Back-end Basics

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Back-end Basics

By Donna Hood Crecca - 05/05/2003
What do bananas and gasoline have in common? Both can now be found at your local supermarket, mass merchant or warehouse club store.

Fuel appears to be a natural product extension for high-volume retailers. HVRs, as they are known, are touting cut-rate gas prices at the curb to entice shoppers into their parking lots and, ultimately, into their stores, most with positive in-store results. The likes of Meijer's, Wal-Mart and Costco are applying the tried-and-true model that has made them successful with everything from perishables to pocketbooks: big volume, low price.

But procuring and handling petroleum is a bit more complicated than getting a box of bananas from the warehouse to the sales floor. HVRs have had to quickly bone up on the in the ins and outs of two crucial areas of fuel marketing: the mechanics of handling fuel and procurement.

The back-end of a fuel-marketing program involves everything from construction and equipment to regulatory compliance and environmental oversight. As prime conduits for our nation's food supply, HVRs are well-versed in emergency planning and dealing with government regulations.

"Most supermarket chains already have infrastructure in place and contingency plans prepared to deal with various crises. Extending them to fuel is not that much of a stretch," said Lou Scudere, vice president, research and site development of Abingdon, Va.-based K-V-A-T. Twenty-one of the company's 86 stores in the Southeast now offer fuel.

"Having said that, I don't believe that any supermarket chain has ever had a bunch of bananas simultaneously burst into flame."

For that reason, most hypermarketers committed to fuel marketing have developed infrastructures anchored in petroleum expertise by schooling their own personnel, hiring petroleum pros or engaging consultants to develop their fuel programs. Wal-Mart, for instance, opted to outsource completely. The Bentonville, Ark.-based retail giant has regional lease agreements with Murphy Oil Corp., Tesoro Petroleum Corp. and Sunoco Inc. to operate fuel centers on its lots.

Costco Warehouse Corp. tapped industry experts to help develop its stations and fuel supply relationships when it first got into gasoline retailing in the early 1990s. Since then, the Issaquah, Wash.-based merchandising stalwart has developed internal experts, headed by Paul Latham, vice president of gasoline. Under his watch, a staff of 18 oversees operations at the 168 fueling sites at Costco stores. The only individual with a petroleum background is a recently hired compliance manager.

"Many [supermarket] organizations do rely on consultants and suppliers to give advice initially on site design and equipment selection," said K-V-A-T's Scudere. "The regulations, although unfamiliar, are not really that daunting due to the fact that most of the state-of-the-art leak detection equipment today supplies all of the regulatory information necessary to comply with environmental reporting requirements."

The decision to handle the back-end of the fuel program internally is typically made when the volume of sales justifies the addition of dedicated personnel, he noted.

Coping With Compliance

The key issues confronting HVRs on the environmental front are the same ones faced by traditional petroleum marketers: proper storage tank installation, monitoring of the site, and utilizing secondary containment of underground piping, tanks, submersible pumps and dispensers, according to James Walton, vice president of environmental systems at Cincinnati-based OPW Inc.

To ensure the safety and compliance of equipment, HVRs are wise to opt for quality companies and products over the lowest-priced contractor, Walton advised. The OPW package, he explained, "enables the end user to deal with one supplier, rather than a basket of 15 sub-suppliers with the lowest cost items, which is not what you want to bury to control dangerous fluids with fluctuating pressures, temperatures and other environmental issues."

For most HVRs, the transition to dealing with environmental and regulatory issues linked to fuel marketing was not a great leap. "The changing regulations certainly provide significant challenges, but we're accustomed to dealing with regulations in many aspects of our business, so we don't view that as particularly burdensome," said Costco's Latham, adding, "Understanding the regulatory environment and insuring we're in compliance with all requirements is a huge focus for us. I recommend that retailers considering getting into fuel marketing get someone on their staff with a thorough understanding of the environmental and regulatory issues in their market areas."

Major HVRs, like Costco, utilize national contractors to handle tank alarm monitoring and point-of-sale system maintenance. A network of local and regional contractors typically is used to address construction issues, and equipment manufacturers attend to maintenance and repair.

In developing these contracts, however, HVRs are known for applying the high-volumes, low-cost strategies that drive their negotiations of traditional product categories. They do this despite the reality that they don't always qualify as 'high volume' due to the comparatively low number of sites located in each market.

"In a given market, you may have a handful of supermarkets or a single club store versus 20 or more branded gasoline stations," said an equipment industry insider. "Equipment companies aren't going to get rich servicing the HVRs and building their stations. National contracts aren't exactly rational [for the equipment company]. The travel time involved in moving the big equipment from one retailer's site to their next one would be a cash drain. And those big retailers really beat you up on pricing—they're looking for rock-bottom rates."

Procurement Roulette?

The competition on retail prices has some HVRs applying petroleum procurement strategies that observers believe may soon be the undoing of more than a few of the newer fuel programs.

"The type of retail marketing these operators are accustomed to is cut-throat, and they're offering that type of pricing at the pump," observed Fadel Gheit, senior energy analyst at Fahnestock & Co. in New York. "In Europe, this approach totally destroyed margins on fuel. When you keep pushing prices down to the point that they're below the break-even point, no one makes any money and the program ultimately backfires."

A vicious cycle appears to be underscoring HVR fuel marketing. The retailer gets into gas to draw customers into the store, thus gasoline is typically priced as a loss leader. Not only does this strategy deliver a competitive edge in the consumer marketplace it also drives up that retailer's volume. That enables these big-box behemoths to gain the attention of major refiners and suppliers, qualify themselves as volume retailers and secure superior deals. As competition at the curb heats up and the retailer instinct to procure the product at the lowest price simultaneously kicks in, margins are basically annihilated.

As a result, the risk management that comes into the petroleum procurement model is far greater than that involved in buying bananas in bulk.

"In reality, the back-end fuel center management is not that much different than the management of other perishable commodities such as fresh meat and produce, [where supermarket operators] have to deal with the fluctuations of those respective markets on a daily basis," said K-V-A-T's Scudere. "Where petroleum departs from the traditional supermarket perishable acquisition model is in the massive volume which is required to begin to practice risk management in product acquisition."

Pick Your Poison

Tom Kloza, chief oil analyst at Oil Price Information Services in Lakewood, N.J., identifies three strategies employed by HVRs when buying petroleum.

The first is the Wal-Mart model: lease lot space to an experienced petroleum marketer that either has ties to supply outlets or is a refiner as well. Because the actual price the station operator pays for the petroleum is not publicized, one can only guess at the wholesale and the margin involved. So, how beneficial such deals are to the fuel marketer is somewhat unsure.

"The street numbers imply that the wholesale number is ultra-competitive," Kloza said. "The jury is out as to the success that refiners like Tesoro have had with these outlets."

A second strategy is buying daily or weekly at the best available number, without booking the price on a term basis. Typically, this involves buying unbranded petroleum at the best available wholesale price, a strategy employed by many large, unbranded convenience stores and now, said Kloza, BJ's Wholesale Club, which offers petroleum at more than 50 of its 134 locations.

Companies including Kroger, Safeway and Winn-Dixie employ what Kloza refers to as a "formula price" strategy. This involves buying via aggressive formula deals designed to insure that they are purchasing at the very competitive numbers available to bulk dealers in a given operating area where the fueling sites are located. In some cases, HVRs are buying on the spot market.

Costco, with over a billion gallons in sales annually, now drives the hardest bargains, Kloza added. This spring, the club giant requested the opportunity to buy on terms that references both the spot and rack markets, with 24 hours of price protection. The controversial request caused some refiners to take a pass bid, wrote Kloza in Oil Express in June.

Hedging Your Bets

While the exact nature of most petroleum purchasing deals are not readily available, both Kloza and Gheit doubted that HVRs are hedging — locking into a fixed price over a set term. If they are, Gheit predicts, they will soon abandon that strategy.

"Hedging is like buying a very risky insurance policy — you don't burn your arm to collect the insurance money," he said. "In the long run, no one makes money on hedging. Fuel management executives get fired and companies take big financial hits when hedging is part of the strategy. If they're hedging, they'll learn soon."

That day may come quickly. Those relying on unbranded gasoline are typically hardest hit by price inversions — when street price fall below the branded rack — and anyone hedging or employing some of the riskier strategies will be walloped. "HVRs that tied their purchase prices to averages of postings, or 'posted lows' could be at a distinct disadvantage in the event of a price inversion," Kloza explained.

Supply shortages represent the biggest threat, however. As users of unbranded petroleum, HVRs will likely find themselves among the first to see their product dry up. Since the operational and financial models for HVR petroleum marketing programs were developed with no history of price inversion and supply shortages taken into account, one can imagine the potential impact on the HVR model.

"Until now, HVRs have generally succeeded [with their petroleum programs] with slim and scant retail margins, but it's worth it because of the boost in inside sales," mused Kloza. "A summer or two of significant losses for the gasoline offering could change this paradigm significantly. Wall Street likes to measure the chain retailers in terms of same-store sales. At the end of the day, profits have to be generated."

And if petroleum doesn't pan out properly, there's always bananas.