Welcome to the seventh and final installment of comprehensive series covering best practices to incorporate into your business for improved fuel management. Our team of industry experts are committed to sharing insights and strategies that will help you mitigate your exposure to market volatility, effectively manage fuel contracts, and make informed decisions regarding your fuel purchases and sales.
In this instalment, we address a topic that may seem intimidating to even the most sophisticated fuel buyer – hedging. However, it is important to understand that adopting a hedging program is not something to fear or consider as mere speculation.
In my extensive experience working with fuel buyers and sellers, I have found that the most effective way to explain a well-structured fuel buying program is to examine it from two perspectives. First, there is the physical fuel buying program, which encompasses the methods used to purchase actual fuel.
Second, there is the “paper” side of the portfolio, commonly known as hedging. While it is relatively straightforward to grasp the concept of optimizing the physical side by securing the best deals from suppliers through transparent contracts, hedging is more intricate and warrants a closer examination.
What is edging?
Fuel hedging or fuel risk management is a strategy companies use to reduce or eliminate their exposure to volatile and potentially rising fuel costs. It is a contractual tool that allows a company to fix or cap a fuel price at a certain level and for a specific period.
Why do fuel buyers and sellers need to hedge?
The answer is simple – to manage risk. Fuel prices are constantly fluctuating and can experience significant volatility at time. To illustrate this, let us consider a couple of scenarios:
1. Suppose you are a buyer of diesel fuel for a large township based in the Northeast. Your annual budget for diesel fuel is $50 million. Now, imagine an extended winter freeze grips the region, causing refinery production issues and distribution challenges along a key pipeline. As a result, diesel fuel prices skyrocket for an extended period. Suddenly, it appears that your $50 million fuel budget may quickly escalate $60 million or even higher
The question arises: where does that additional funding come from?
You have no choice but to purchase the fuel to keep your township’s trucks running, regardless of the direction in which prices move. The risk lies in your fuel budget spiraling out of control.
2. Consider a different scenario where you are a major supplier of diesel fuel in California. One of your largest clients is a farming company that purchases diesel fuel exclusively during the region’s 5-month farming season. The client has asked for a “locked in” price, meaning they desire one fixed price for the entire five-month period.
As a supplier, you want to accommodate their request because of their substantial volume of purchases. Let’s say you provide them with a locked-in price of $3.00. However, due to refinery and shipping issues, the physical market price during that five-month stretch jumps to $4.00 per gallon. Although you must still honour the agreed-upon price of $3.00, you are losing $1.00 per-gallon. Unfortunately, you cannot back out of the deal just because the market turned against you. Again, you need to participate in the market, regardless of prices movements.
In both cases, if the buyer and seller had properly hedged their physical fuel positions, the hedge would have largely mitigated the additional costs, ensuring both parties remained financially
Let’s simply things a step further. A “hedge” refers to a financial instrument such as a futures contract or an option offered by a regulated exchange like CME. Alternatively, it can be an “over the counter” instrument provided by an independent financial institution like a bank. By implementing proper fuel hedging (which we will discuss shortly), any losses incurred in your physical fuel position due to unfavorable market movements are compensated by funds that flow into a commodities account.
To successfully navigate the world of hedging, keep in mind the following crucial points:
1. Collaborate with a qualified broker who can guide you through establishing your hedging program. Start small and avoid hedging everything at once.
2. Determine whether you will hedge through an exchange or over the counter. If you opt in to hedge through an exchange like CME, the exchange guarantees performance of the counterparty. On the other hand, using an over-the-counter provider poses the risk of that counterparties business faltering, leaving you in a precarious position. Most fuel buyers and sellers choose to hedge through an exchange.
3. Obtain internal buy-in. Involved a team of your colleagues to adopt hedging, designate only one person to manage the day-to-day decision-making process.
Risk versus rewardAt this point, hedging may seem like an excellent strategy with no downsides. However, there are certain factors related to hedging that you and your company should be aware of, particularly “margin.” Each day, your hedge will “mark to the market.” If you hedge through an exchange, they will require you to allocate a cash margin, which can be a substantial amount of capital. There may be days when the hedge moves against you, triggering a margin call that necessitates replenishing your margin account. Additionally, you must decide whether to utilize a standard futures contract or perhaps an option, which functions similarly to an insurance policy. With an option, you pay a premium to secure the right to exercise it if the market reaches a specific level, known as the “strike price.”
None of the aspects I just mentioned should deter you. If you work with a reputable futures broker, they will guide you through the process.
Ultimately, hedging enhances competitiveness and often gives you an advantage on your competitors who do not hedge.
In conclusion, implementing a well-planned program is a vital step for fuel buyers and sellers to effectively manage risk. By striking a balance between physical fuel purchasing strategies and hedging, you can safeguard your business from unpredictable price fluctuations.