Given the significant volatility in fuel prices in recent weeks, we’ve been fielding numerous inquiries from companies who are interested in developing and implementing a program to place a cap on fuel expenses for the first time in their company’s history. If you require the knowledge to do so yourself, this post along with others to be published in the future will help you obtain a better understanding of the most common fuel expenditure capping strategies available to commercial and industrial fuel consumers.
For starters, what is a futures contract? A futures contract is simply a standardized contract, between two parties to buy or sell a specific quantity and quality of a commodity for a price agreed upon at the time the transaction takes place, with delivery and payment occurring at a specified future date. The contracts are negotiated on a futures exchange, such as the New York Mercantile Exchange or “NYMEX”, 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 while the party agreeing to sell the futures contract, the "seller" of the contract, is said to be "short" the futures.
In essence, a futures contract obligates the buyer of the contract to buy the underlying commodity at the price at which he bought the futures contract. Similarly, a futures contract also obligates the seller of the contract to sell the underlying commodity at the price at which he sold the futures contract. In the vast majority of instances, however, very few futures contracts actually result in delivery (less than 2%), as most are utilized for hedging and are bought back or sold back prior to expiration.
There are three primary futures contracts which are commonly used for fuel hedging: ULSD (ultra-low sulfur diesel), WTI Crude Oil, and RBOB gasoline, which are traded on NYMEX. Regardless of whether you're looking at hedging diesel fuel, gasoline, or any other refined product, these three contracts serve as the primary benchmarks across the globe. In addition, there are many other contracts (futures, swaps and options) available for fuel hedging, most of which are tied to one of the major, global trading hubs of Asia, Europe, or the United States. As an aside, the NYMEX futures contract was previously known as heating oil and as such still trades under the symbol HO.
How can you utilize futures contracts to hedge your exposure to rising fuel prices? Let's assume that your company owns or leases a large fleet of vehicles and to ensure that your fuel costs do not exceed your budgeted fuel price, you have been asked to "fix" or "lock in" the price of your anticipated fuel consumption. For sake of simplicity, let's assume that you are looking to hedge (by "fixing" or "locking" in the price) 42,000 gallons of ULSD (diesel fuel) which you anticipate consuming in August 2020. To accomplish this, you could purchase one September ULSD futures contract, which happens to trade in 42,000 gallon increments (42,000 gallons = 1,000 barrels). In this example, you purchase the contract at the price of $1.15/gallon (which excludes taxes and basis differentials as well as distribution and transportation fees).
Now let’s theoretically fast forward to August 30, the expiration date of the September ULSD futures contract. Since you do not want to take delivery of 42,000 gallons of ULSD in New York Harbor which is the delivery point of the NYMEX ULSD futures contract, you decide to close out your position by selling your one September ULSD futures contract at the prevailing market price.
In scenario one, let's assume that the prevailing market price, at which you sold your future, was $2.00/gallon. In this scenario, your gain on the futures contract would equate to a profit of $0.85/gallon ($2.00-$1.15=$0.85). As such, in this scenario your net cost will be $0.85 less than the price you pay at the pump in August due to your futures hedge gains.
In scenario two, let's assume that the prevailing market price, at which you sold back the future, was $1.05/gallon. In this scenario, your loss on the futures contract would equate to $0.10/gallon ($1.15-$1.05=$0.10. Contrary to the first scenario, in this scenario your net cost will be $.10 more than the price you pay at the pump in August due to your futures hedge loss.
In both scenarios, the futures price you enter into will effectively become your basis cost at the pump. You will lock in a fixed price, ULSD futures – diesel price at the pump, regardless of market movement and direction. As this example indicates, purchasing a ULSD futures contract provides you with the ability to hedge and fix your anticipated diesel fuel costs for a specific month(s), regardless of whether the price of ULSD futures increase or decreases between the date that you purchased the futures contract and the date the futures contract expires.
While this example focused on hedging diesel fuel with ULSD futures, the same methodology applies to hedging gasoil, gasoline, heating oil, jet fuel, etc.
While there are many details that need to be considered before hedging with futures, the basic methodology of hedging fuel price risk with futures is pretty simple. That is, if you need to hedge your exposure to potentially rising fuel prices you can do so by purchasing a futures contract. Similarly, if you need to hedge your exposure to declining fuel prices, you can do so by selling a futures contract.
Many companies find that hedging their fuel price exposure is a cumbersome undertaking as futures contracts expire on a specific day of the month and most businesses consume fuel every day. As such, many companies find that swaps serve as a better tool as most fuel swaps can be tailored to fit the specific fuel needs of a particular company.
A swap is an agreement whereby one party exchanges their exposure to a floating (often referred to as spot, index, or market) fuel price for a fixed fuel price, over a specified period(s) of time. Swaps are available on nearly all types of fuel including bunker fuel, diesel fuel, gasoil, gasoline, heating oil, jet fuel, fuel oil, etc. Swaps received their name as the buyers and sellers of swaps are “swapping” cash flows with one another, floating for fixed and vice versa.
Swaps are often a more ideal fuel hedging instrument, as opposed to a futures contract, because futures contracts expire on a specific day each month and are composed of a standardized amount, while swaps can settle based on the average price over a predetermined amount of time and can be adjusted to fit unique fuel size requirements. The swaps settlement style is clearly better aligned with the way the vast majority of commercial and industrial consumers purchase fuel.
Commercial and industrial fuel consumers in numerous industries (air, marine, rail and road transport, manufacturing, mining, processing, etc.) utilize swaps in order to hedge their fuel price risk by fixing or locking in their fuel costs. Similarly, many fuel marketers, refiners, and traders utilize swaps to hedge their inventory and margins as both are impacted by price volatility. Many fuel marketers also utilize swaps to hedge their price exposure associated with the sale of fixed price fuel. In addition to fuel and other energy commodities, swaps are also utilized by companies seeking to hedge their exposure to foreign exchange, interest rates, metals, agricultural commodities, and energy.
As an example of how one can utilize a fuel swap to hedge their exposure to volatile fuel prices, let's assume once again that your company owns or leases a large fleet and wants to lock in a fixed price for a portion of your anticipated fuel consumption in November. In order to do accomplish this you could purchase a November diesel swap from one of your counterparties, often the commodity trading division of a bank or major oil company. You could purchase an outright futures swap, which obligates you to the underlying price of diesel, or you could purchase an option swap, which gives you the right but not the obligation to exercise protection against adverse price movement. Purchasing a November futures swap at a designated price will return gains if the price of diesel increases in November and will also obligate you to pay the counterparty should the price of diesel decrease in November. Purchasing a November option swap will give you the right to receive gains should the price of diesel increase in November but not the obligation to pay if the price of diesel decreases in November.
Now let’s examine how a swap will impact your costs if diesel fuel prices during November are both higher and lower than the price at which you paid for the swap, $1.20/gallon for this example.
In the futures swap situation, let's assume that diesel prices in November are higher and so is the price for diesel as traded at the New York Mercantile Exchange, NYMEX, each business day with a final settlement of $1.30/gallon. In this situation, your swap would provide you with a hedging gain of $0.10/gallon ($1.30-$1.20=$0.10). As a result, you would receive a payment of $0.10/gallon from your counterparty, which would offset your actual fuel cost by $0.10/gallon.
In the second situation, let's assume that diesel prices in November are lower and that the price for diesel futures, again as published at NYMEX each business day in November, is $1.10/gallon. In this situation, your swap would result in a hedging loss of $0.10/gallon ($1.20-$1.10=$0.10). As a result, you would be required to make a payment of $0.10/gallon to your counterparty.
In an option swap situation, let’s assume your concern is that diesel prices increase in November from their current price of $1.10/gallon to $1.25/gallon. You could purchase an option swap for your specific amount of fuel consumption that will protect against that $.15/gallon increase, and not have an obligation to pay anything to your counterparty should the price decrease instead. In that scenario, should the price drop from $1.10/gallon to $1.00/gallon, you do not owe anything to the counterparty.
As this example indicates, purchasing a diesel fuel swap allows a trucking company to hedge their exposure to unpredictable diesel fuel prices. If a fleet purchases a swap and the price of diesel fuel increases, the gain on the swap will offset the increase in their actual fuel expense. Conversely, if the price of diesel fuel declines, the loss on the swap will offset the decrease in their actual fuel expense. As a result, when a trucking company hedges with a fixed price swap, the fleet is “locking in” their diesel fuel cost regardless of whether diesel fuel prices are higher or lower when their swap expires.
As previously mentioned, fuel marketers, traders, and refiners can also employ swaps to hedge their exposure to fuel prices as well. As an example, a refiner who needs to hedge their exposure to potentially declining diesel fuel costs (as the market value of their inventory/stocks changes in line with market prices) could do so by selling (also known as shorting) a diesel fuel swap.