The Corner

A gasoline hedge for the little guy.

When it comes to high gasoline prices, the government can do something. It can loosen restrictions on drilling (and make some money while they’re at it), end the ethanol mandate, abolish rules on regional and seasonal blends, and stop doing other things that are causing the problem.

But how about an additional solution from the free market? A reader who has been an energy trader for 15 years wants to create a service (he calls it the G3P) that would let you insure yourself online against high gas prices in future months, taking advantage of technological advances that give the consumer greater access to futures markets. Here’s the explanation:

Throughout the country, average retail gasoline prices track gasoline futures prices. And they track very well. This is the market basis of the G3P (the Gas Price Protection Program)…[A]s regional trading markets have evolved, futures prices set spot prices.

All this means that, over a month’s time, the gasoline futures market can be used to manage retail prices. But … the futures market is designed for energy and trading companies and, as such, each contract represents 42,000 gallons — far too much for average consumer. So how can consumers use it to their advantage? That’s where the G3P comes in. The G3P bridges the gap between consumers and the risk management instruments in the energy futures market.

Here’s how it would work:

“Hugh” lives near Los Angeles and buys approximately 200 gallons of gasoline per month. The current average unleaded regular price is $3. 45/gal. Based on his experience and expectations, he is concerned the price will go as high as $4.00/gal, costing him an additional $110 per month over current prices.

He decides to participate in the Insurance service of the G3P, which offers to protect him against prices exceeding different levels in several forward months. He chooses June 2008 for 100 gallons, where the fee (premium) for the price exceeding $3.70/gal is 6.0 ¢/gal, totaling $6 for 100 gallons. Hugh enrolls on-line, paying the $6 premium up-front by PayPal…

Case 1 – the average index price of gasoline for June was $ 4.20/gal.

Hugh is reimbursed $(4.20-3.70)/gal x 100 gals, or $50, having paid only $6 for price

protection.

Case 2 – the average index price of gasoline for June was $3. 40/gal.

Hugh receives no reimbursement because the average price of $3. 40/gal is less than

$3.70/gal (the “strike” price) for June.

There is also a fixed-price option.

‘David’ locks in 100 gallons for August 2008 at $3.70/gallon for geographic region ‘R’. Depending on David’s credit-worthiness, he pays $370 up-front for settlement on the gross (or nothing up-front for settlement on the difference). The swap settles in early Sept. 2008 … Case A: the average August retail price of regular unleaded in region R is $4.20/gallon David is reimbursed $420 (net gain on ‘hedge’ $50). Case B: the average August retail price of regular unleaded in region R is $3.50/gallon David is reimbursed $350 (net loss on ‘hedge’ $20). The transaction is financial only, so David’s actual physical gasoline purchases have no bearing. The extent and location of his hedges are entirely up to him.

I think I understand this — sort of. I have no idea how they would price this kind of insurance/hedge, but I’m sure somebody could figure out a way to make it work.

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