An Introduction to Fuel Hedging

An Introduction to Fuel Hedging

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Utilizing Financial Derivatives to Manage Fuel Price Risk

An Introduction to Fuel Hedging

In fuel intensive industries, fuel prices can have a significant impact on the bottom line, not to mention adding to the difficult task of budgeting for future fuel expenditures. 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 know how to develop a system that will allow you to accurately estimate your fuel costs for next month? What about the next quarter, or the next year?

Many factors affect fuel prices. However, economic conditions, storage inventories and weather,
as well as the markets perception of these factors, are the primary factors that drive fuel prices. Most large fuel-consuming companies, such as those in the aggregates industry, can mitigate their exposure to volatile and potentially rising fuel costs, as well as natural gas and electricity costs, through hedging. Hedging allows market participants (companies that consume large quantities of diesel fuel and other energy commodities) to lock in prices and margins in advance, while reducing 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, while heating oil, gasoil and gasoline futures are trading at $3.1144, $959.50 and $2.9144, respectively. As an example of just how volatile energy prices have become, October crude oil futures increased $25/barrel in one day. Where will fuel prices be trading three months, one year or two years from now? Thats anyones guesshence, the reason why large fuel consuming companies can benefit by embracing the concept of fuel hedging.

Avoid the Risk

The fluctuating price of fuel can present large financial risks 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. Another reason is to improve or maintain the competitiveness of the company. All companies are subject to competition; they compete with domestic and offshore companies that produce similar goods for sale in the global marketplace. Being able to accurately forecast and/or manage fuel costs can give a company a competitive advantage.

An Introduction to Fuel Hedging

Hedging reduces exposure to price risk by shifting that risk to companies that have opposite risk profiles or to investors who are willing to accept the risk in exchange for a potential profit opportunity. Fuel hedging involves establishing a position in a financial instrument that is equal and opposite of the companys exposure in the physical fuel market. (The physical market is the market where a company procures and consumes the actual fuel that it consumes in its dayto-day operations). Hedging works because the cash prices and financial derivatives tend to have a strong correlation to their respective counterparts. Even though the correlation between the cash and derivatives may not be one-to-one, the risk of an adverse change in the correlation is generally much less than the risk presented by not hedging at all. Again, the purpose of fuel hedging is to mitigate the companys exposure to volatile and potentially rising fuel prices, thus stabilizing its fuel expenses. Hedging is not a means for an aggregate producer to gamble on the price of fuel. Gambling on fuel prices, also known as speculating, often produces results that are worse than doing nothing at all. Large fuel-

consuming companies should only utilize hedging to reduce the probability that the company
will be negatively affected by rising fuel prices. On the other hand, speculators are of the opposite mentality. They bet on the direction of fuel prices in hopes that they will be able to buy low and sell high. A company that does not hedge its fuel costs is generally stating one of two things: 1. Our company has the ability to pass on any and all increases in fuel prices to our customers, without a negative impact on our profit margins. 2. Our company is confident that fuel prices are going to fall. We are comfortable paying a higher price for fuel if, in fact, our analysis proves to be incorrect.

An Introduction to Fuel Hedging

The Tools of the Trade

Fuel swaps are contracts in which two parties agree to exchange periodic payments for fuel. In the most common type, one party agrees to pay a fixed price for fuel on a specific date(s) to a counterparty who, in turn, agrees to pay a floating price that references a widely accepted price published by an independent publication. Examples include the wholesale price of ultra-lowsulfur diesel fuel and jet fuel as published daily by Argus and Platts, or a government index that covers the price of on-highway diesel fuel published such as the one published each week by the Department of Energys Energy Information Administration. Which benchmark a company should use for fuel hedging must be determined on a companyby-company basis. This depends on a number of factors such as location of the companys operations, grades of fuel consumed and tolerance for risk. A fuel option contract gives the holder the right, but not the obligation, to buy or sell a specified amount of fuel (or a fuel swap or heating oil futures contract) at a specified price within a specified time, in exchange for paying an upfront premium. Call options and put options are other variables in the mix. A fuel call option (cap) is a contract that gives the holder the right, but not the obligation, to buy fuel at a set price (the strike price) on a given date. A fuel put option (floor) is a contract that gives the holder the right, but not the obligation, to sell fuel at a set price (the strike price) on a given date.

Hedging in Action
The following example shows how you can use a diesel fuel or jet fuel swap to create a known, future fuel cost. Assume that on March 15 you want to ensure that your cost of fuel, during the month of May, is fixed as of March 15. As such, you decide to buy a $3.00 May fuel swap based on the price published by Argus. The current price for diesel fuel may be lower or higher than $3.00/gallon. However, that is immaterial because your swap is not based on the current price; you are buying a swap

An Introduction to Fuel Hedging

based on the average daily price of fuel in during the month of May. As a result, regardless of where fuel prices are trading during the month of May, your net cost will be $3.00 per gallon (excluding transportation costs, taxes and environmental fees). To expand on this example, if fuel prices during the month of May average $4.00 per gallon, you would pay your fuel supplier(s) an average price of $4.00 per gallon; however, you will receive a payment of $1.00 per gallon from the company that sold you the swap. Conversely, if May fuel prices average $2.50 per gallon, you would pay your fuel supplier an average of $2.50

per gallon, and you would pay the company that sold you the swap $0.50 per gallon. Either
way, your net cost would be $3.00 per gallon.
Fuel Swap Example Settlement Price = $2.50 Date Mar 15 May 31 Result Financial Hedge Buy Feb $3.00 Fuel Swap Receive Physical Fuel Consumption Buy Receive Mar 15 Feb $2.50 Fuel Swap $0.50 Loss $2.50 Purchase $2.50 Purchase May 31 Result Date Settlement Price = $4.00 Financial Hedge Buy Feb $3.00 Fuel Swap Receive Physical Fuel Consumption Buy Receive

Feb $4.00 Fuel Swap $1.00 Gain

$4.00 Purchase $4.00 Purchase

Net Cost: $2.50 + $0.50 = $3.00

Net Cost: $4.00 - $1.00 = $3.00

Summary
There are many ways to reduce your companys exposure to volatile fuel prices, including futures, swaps and options. By developing and implementing a sound fuel hedging program, you will not only be able to mitigate your risk, you will also be able to accurately forecast your future fuel costs. Not to mention, you might also be able to provide your company with a competitive advantage. If you decide to develop and implement a fuel hedging program, fuel costs will no longer be on the list of things that keep you awake at night.

Mercatus Energy Advisors is the leading, independent, energy risk management advisory firm. We provide our clients with innovative solutions in the financial and physical energy commodity markets through a comprehensive suite of quantitative and qualitative services. For more information, please call us at +1.713.970.1003 (Houston) or +44.20.3608.1277 (London) or visit our website at www.mercatusenergy.com 2012 Mercatus Energy Advisors. All Rights Reserved