTH

DAKOTA—Not Used In Dances with Wolves!”

So, on the massive passives and on herding of traders, I’ve spoken to a lot of people about how we might address this circumstance. To be honest, I haven’t figured out an appropriate method. The answer that folks usually give me is to simply prohibit them from participating in the market. I don’t like that idea at all, and I’ve said so.

The bottom line is that these position limits will not completely stop the influence of excessive speculation. However, they will help, a lot. More, however, needs to be done. The art in it will be figuring out a balanced way to do something—in our Tradium-like world—in a way that liquidity isn’t sacrificed.

Gas Pains and Energy Policy

One final thing on energy and gas prices, specifically. I wrote about this in an op-ed this week. If you’ve heard some of the folks on the campaign trail recently, you'd think President Obama was the filling station fella with the long pole—actually raising gas prices all by his lonesome. In actuality, presidents can’t do much to effect energy prices in the short term.  But then again, that's not opportune to say in an election year talking point.

When President Bush was in office, in 2008, is when we saw the highest gas prices in history—a record that still holds today.   Today’s nationwide average was $3.87 per gallon.  (By the way, WTI crude settled at $98.31 today). However, in 2008 when candidate Obama delivered his convention speech, he correctly didn't complain about President Bush and high gas prices.  Governor Romney admonished the President for allowing gas prices to increase. Oh well.

What can be done by any President in the short term amounts to only one item:  the Strategic Petroleum Reserve (SPR).  President Obama used it last year (in cooperation with 27 other countries and a total of 60 million barrels) and gas prices reduced—although only for a little time.  The SPR, however, really is for the grimmest conditions.  While using it is at the decision of presidents, traditionally they've been hesitant to do so.

Presidents can, and have, tried to address gas and other energy prices through longer-term strategies.  President Obama, as I mentioned, sought to end excessive speculation in energy and other markets by limiting the large positions any trader may hold.  That’s a feather in his hat, in my view. The President also called for increased penalties for manipulators. The President’s energy policy will—years after he is out of office—reduce by half the amount we all pay for fuel by requiring more efficient vehicles (54 miles-per-gallon by 2025).  In addition, his energy policy promotes other fuel sources (wind, bio-based products, solar, hydro, nat gas and clean coal to name a few).  To some degree, that's working now.  We have become over 70 percent self-sufficient in energy in this country. For the first time since 1949 we have exported more oil and fuel products than we have imported. We have done that two years running.

The complex thing with gas prices is that the longer-view strategies take time to go forward, and reaching political settlement is evasive on something that doesn't have an immediate impact and that can’t be marketed in the next election.  That's why it is a simpler proposition to blame a president . . . even when it is exceptionally inappropriate, in my view.

Cheetahs

The last issue area let’s visit has to do with technology. “What’s the frequency, Kenneth?”—the high frequency traders or guys I affectionately call “cheetah traders.” Let me be clear, not “cheaters” like Boston card cheaters, but cheetahs, like the speediest land mammal. These cheetah traders are fast, fast, fast. They are out there 24-7, 365 in Tradium-like markets trying to scoop up micro-dollars in milliseconds. Like the Massive Passives, they are fairly new to markets, certainly to the extent they are in markets today.

For years, I have questioned their value. I wrote an op-ed in the Financial Times almost two years ago called “Cyber Cowboys” where I questioned the value of the HFTs. I’m not suggesting that they don’t provide some liquidity, although I suggest that it is “fleeting liquidity” since they don’t typically hold positions for more than a few seconds. If you want someone to hedge your heating oil for a minute, I know just the cats for you. And at the end of the trading day—although for some it never ends—they are pretty much flat—holding level positions.

I’m impressed with the technology they use and in awe of some of the folks who are behind this sort of trading. They are big-time brainiacs doing innovative and important work, and it is really cutting edge stuff. I certainly don’t want to endanger them as a species.

However, I don’t (as some do) simply think they are the envy of the world. The exchanges like them because they are market makers and provide increased volume. That’s understandable. On the other hand, they were part and parcel to the Flash Crash in May of 2010. Furthermore, because of their speed, cheetahs can sometimes have an impact in markets far beyond their position size. Other traders may look to the cheetahs as early indicators of market movements. In fact, I have seen where this has also started a herding effect (tatanka) in markets and moved prices significantly and swiftly. I think there is a good case to be made that, contrary to what many suggest, they can increase volatility at times.

Another point here is about technology, generally. We all know that sometimes it doesn’t do what it shoulda, woulda or coulda. Just like I went through a partial list of all the problemos with the banks, I can (and have), done the same for multiple malfunctions with technology we’ve seen in markets in the past few years. We saw a major problem at the Tokyo Stock Exchange in August. We all know that NASDAQ had a big issue when Facebook went public. Heck, the CFTC computer system was compromised earlier this year. Just last Friday we saw a 56-minute trading halt in Globex nat gas complex trading. And, early Monday morning we saw another trading halt on CME Globex Volatility Quoted Options, Interest Rate Options, and TRAKRS futures and options. And in June of last year, the natural gas market crashed eight percent in 15 seconds in overnight trading. These are all problems with technology and my point is that we shouldn’t just accept technology as the best thing in the world. We need to realize that like many things, there will continue to be issues. Like that tee shirt, right, “I have issues.” Well, technology has issues.

Here is another problem, the third largest trader by volume at the CME used to be, perhaps still is, a cheetah trader out of Prague, Czechoslovakia. If regulators want to get books and records from that cheetah trader in Prague, forget about it. You see, the cheetahs aren’t even required to be registered with the CFTC. We should do at least four things, and soon:

1. (Registration) As a pedestrian first step, the cheetahs need to be registered;

2. (Testing) but, they should also be required to test their algorithms before they are deployed in the live market production environment; and

3. (Kill Switches) they should have kill switches in case one of these cheetah programs goes feral; and finally

4. (Wash Trading) many times these traders are trading so super-fast that they actually cross their own trades in the market. We call those “wash sales” and they are illegal. We need to get a handle on that and stop it. Wash blocker technology should be required on all cheetah programs and we should require a full accounting of when they happen, and why and what is being done to stop it. And by the way, the report to the CFTC should be signed by the head of the pride, by the leader of the cheetah to ensure that we are getting it from the top.

There are other technology-related things that should be done and I am hopeful that we will soon put forward a concept release on technology issues for the public to comment upon. In fact, I had hoped that we would issue the concept release this summer. We should do it soon pardner. We’re burnin’ daylight. (There, we got the cowboys and Indians in there).

The Destruction of Tradium

If we do these things I’ve spoken about in a responsible fashion—the Volcker Rule, speculative position limits, caging the financial cheetahs, a culture shift in the financial sector—and if we implement the rest of Dodd-Frank in a thoughtful and balanced manner, we will make the financial sector more competitive, provide greater transparency and cultivate increased confidence.

In Tradium, too, all of these things would help pave the way for a positive future. But, unfortunately, Tradium’s days are finished. They are ending as I speak. Sad, right? Twelve, eleven, ten . . . I’d better skedaddle.

It has been a “trasure” being with you. Sorry, “trasure” means “pleasure” in Tradium. It has been a pleasure, a pleasure, being with you…three, two, one—poof!

I know some of you might wonder, being the caring folks that you are, why Tradium had to simply go “poof” and disappear. You were getting to have some affinity for it, weren’t you? Was it the cold-blooded titans, the living on credit, excessive speculation or technology? Was it global warming? What did it in? Well, it only lived inside of my head, oh no (the dream police—police, police).

Thanks for your time and attention. Wakan Tankan Nici Un—May the Great Spirit walk with you.

http://www.cftc.gov/PressRoom/SpeechesTestimony/opachilton-68 

Another in a growing trend in the industry

Friends,

U.S. crude oil demand fell to its lowest in nearly four years in July as the middling U.S. economy and fuel efficiency gains weighed on consumption, the American Petroleum Institute said on Friday.

A large chunk of the decline in oil demand came from gasoline use. At the height of summer driving season, petroleum demand dropped 2.7 percent from a year earlier to 18.062 million barrels per day. It was the smallest amount of U.S. oil consumption for any month since September 2008.

Although, demand for distillate fuel, which includes diesel and heating oil, rose 4.9 percent to 3.622 million bpd in July, the API said. Unfortunately much of the distillate demand appears to be export driven, as developing nations require more and more diesel and residual fuel.

Despite some recent optimism that our economy is improving, the reality for oil and heating companies is not so optimistic as local consumer demand becomes les and less.

--Sean Cota 

http://www.api.org/news-and-media/news/newsitems/2012/aug-2012/petroleum-demand-slips-further-in-july.aspx 

Potential of a Massive Propane Shortage this Winter (2012-2013) May Leave You High and Dry

What would you do if a third of your propane supply disappeared when you need it most?There is a good chance that supplies of propane in New England (PADD-1A), may be tighter this winter than in any year in the past.  If we experience another warm winter, your business should be fine; but if we experience an average winter or a colder than average winter, the New England region could be faced with a supply shortage of more than 30%. This could affect your business dramatically and negatively by the potential price spikes, and a lack of propane gas to sell. 
 
What would cause this extreme potential supply shortfall in New England? 
New England (PADD-1A) has unique logistical challenges.Unlike the rest of the country, New England PADD-1A, is not close to a refinery or a natural gas upgrading plant, and has no pipelines supplying propane to the region.  New England’s traditional supply points for propane are the Teppco pipeline terminating in Selkirk New York, a half dozen rail terminals, and two large refrigerated import terminals in Portsmouth, New Hampshire and Providence, Rhode Island.  Any disruption in any of these supply points usually causes supply problems leading to a basis blowout.
 
The cheap new energy is in the wrong place.The propane gas supply sources are changing quickly. New sources of supply have emerged in the Upper Midwest of the Dakota’s and Appalachia but what does this mean for you? What’s changed in the dynamics of the propane supply system that New England marketers depend?
 
New sources of supply and where it is coming from?The recent boom in gas and oil production from the Bakken and Marcellus shale energy fields that is transforming the US energy market is not yet a viable and sufficient source of supply for New England. The current distribution systems of oil and gas pipelines are all in the wrong place. Since World War II, the supply system was structured on moving refined products from the Gulf Coast energy region, north and east.  This lack of reliable and cost effective transportation for peak demand has forced suppliers from Bakken and Marcellus to deeply discount their product prices compared to both the traditional price setting point of Mount Belleview, Texas and to world propane prices. Producers seeking to profit on crude oil in the Bakken region are stuck with the Natural Gas Liquids (NGLs) as a byproduct.  Recently, this oversupply of NGL’s by cause producers to leave the propane in an NGL mix for plastics. This dumping forced the Midwest Conway market to sell as low as 10 cents per gallon.
 
Wholesalers are trying to take advantage of this price differential, and passing on much of the reduced costs to marketers.  Unfortunately, New England is at the end of a complex distribution system with many bottlenecks.  The Teppco Texas Eastern Pipeline is from Texas to Selkirk, New York and not from Bismarck, North Dakota.  The rail bottleneck is lack of cars, and allocation of transportation volume based prior years’ shipping.  The trucking bottleneck is that there are not enough 10,000 LPG transport trucks and hazmat licensed drivers to move the product in volume from the Bakken shale oil/gas formation to New England.  PADD-1A’s ocean terminals can only get product from another country due to US shipping laws, causing higher costs, and longer delivery times.  These bottlenecks for accessing new American cheap sources of energy are significant.
 
So what about the old sources of supply?The old supply points are still there and are still priced on traditional market prices. The problem with the supply of off-shore product is that the Jones Act prevents supply tankers with a foreign flag from moving from one US port to another.  Almost all LPG ocean vessels are foreign flagged.  This means supply times from a common supply point like Algeria is two to three weeks. The average propane marketer has only two to five days of storage. You can’t get it in time!
 
Additionally, the pricing of product from the Middle East has increased dramatically since the beginning of 2012. In March of this year, Middle Eastern product sold FOB for $1150 per metric ton or $2.23 per gallon, while at the same time, Mont Belleview, Texas TET price sold for $1.25 per gallon.  Because propane from ocean terminals are priced at a $1.00 per gallon or more over domestic sources, very few marketers have sourced supply from them this summer.   This has led to little or no scheduled foreign supply to these terminals this winter.  For all practical purposes, these terminals, which traditionally supplied 30% to 40% of peak load, will not supply New England this winter.
 
Nominated volumes and volume contracts build a stable price and supply. Lack of contracts creates volatility.You will constantly hear about nominated volume supply contracts in the propane industry.  This is a contract that requires you to buy a minimum amount of product, from a particular supplier, at a particular location, and for a specific time interval (usually a monthly allotment).   These contract requirements for unpriced product, although a throwback to another era, exist for several important functions.
 
Suppliers want to lock in retailers as customers. For retailers, this is not necessarily a negative thing. Suppliers who have contractual relationships with retailers will ensure that these retailers have product in their system when they need it and lock in supply contracts further upstream. Suppliers, though, are constrained by rail, pipeline and shipping.  For example, railroads and pipeline operators would like to transport the same amount of product everyday regardless of demand. This is why in propane retailing it is import to maximize summer deliveries to customers.  Even if they do not need the fuel, it will help to meet winter demand needs by building an allocation ratio for railroads and pipelines.
 
New England and PADD-1A has run out of propane before…The retailers in New England have had many examples of when of these supply systems have proven to be unreliable for supplying propane when you need it most.   To compensate at these crisis points, the shaving of the peak load has been done via the two ocean terminals.  The two terminals have traditionally supplied 100 million to 250 million gallons into the PADD-1A market.  This year, these ocean terminals because of a price dislocation, will not have product at during peak demand as they have in the past.
 
According to the DOE’s EIA, the total propane sold in PADD-1A is 600 million gallons per year.  Loosing even 100 million gallons at peak could be catastrophic.  This possible shortage is a perfect storm that has been building unnoticed on the horizon. 

Your action plan:You need to build a plan of attack on how to deal with the potential of an extreme shortage.

Diversify your supply.Unless you are will a reputable supplier who knows that you are using them as your sole source of supply, you need additional suppliers. You will also need to go further than you normally would to get your source of supply.   Your suppliers may have supply outside of New England.  Ask them where it is, and would they supply you from that point in a tight market.  If you’ve had supply in the ocean terminals last year, you might want to see what you can afford to buy from them and blend it into your overall costs.   High priced product is better than no product.
 
Build in a plan for delayed supply from places unimaginable.If you had to get product shipped from Kansas or Texas, who would you call?  In the past, marketers have had product trucked in from that far away.  These trucking costs exceeded $1.00 per gallon. Who would be willing to ship a hazardous material placarded 1075 for 2000 miles and ten states?  The list is short.  Think about that now, and reach out.
 
Build supply allocation now.You will need to supply as much product as you can this summer. Fill your customers’ tanks now, even if it presents a receivable problem. Do a second fill up before the winter allocation schedule begins.  This will help when supply gets tight.   The failure to do so, reduces you supply on rail and pipeline in the coldest of weather. 
 
Plan on wholesaler outages and decide which customers will run out.Create a plan for your customers to run out when there is little supply.   It sounds crazy, but it’s better for a cooking and hot water account to run out of product than a heating account whose house freezes.  You can always have a service tech dump in a couple of 20 or 30 pounders in hot water or cooking than to get sued for failure to deliver to an automatic delivery home that needs $150,000 in repairs. 
 
Increase your prices to your customers BEFORE you experience the higher product costs (you’re going to miss it anyway).Make sure to pass on increased costs to your customers early on.  You will never keep up with the additional costs on items like extra shipping, surcharges, overtime, and the inevitable older receivables.  In my decades in the business, every time I thought I was ahead of the increased cost structure, I looked at my monthly financial statements and found that I always missed it.  My only advantage was that my competitors missed it by more.
 
Check your hedges and their trigger points.A basis blowout event is one of those rare items in risk mitigation, and consumer price programs, that is very difficult to hedge.  Often in these events, the risk is laid off on you, the marketer.  This is another expense that you must account for when deciding how much to increase prices for your consumers.  Carefully consider how much this cost shift needs to be.
 
Forewarned is for armed.It is ironic that the new supplies of cheap new sources of American propane, will likely lead to the largest shortage and basis blowout in propane history for New England.  
 
You are forewarned.  You have the advantage of reading this newsletter and gaining from our years of experience.  Your mistakes in what could be a record supply disruption event, could be very costly. 
 
If you have concerns that we can help with, give us a call.  Learn from us.
 
-Sean Cota 

What Happened to Energy Commodity Markets in the Last Decade? (Part 1 of 3 of financial commentary).
Sean Cota’s commentary on how commodity markets have changed in the last decade.
As you may know I have been working on financial reform in commodities since 2004. During that period a lot of things about the trading world has been revealed about how the world for petroleum marketers has changed.  For petroleum marketers, the traditional model of supply and demand fundamentals no longer exists in the products we buy and sell.

Supply and demand
Classical market economics told us that prices are based on supply and demand. If the supply of particular commodity went down and the demand remained constant, prices went up. If demand went up with supply static, again prices would rise. If demand went down, supply increased, and prices would decline significantly.  You get the picture. But that was before the investment banking community securitized the commodity markets in the same way they securitized housing mortgages and other financial instruments.

The securitization of the commodity markets
This securitization, enabled by the Commodity Futures Modernization Act of 2000 which first lead to the Enron excesses, began to ramp up in 2004. Over time supply and demand mattered less and less as to what the price of a particular commodity was. Today we find that these markets are opaque, Dark Markets. Most energy trading is no longer on the New York Mercantile Exchange (NYMEX).  Traditional regulated exchanges were very transparent in pricing and clearing.  The price bids and offers were seen by the entire market.  In addition, the exchange clearing functions (for which most of the margin is based), guaranteed the trade.

The dark world of Dark Markets
Today, NYMEX only represents only about 20% of the total market.  The rest of trading in energy is in the form of swaps. Swaps are often over the counter contracts where an investment bank or hedging company who deals with an investment bank, is basically making a bet that the prices will be in a certain range. They can either do that with futures contracts meaning that they will deliver a certain volume of product at certain time in the future at a certain price with a certain differential for a particular point of delivery.  In most cases these swaps are identical to futures contracts, with the exception that they are a Laissez-faire market.  These swap trades are now mainly in the unregulated Dark Markets, where it is impossible to know who is buying at what volumes and to what extent.
If we went back to the old world of oil trading on the NYMEX composition of trading was a mixture of speculators and commercial players where ¼ to 1/3 consisted of speculators with the balance being commercial players.  The majority of the trading were commercial players hedging in the future. Those hedgers could be refineries or crude oil producers selling product or retailers purchasing product or refiners purchasing crude oil.  Today, paper contracts with traders who have no commercial interest in delivery make up between 70 and 90 percent of the volume depending on how you measure it.  They are not hedging commodity or commercial risk.  They are just betting on the price.

Technology changes but not human behavior
At the turn of the 19th century when France and England where at war, Lloyds of London would insure ships and cargo. If the ship was sunk, the ship owner would be reimbursed or if the cargo was lost the cargo shipper would be reimbursed. Lloyds at the time was a form of trading desk where anyone with cash could place bets on the insurance.  Many of the parties betting on the risk had no “insurable interest.” Today this would be calle d a Naked Credit Default Swap. What they found is that those who bet the ship would sink would tell the French navy where the ship was and the French Navy would sink the ship and the speculative betting party would then be reimbursed. That activity was finally banned but today it exists in much of the trading that occurs in these markets. Today this is legal in most trading.  These parties either know what is going on in the Dark Market or have a sufficient volume that make up overwhelming proportions of the trading. Today it is these trades that influence the prices to a large degree. Because they have no insurable interest meaning that they are not a producer or seller their bet is based upon moving money and it doesn’t matter what occurs to the underlying commodity for the commercial players.  Their only desire is to profit  on the trade. Because they can influence the change in price, they have no incentive for stable pricing.  Their incentive is for volatile pricing where they can control the price, direction and exit at an advantage to the traditional trader or hedger.  Their volume and trading style forced the price of the commodity up.  When these large players feel the price has reached a critical point then they will first short the price of the commodity contract and then they will sell their existing contracts into the market, forcing the market into a rapid decline; while the average commercial player who is insuring an interest, is merely going along for the ride without influencing how or when the decline occurs.

Dodd–Frank Wall Street Reform and Consumer Protection Act of July 2010. Light or continued darkness?
In the aftermath of the near complete financial collapse of 2007-2008, the Dodd–Frank Wall Street Reform and Consumer Protection Act of July 2010 was a rational attempt to bring back transparency and systemic risk protection back to the highly leveraged, highly risky, opaque dark market trading world.
 I’m proud to stay that bill that the retail petroleum industry along with hundreds of partnering organizations had significant influence, particularly in the commodity arena.  Despite Dodd-Frank becoming law nearly two years ago, only 10 to 20% of it has been implemented. Dodd-Frank did a series of things in the context of oil trading under Title 7 which were significant. One of the items was to take the Dark Market of swaps and have them be reported in a transparent manner. Swaps are just another variation of a futures contract. So when you hear the word swap think of futures trading because in reality they are mostly just that. Dodd-Frank would require price discovery in these swaps. If you are part of the investment banking community who has market controlling influence in this Dark Market of swaps, you do not want transparency.  It is no surprise now that we are in the administrative role making process of Dodd-Frank, these investment banks who control these OTC derivatives, are fighting how much should be transparent, and if so when. Transparency works against traders who are selling a contract that in a visible market, customers wouldn’t buy. The CFTC’s original position on transparent reporting was that it should be live so the public can see the trades at the same time as the regulator. That has now been throttled back to short time duration but still gives an advantage to the high frequency traders. HFT, High Frequecy Trading and future flash crashes in commodities will be a topic for a future newsletter.

Clearing of trades is life insurance
Another issue that Dodd-Frank addressed which was significant for the commodities world is that it required a clearing of trades. Clearing is important and is what has occurred over the last century on NYMEX.  An example of this would be a retail oil company buys a contract on the NYMEX, the physical counterparty would be a refinery.  The NYMEX Exchange functions as the middleman. The exchange records what that price is so that there is transparency in the pricing.   The clearing function of the exchange guarantees that if either company goes out of business the exchange will guarantee the trade.  Without this, everyone is in bankruptcy court for years. In the current world if your oil hedge was with Lehman Brothers you would still be in bankruptcy court trying to recover your investment today.  Clearing is very important but it is not free. If someone is going to provide life insurance for you they aren’t going to do it for free. The clearing function charges show up in the margin required on those trades.  Traders whose interests are short term (even by the millisecond) want to avoid these margin requirements so they use OTC and less regulated markets like Inter Continental Exchange (ICE).  Ironically ICE is a U.S. company based in Atlanta, Georgia, but is regulated in most trades by a London UK laissez-faire regulator.  Clearing gets you paid promptly and keeps you out of bankruptcy. Additionally, the mere fact that higher margins are required will deleverage markets.  A 1% OTC margin to a 5% NYMEX would reduce oil trades by 5 times.  When traders have to put up more money they don’t go to their bank and write a check, they sell positions in order to cover the margin, and that forces markets down.
 
A speed limit only for Aston Martin's, Bugatti's, and their peers.
The last area of interest to commercial parties in commodity market reform that I will discuss is position limits.  However, these limits when they go into effect are really not limits at all.  The rule is that there will be two pools of limits.  One for the cash settled market where there is never the intent to take delivery.  The limit in this cash settled market is defined that one trader cannot own more than 100% of the deliverable market.  The other pool is for the traditional DCM NYMEX type of market.  In this market, traders can demand physical delivery.  As with the cash settled market, in this market, again a single trader cannot own more than 100% of the deliverable.  Combined, one trader can own 200% of the deliverable market.  The financial community wanted limits many times higher. But I ask you, what is the price impact, in any market, if you allow one single person to own 200% of all that is available? So these limits, although they will to some degree deleveraging these markets, really are not limits at all.

Effective Date of Rules, maybe someday…
Most of these rules covering the 80% of the market that is unregulated will come into effect after the election, at the earliest.  The Securities Industry and Financial Markets Association (SIFMA) and the International Swaps and Derivatives Association (ISDA) challenged these new rules in December.  If they are successful with an injunction to prevent implementation, the new rules will not be implemented for years.

Knowing what you don’t know
The world of the commercial petroleum company, and industrial consumer, or the public, is still an unregulated dark market world. The traditional hedger will only have a glimpse of this dark world through the cloudy window where we see the NYMEX trades. Prices in this brave new world of commodity trading reflect what we don’t see, and about the huge increases and decreases in money flows as they move through these markets.
This is the world of oil in which we all live day to day. The supply and demand numbers do not matter to a great extent for the purposes of determining price. The supply and demand numbers really only matter for the timing of technical trading, and that’s it. Knowing that these markets work this way, gives you the knowledge of how to trade and how to participate in trading when your hedge turns out to be controlled by a rigged game.
…And sometimes the best play is not to play.
       -Sean Cota
 
 Lake Rudd and Company will be at the Atlantic Regional Energy Expo, AREE, in Atlantic City May 1 ->3, 2012.  
No statement within this communication should be construed as a recommendation, solicitation or offer to buy or sell any futures or options on futures or to otherwise provide investment advice.

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