An Introduction to Fuel HedgingUtilizing Financial Derivatives to Manage Fuel Price Risk
2In fuel intensive industries, fuel prices can have asignificant impact on the bottom line, not to mentionadding to the difficult task of budgeting for future fuelexpenditures. If fuel costs are not actively managed,they can lead a company to exceed budget forecasts,or worse, lower profit margins or losses. Do you knowhow to develop a “system” that will allow you to accu-rately estimate your fuel costs for next month? Whatabout the next quarter, or the next year?Many factors affect fuel prices. However, economicconditions, storage inventories and weather, as wellas the market’s perception of these factors, are theprimary factors that drive fuel prices. Most large fuel-consuming companies, such as those in the aggre-gates industry, can mitigate their exposure to volatileand potentially rising fuel costs, as well as natural gasand electricity costs, through hedging. Hedging allowsmarket participants (companies that consume largequantities of diesel fuel and other energy commodi-ties) to lock in prices and margins in advance, whilereducing the potential impact of volatile fuel prices.As this is being written, WTI futures are trading at$97.84/BBL and ICE Brent is trading at $114.71, whileheating oil, gasoil and gasoline futures are trading at$3.1144, $959.50 and $2.9144, respectively. As an ex-ample of just how volatile energy prices have become,October crude oil futures increased $25/barrel in oneday. Where will fuel prices be trading three months,one year or two years from now? That’s anyone’sguess—hence, the reason why large fuel consumingcompanies can benefit by embracing the concept offuel hedging.Avoid the RiskThe fluctuating price of fuel can present large financialrisks that have a significant impact on the bottom line.And that is the primary reason why many large, fuel-consuming companies hedge their fuel risk. Anotherreason is to improve or maintain the competitivenessof the company. All companies are subject to competi-tion; they compete with domestic and offshore com-panies that produce similar goods for sale in the globalmarketplace. Being able to accurately forecast and/ormanage fuel costs can give a company a competitiveadvantage.Hedging reduces exposure to price risk by shiftingthat risk to companies that have opposite risk profilesor to investors who are willing to accept the risk inexchange for a potential profit opportunity. Fuel hedg-ing involves establishing a position in a financial in-strument that is equal and opposite of the company’sexposure in the physical fuel market. (The physicalmarket is the “market” where a company procuresand consumes the actual fuel that it consumes in itsday-to-day operations).Hedging works because the cash prices and financialderivatives tend to have a strong correlation to theirAn Introduction to Fuel HedgingUtilizing Financial Derivatives to Manage Fuel Price RiskBy developing and implementing a sound fuelhedging program, you will not only be ableto mitigate your risk, you will also be able toaccurately forecast your future fuel costs.
An Introduction to Fuel Hedging3respective counterparts. Even though the correlationbetween the cash and derivatives may not be one-to-one, the risk of an adverse change in the correlationis generally much less than the risk presented by nothedging at all.Again, the purpose of fuel hedging is to mitigatethe company’s exposure to volatile and potentiallyrising fuel prices, thus stabilizing its fuel expenses.Hedging is not a means for an aggregate producer togamble on the price of fuel. Gambling on fuel prices,also known as speculating, often produces resultsthat are worse than doing nothing at all. Large fuel-consuming companies should only utilize hedging toreduce the probability that the company will be nega-tively affected by rising fuel prices. On the other hand,speculators are of the opposite mentality. They beton the direction of fuel prices in hopes that they willbe able to “buy low and sell high.The Tools of the TradeFuel swaps are contracts in which two parties agreeto exchange periodic payments for fuel. In the mostcommon type, one party agrees to pay a fixed pricefor fuel on a specific date(s) to a counterparty who,in turn, agrees to pay a floating price that referencesa widely accepted price published by an independentpublication. Examples include the wholesale price ofultra-low-sulfur diesel fuel and jet fuel as publisheddaily by Argus and Platts, or a government index thatcovers the price of on-highway diesel fuel publishedsuch as the one published each week by the Depart-ment of Energy’s Energy Information Administration.Which benchmark a company should use for fuelhedging must be determined on a company-by-com-pany basis. This depends on a number of factors suchas location of the company’s operations, grades of fuelconsumed and tolerance for risk.A fuel option contract gives the holder the right, butnot the obligation, to buy or sell a specified amount offuel (or a fuel swap or heating oil futures contract) ata specified price within a specified time, in exchangefor paying an upfront premium. Call options and putoptions are other variables in the mix. A fuel call op-tion (cap) is a contract that gives the holder the right,but not the obligation, to buy fuel at a set price (thestrike price) on a given date. A fuel put option (floor) isa contract that gives the holder the right, but not theobligation, to sell fuel at a set price (the strike price)on a given date.Hedging in ActionThe following example shows how you can use a dieselfuel or jet fuel swap to create a known, future fuel cost.Assume that on March 15 you want to ensure thatyour cost of fuel, during the month of May, is fixed asof March 15. As such, you decide to buy a $3.00 Mayfuel swap based on the price published by Argus. Thecurrent price for diesel fuel may be lower or higherthan $3.00/gallon. However, that is immaterial be-cause your swap is not based on the current price; youare buying a swap based on the average daily price offuel in during the month of May. As a result, regardlessof where fuel prices are trading during the month ofMay, your net cost will be $3.00 per gallon (excludingtransportation costs, taxes and environmental fees).A company that does not hedge its fuel costs isgenerally stating one of two things:– Our company has the ability to pass on anyand all increases in fuel prices to our customers,without a negative impact on our profit margins.– Our company is confident that fuel prices aregoing to fall. We are comfortable paying a higherprice for fuel if, in fact, our analysis proves to beincorrect.
An Introduction to Fuel Hedging4To expand on this example, if fuel prices during themonth of May average $4.00 per gallon, you wouldpay your fuel supplier(s) an average price of $4.00 pergallon; however, you will receive a payment of $1.00per gallon from the company that sold you the swap.Conversely, if May fuel prices average $2.50 per gal-lon, you would pay your fuel supplier an average of$2.50 per gallon, and you would pay the company thatsold you the swap $0.50 per gallon. Either way, yournet cost would be $3.00 per gallon.SummaryThere are many ways to reduce your company’sexposure to volatile fuel prices, including futures,swaps and options. By developing and implementing asound fuel hedging program, you will not only be ableto mitigate your risk, you will also be able to accuratelyforecast your future fuel costs. Not to mention, youmight also be able to provide your company with acompetitive advantage. If you decide to develop andimplement a fuel hedging program, fuel costs will nolonger be on the list of things that keep you awakeat night.SeƩlement Price = $2.50DateMar 15May 31ResultFinancial HedgeBuyFeb $3.00Fuel SwapFeb $2.50Fuel Swap$2.50Purchase$2.50Purchase$0.50 LossReceive Buy ReceivePhysical Fuel ConsumpƟonSeƩlement Price = $4.00DateMar 15May 31ResultFinancial HedgeBuyFeb $3.00Fuel SwapFeb $4.00Fuel Swap$4.00Purchase$4.00Purchase$1.00 GainReceive Buy ReceivePhysical Fuel ConsumpƟonNet Cost: $2.50 + $0.50 = $3.00 Net Cost: $4.00 - $1.00 = $3.00FUEL SWAP EXAMPLE