An Introduction to Fuel Hedging - Utilizing Financial Tools to Manage Fuel Price Risk

1. An Introduction to Fuel Hedging
Utilizing Financial Derivatives to Manage Fuel Price Risk

2. 2
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 accu-
rately 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 market’s perception of these factors, are the
primary factors that drive fuel prices. Most large fuel-
consuming companies, such as those in the aggre-
gates 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 commodi-
ties) 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 ex-
ample 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? That’s anyone’s
guess—hence, 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 competi-
tion; they compete with domestic and offshore com-
panies 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.
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 hedg-
ing involves establishing a position in a financial in-
strument that is equal and opposite of the company’s
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
day-to-day operations).
Hedging works because the cash prices and financial
derivatives tend to have a strong correlation to their
An Introduction to Fuel Hedging
Utilizing Financial Derivatives to Manage Fuel Price Risk
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.

3. An Introduction to Fuel Hedging
3
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 company’s 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 nega-
tively 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.
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-low-sulfur 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 Depart-
ment of Energy’s Energy Information Administration.
Which benchmark a company should use for fuel
hedging must be determined on a company-by-com-
pany basis. This depends on a number of factors such
as location of the company’s 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 op-
tion (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 be-
cause your swap is not based on the current price; you
are buying a swap 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).
A company that does not hedge its fuel costs is
generally stating one of two things:
– 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.
– 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.

4. An Introduction to Fuel Hedging
4
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 gal-
lon, 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.
Summary
There are many ways to reduce your company’s
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.
SeƩlement Price = $2.50
Date
Mar 15
May 31
Result
Financial Hedge
Buy
Feb $3.00
Fuel Swap
Feb $2.50
Fuel Swap
$2.50
Purchase
$2.50
Purchase
$0.50 Loss
Receive Buy Receive
Physical Fuel ConsumpƟon
SeƩlement Price = $4.00
Date
Mar 15
May 31
Result
Financial Hedge
Buy
Feb $3.00
Fuel Swap
Feb $4.00
Fuel Swap
$4.00
Purchase
$4.00
Purchase
$1.00 Gain
Receive Buy Receive
Physical Fuel ConsumpƟon
Net Cost: $2.50 + $0.50 = $3.00 Net Cost: $4.00 - $1.00 = $3.00
FUEL SWAP EXAMPLE

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