Chapter 4:

Marine Fuel Pricing

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Chapter 4: Marine Fuel Pricing

o A low derivative of petroleum, prices are closely related to world oil prices
o Volatility depends on many factors, including political and economic events around the
world
o Disturbances and shocks to the world oil market are transmitted to the bunker market,
causing large fluctuations in bunker prices
o Three basic underlying causes for fluctuations:
 Crude and its products are global commodities - prices are determined by supply and
demand factors on a worldwide basis
 Price of crude mainly determines prices of its products. Thus, prices are largely
determined by worldwide demand for and supply of crude oil
 Prices reflect interactions of many buyers and sellers, each with their own view of
demand/supply of crude and its products. Interactions occur both in physical and
futures markets, and prices respond quickly to current and expected future changes in
supply/demand conditions
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Oil Product Prices (Rotterdam) (USD per Bbl) 3

Chapter 4: Marine Fuel Pricing

Major causes of Oil Price Volatility:

1. OPEC – Policies, Production decisions
2. Spare Production Capacity
3. Non-OPEC Supply Growth
4. Global economic growth
5. Inventories
6. Geopolitical Risks
7. Weather
8. Speculation, hedging, investment
9. Exchange rates, Inflation
10. Alternative energy
11. Global Trading Patterns
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Chapter 4: Marine Fuel Pricing

Bunker Pricing and Risk Management

• Fluctuations in bunker prices most important source of risk
• Costs vary on length of voyage, age of ship, size/efficiency of engines
• Long-haul voyage - bunker cost may be more than 75% of voyage costs
• For a short-haul voyage, it could be as low as 20%
• On average, bunker costs account for more than 50% total voyage costs
• Volatility in bunker prices have a major impact on the operating profitability of
shipping companies and ship operators
• Bunker prices are naturally related to world oil prices, which exhibit substantial
variability both in the short and long term

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Chapter 4: Marine Fuel Pricing
• Extremely important to control and minimize their exposure to bunker-market
fluctuations in order to secure their operating profit
• Bunker fuel hedging is a tool that can help to eliminate the risk of bunker budgets
getting out of control
• Example - prices in 2009 were much more volatile, with price distribution spread
across a range of $250, whilst the range for 2010 was only $150 with a higher mean
price
• Reasons why to hedge:
 Bunker prices fluctuate - the oil market is extremely volatile
 Bunker oil expenses represent a large fraction of the operational costs
 Insurance against price fluctuations
 Pro-active
• strategy for budget protection
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Chapter 4: Marine Fuel Pricing

Term deals - long-term contracts between a seller and a buyer of fuel. They agree on
quantities, grades, ports, and nomination procedures.
There are two different pricing solutions.

1. Fixed price physical - In this case, the fuel price is agreed when the contract is signed
and will be valid throughout the period of the contract. This type of contract gives
certainty of supply and certainty of price.
2. Floating price physical - In this case, the price will be related to a published market
price, and will vary from lifting to lifting. This type of contract gives certainty of supply
but not certainty of price.

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Chapter 4: Marine Fuel Pricing

Price Hedging
• A hedge is a position established in one market in an attempt to offset exposure to
price fluctuations in some opposite position in another market with the goal of
minimizing one's exposure to unwanted risk
• Mechanism developed in the 18th/19th centuries to aid farmers to manage cash flow
and to help manufacturers manage price fluctuations in their raw materials
• Key objective is to reduce exposure to the risk of price fluctuations
• Effectiveness of a hedge is a measure of how close the eventual fuel cost (physical/and
paper settlements) is to the budgetary estimate at the time the hedge deal was
commenced
• Choice of when and how to hedge is neither simple nor amenable to modeling

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Spot Markets Versus Futures Transactions

• “Spot markets” - often referred to as “physical market” - transactions involving
purchase or sale of a commodity, for near-term delivery – say over the coming month
• Numerous spot markets at different trading locations around the world
• Each spot market consists of many buyers and sellers, including refiners, traders,
producers, and transporters, transacting throughout the chain of supply - from the oil
well right through to the refinery
• These allow buyers and sellers (e.g., refiners and marketers) to more easily adjust their
crude oil and petroleum product supplies to reflect near-term supply and demand
conditions in both the product markets and the crude oil markets

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• A futures contract concerns the future purchase or sale of bunkers

• It is a contract that carries the obligation for delivery of a given quantity of bunkers in
the future
• Contract specifies the volume, grade of oil, price, future time in which bunkers are
bought or sold, and location where it is to be delivered
• Buying and selling of futures contracts occurs on organized exchanges
• Since the vast majority of traders “close out” their positions, futures transactions rarely
entail the actual delivery
• The futures market is often referred to as the “financial market”
• The specific crudes underlying futures contracts are often called “marker” or
“benchmark” crudes – WTI on NYMEX, Brent on ICE etc.
• Prices of futures contracts are connected to prices in the physical market

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Common Types of financial derivatives

1. Forward
• Two parties agree on buying or selling an asset at an agreed price
• Actual exchange then happens on a future date, thus the term forwards
• No outside party is involved
• The contract in a forward type of financial derivative is non-standardized - choice of the
parties
• A Forward Bunker Agreement is defined as an OTC agreement between a bunker seller
and a bunker buyer to exchange a specified quantity of bunker of certain quality, at an
agreed price and at a certain place and time of delivery in the future
• Bunker prices can thus be fixed for a certain date in the future
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2. Futures contract
• It is simply a standardized contract, between two parties to buy or sell a specific
quantity and quality of bunkers
• The price is agreed upon at the time the transaction takes place
• Delivery and payment occurring at a specified future date
• Contracts are negotiated on a futures exchange, such as CME/NYMEX or ICE, which
acts as a neutral intermediary between the buyer and seller
• The party agreeing to buy the futures contract, the "buyer", is said to be "long" the
futures
• The party agreeing to sell the futures contract, the "seller" of the contract, is said to be
"short" the futures

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• There are three primary futures contracts which are commonly used for fuel hedging:
ULSD (ultra-low Sulphur diesel) and RBOB gasoline, which are traded on
CME/NYMEX and gasoil, which is traded on ICE.
Forward contract Futures contract

Private contract between two parties Traded on an exchange-base

Contract is not standardized Contract is standardized

One delivery date is specified Allows a range of delivery date

Settled at the end of contract Settled daily

Physical delivery or final cash settlement Contract is usually closed out

Usually take place Prior to maturity

Parties accept some credit risks Virtually no credit risk

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3. Swaps Agreement
• Agreement where parties exchange exposure to a floating (spot, index or market) fuel
price for a fixed fuel price, over a specified period(s) of time
• Available on nearly all types of fuel including fuel oil, diesel, gasoil, etc.
• So named as buyers and sellers are “swapping” cash flows with one another - floating for
fixed and vice versa
• A better ideal fuel hedging instrument than a futures contract
• Futures contracts generally expire on a specific day each month while swaps settle based
on the average price over the course of the month
• Settlement style is clearly better aligned with the way the vast majority of commercial
and industrial consumers purchase fuel

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• Strategy is simply a fixed price swap based on one of the "liquid" (actively traded)
bunker fuel indices such as Platts Gulf Coast 3% fuel oil, Platts Rotterdam 3.5% fuel oil
or Platts Singapore High Sulphur fuel oil 380 CST

Forward contract Swap contract

Single forward contract Portfolio of forward contracts

One future delivery date is specified Several future delivery dates

Settled at the end of contract Settled by period

Physical delivery or final cash No physical delivery, only final cash

Parties accept some credit risks High credit risk

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4. Options
• Options gives holders the right, but not the obligation to buy or sell an underlying asset
at a pre-determined price, somewhere in the future
• When you take an option to buy an asset it is called a ‘call’ and when you obtain the
right to sell an asset it is called a ‘put’
• To determine whether it is profitable to exercise an option, the current market price
(spot price) and the price in the option (strike price) need to be compared
• By comparing both prices, a choice can be made to either exercise the option or let it
expire
• When exercising an option there are three positions on which the holder can find
themselves

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• The first is in the money (ITM), where strike price is more favorable than the spot
price and thus it will be advantageous to exercise the option
• The second is at the money (ATM) in which the strike and spot price are equal and so
no advantage can be gained
• The third is out the money (OTM), where strike price is higher than spot price. In this
case it is better to let the option expire and buy the commodity at the current market
price.
There are two ways of settling an option between two parties.
• The first way is to physically deliver the underlying commodity
• The other way is to cash settle the option
• In this way the difference between the spot and strike price is paid to the holder of the
option upon exercising of the option
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• An option has a few advantages over other derivatives.

• The most important advantage is that an option is not binding, in the way is does not
obligate one to buy a commodity.
• It gives you the right to buy it and so when the price of the option is higher than the
current market price you can just let the option expire and buy at the spot price.
• The only loss made, will be the premium which is the cost for maintaining the option.
• Another advantage is the usefulness of options as a hedging tool.
• Options offer the tools to successfully hedge price movements with a small
investment risk.

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Chapter Ends !!!

Questions ???

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