Royal Oil* - Home Heating Oil in New Hampshire – Part 2

In Part 1 of this series, we took a broad look at the home heating market in the Northeast. Specifically relating to New Hampshire was the inevitable conversion to ultra-low sulfur distillate for home heating oil and the fall-off in home heating oil consumption since 2004. In this post, I take a closer look the pricing issues that relate to home heating oil (HHO).

Over the past decade we have seen some wild fluctuations in oil prices, with a big run up in prices prior to the 2008/2009 recession, followed by a fall off and then an increase since 2009.  Since 2000 there has been a general increase and crude oil seem to have settled, at least for the moment, into the $90 to $100/barrel range. Of course, this resulted in a similar increase in home heating oil prices, as shown in the chart below.

As I noted in my previous post, we have seen a massive fall off in heating oil consumption during the same period. Some reasons I provided for the fall-off included fewer homes using HHO (a 10% decrease), a decade-long warming trend, homeowners using supplemental heating sources such as wood pellets, and good old-fashioned Yankee frugality driven by the rising price of HHO over the decade.

Let’s dig into the effect of pricing in a bit more detail. The following chart includes both the drop in HHO retail sales and the increase in price since 2002. There appears to be a connection between the two, with higher prices leading to lower consumption.

To investigate this connection further, I plotted the annual HHO consumption against oil price in the left-hand figure below and it appears, based on the cluster of data points around the trend line, that there is a reasonable correlation between HHO consumption and oil prices. If you share a statistically geeky bent with me, you would have noted the R² value, also known as the correlation coefficient, is 0.54, which is a moderately acceptable value for correlation such as this. A value of 1.00 would be a perfect correlation. The correlation coefficient indicates that 54% of the HHO consumption decrease can be explained by the price increase. This begs the question – what is the cause of the other 46%?

In my previous blog, I provided data which indicated that, before this very cold winter that we are presently living through, there was a decade-long warming trend underway. I thought it worthwhile to therefore take a closer look at the correlation between the how cold the winters were (as measured by heating degree days (HHD)) and HHO consumption - this is shown in the right-hand chart below. Here too a not-unexpected correlation is evident, as higher HHD values (colder winters) generally led to increased home oil consumption. There is also a greater scatter in the results around the trend line, and so we have a corresponding lower correlation coefficient, 0.34, which, statistically speaking, is not particularly good.

This is not surprising, as it is difficult to extract a trend relating HHO oil consumption to winter temperatures when it is overlaid and obscured by an even more powerful trend of decreasing consumption due increasing prices. However, statistics does provide us with the tools to separate these two effects.

 

Using a tool called multiple linear regression, I determined that the combination of the effect of higher prices and warmer winters is, statistically speaking, better at explaining the HHO consumption data than just price. The analysis indicated the combination of both effects, higher heating oil prices coupled with warmer winters, could explain two thirds or 66% of the decrease in HHO usage. The other one third of the factors includes the decrease in number of homes burning oil, implementation of energy-efficiency measures in homes, and the supplemental heating choices that some homeowners have made. (If you are interested in the details of my analysis, feel free to contact me by email and I will share my data with you.)

This has been an awfully long-winded way of explaining that HHO oil consumption decreased because prices increased and temperatures rose, but now we can at least claim to have some statistical firepower behind our assertion. Before we continue with our exploration of the pricing issues associated with HHO, however, the decrease in HHO consumption as a consequence of increased prices underscores an important point when it comes to energy. We cannot expect to deal with our energy problems through regulation: significant changes in energy use need to be market-driven. Here is a great example of higher prices leading to lower HHO consumption, showing that we respond much better to incentives than we do to regulation.

As noted in previous blogs, I have a great interest in the value chain associated with commodities and especially energy commodities.  I am always working to understand who is making what money in the journey of the commodity from the source to my retail purchase. To understand costs involved in the journey of crude oil to heating oil delivered to our homes, take a look the instructive 2011 graphic below which comes from the EIA. This indicates that the crude oil comprises 65% of the total cost, refining (conversion of crude oil to HHO) contributes 13%, and distribution and marketing contribute as much as 22%.

http://www.eia.gov/energyexplained/index.cfm?page=heating_oil_prices

Percentages are useful, but I prefer to take a look at absolute dollars and cents as that is what I am pulling out of my wallet when I pay for these fuels. Because HHO is very similar to gas station diesel (except for the sulfur content), I thought it would also be useful to provide a comparison to diesel. And while I was on this topic, I also added automotive gasoline into the comparison.

In doing this comparison, we have to remember that federal and state taxes are added to the cost of automotive diesel and gasoline. For example, in NH, total taxes on transportation diesel are as much as 44.03 cents/gallon (19.63 cents of state taxes and 24.40 cents of federal taxes). [By the way, if you have puzzled about the red color of your home heating oil, it is because HHO is not subject to these taxes and a red dye is usually added to distinguish HHO from the fuels intended for transportation use and sold at gas stations. If you are caught running red HHO in your diesel vehicle you are liable to be fined.]

This is an interesting set of data, raising a boatload of questions, but one needs to be cautious in its use. Many folks might challenge me and point out that spot market price comparisons of crude oil, heating oil and retail prices for similar periods are incorrect because it takes time for changes in underlying commodity prices to pass through the value chain all the way to the HHO I am paying for. This is correct, but only up to a point, so I was careful to pick a period when prices were fairly stable and we were not seeing the recent volatility in consumption and prices whipped up by the polar vortex. We will return to this later on in this article.

The first question I had when I looked at this data was: why are diesel and HHO more expensive than gasoline if it is less expensive to produce diesel and HHO at a refinery compared to gasoline? This is determined by the market dynamics for diesel and gasoline and the economic factors of supply and demand. In terms of supply, the US has traditionally been a gasoline-focused market so there is a lot of gasoline refining capacity and supply. More recently, however, the amount of gasoline demanded in US has fallen and so gasoline prices have decreased relative to diesel.

On the other hand, not as much diesel is produced but demand has been increasing, due to increased sales of diesel-burning vehicles and larger exports of diesel. This increased demand for diesel has led to increased prices.

The challenge with HHO is that it is a dual purpose fuel. It is used as for home heating and, in its low sulfur diesel form, it is used for transportation: it is often the larger transportation market dynamics that end up dictating the price for HHO. In this respect HHO shares some similarities to the natural gas market here in New England. Natural gas is a dual purpose fuel as well, used for home heating and electricity production. The continual interplay in the demand from both markets drives price changes.

Let’s return to the margins shown in the table above, particularly the two highlighted. The orange highlight is the price difference between the NH harbor spot price and the NH retail price - the price that you would paid if you used HHO. This price difference is what the EIA refers to as marketing and distribution costs. In December 2013 this margin was 74 cents/gal or 20% of the retail price of HHO. It is important to understand this is not the margin that your local oil dealer is earning in delivering HHO to your house. Like many other commodities, the spot market price is only available to the very big commodity traders and market makers. The local oil dealers end up paying more than the NY price as there is a cost getting HHO to the local NH wholesale market. Instead, the oil dealers pay the NH wholesale price so their margin (shown in yellow) is lower but appears to be of order of 50 cents/gal. Bear in mind that this is an average margin - it does fluctuate and margins for different oil dealers differ depending on their contractual relationships with their wholesale suppliers.

At first glance, this 50 cent/gal margin earned by oil dealers,  appears good, but when one considers that an average oil delivery is about 150 gallons, this equates to only $75 per delivery. After subtracting the deliveryman’s salary and benefits, the diesel consumed in driving to the delivery point, the wear and tear on the vehicle, the costs for back office support and company overhead costs, not much is left in terms of a profit margin. In fact, some industry vendors believe the all-in costs per delivery are of the order of $70!  According to the folks at Oil Heat Council of New Hampshire, the HHO delivery business is very challenging and success is highly dependent on running a streamlined operation focused on keeping down logistics costs and good risk management practices which involve ensuring that HHO prices are hedged at all times.

When you compare these HHO margins with those for diesel retail transportation, it is important to understand that the businesses are very different in nature. Consider the following:

1. Diesel is sold from a central location – a gas station where we take our vehicles to fill them up. HHO is delivered to our homes so the HHO company has the expenses of the delivery vehicle and driver as well as tracking your consumption so they know when to deliver.
2. Retail diesel is a year-round business. HHO is a very seasonal business, in which ~80% of sales are made in the 120-day period between December and March: business very much dries up during the summer months.
3. An important part of the HHO business is customer contracts, which allow customers to lock in or cap prices for the next heating oil season. To offer this service, HHO companies have to lock in their HHO prices many months in advance by hedging their oil price. This involves the purchase of future delivery contracts, which is a form of insurance and so attracts an associated cost.
4. The oil delivery companies also have the costs of maintaining an inventory of oil during the slow season.

I wanted to dig more into the retail margins and how they fluctuate over time. There is unfortunately not much historical data for the margins between retail and NH wholesale prices so I looked the differential between the retail and spot price. The chart below plots the monthly average retail to spot market margin since 2000. A couple of interesting observations come to light.

The margins average about $0.70/gallon (similar to that seen for Dec. 2013 in the table above) but have been creeping up over time, as shown by the long-term trend line in red. There is also a distinct seasonal variation, shown by the black three-month moving average line: the margins are low in the summer and then peak in the winter when demand is high. In the winter the differential has at times risen to over $1.00/gallon.  Although I do recognize the economic forces of supply and demand at work, this makes me grumpy when I have to pay higher margins in the winter. Oil delivery companies sometimes charge more just because they feel they can. A specific case in point - I am presently in dispute with my own oil company who, just a week ago, charged me $4.85/gallon for a 175 gallon delivery because they thought they could. When challenged on the price, they were quick to reduce my bill by $100. This is blatant price gouging and I intend to pursue it further. I am now waiting for a call back from the General Manager of the operation. Clearly they thought they were delivering Royal Oil*.

The general increase in margin between the spot and retail price over time is perhaps a manifestation of how the HHO business has changed. Oil dealers now have half the business they had 10 years ago and perhaps need to charge more per remaining gallon to maintain their own shrinking businesses.

To understand this further, I examined the correlation between the spot and HHO prices and, not unexpectedly, as shown in the left-hand chart below, there is a strong correlation between the two - an R² value or correlation coefficient of 0.97. It then struck me that there is a reasonably long time lag between NY harbor HHO and retail prices so I would expect a delay in a price change passing through the value chain.  To test this idea, I took the analysis one step further and shifted the retail data back one month. This means I am plotting spot prices against retail prices one month later, e.g., November spot prices against December retail prices. In this case, the correlation improves and reaches a value of 0.99 (right-hand figure below). (On plotting spot prices against retail prices two months later, the R² value drops again to 0.95.)

So what do we learn from this second statistical digression? First, and hardly surprising, there is a good correlation between spot and retail prices for HHO but, more interestingly, there is even a better correlation between today’s wholesale prices and next month’s retail prices. This suggests that it takes about a month for changes in wholesale prices to pass through to changes in retail prices. Considering the number of intermediates involved in wholesale to retail business, this makes sense.

This has been a long discussion filled with lots of statistical analysis but these are issues that are of concern to us as energy consumers. I hope that my analysis and research does pull the curtain aside a little so we can get a deeper understanding of the margins in the energy markets and how they impact us.

To summarize, here are the main points:

• HHO consumption in NH has decreased significantly in the past decade, largely due to increases in oil prices and a warming trend.
• Other factors include a reduction in use of home burning oil, supplemental heat from other fuels sources, such as wood and propane, implementation of energy efficiency methods and Yankee frugality.
• HHO is a dual purpose fuel used in home heating and, in its low sulfur form, increasingly as a transportation fuel.  It is the demand changes in both these markets that have driven prices higher than gasoline.
• With the falloff in the HHO business, the margin between spot prices and retail prices has actually increased over time.
•  It takes about one month for any changes in spot prices to pass through to retail prices.

In my next post, I will be writing about kerosene as a home heating fuel and also how we, as consumers, can better protect ourselves from price fluctuations when it comes to home heating.

Until next time, remember to turn off the lights when you leave the room.

Mike Mooiman

Franklin Pierce University

mooimanm@franklinpierce.edu

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(*Royal Oil – A tune by The Mighty Mighty Bosstones who hail from Boston. I have been a ska-music fan going back to the early 80’s, with groups like The Specials, The English Beat and others. However, except for The Mighty Mighty Bosstones, I have never connected with US-grown ska music, preferring the UK- and Jamaica-based bands. The Bosstones are an exception, as I always enjoyed their use of punk and hard core rock in their sound and songs. Enjoy Royal Oil.)