Most companies do not hedge their expected fuel needs. This list includes many airlines and shipping companies; firms where fuel is one of their largest costs. They get hurt when fuel costs rise. For example, the price of diesel has risen 92% from January 2016 to today. So, why haven’t they hedged?
The hedge battlefield is littered with the loss ledgers of failed hedges. Swaps entered at high prices where fear is worst, toxic complex derivatives that blew up after being constructed to appear free, and hap-hazard purchases based on the opinion of experts. No wonder Boards of Directors have called a halt to hedging, leaving the companies to take market prices as they rise and fall.
Is there a better way out there? The answer is a resounding yes!
A fuel hedge can perform exactly as insurance (e.g. fire, casualty, property) does. Realized risk, i.e., rising prices, is offset with a payment. No realized risk, i.e., falling prices, invokes no action from the insurance contract. A known premium, just like in all insurance, is paid to acquire the contract. Companies would not consider opening their doors without their buildings, assets, and potential liabilities covered by insurance. Companies do not suffer unexpected losses from purchasing insurance. Why not put fuel supply cost in the same category?
Those who use the Volatility Limiting Strategy (VLS) insure themselves against adversity in their fuel supply cost. To them, VLS is an insurance policy. Here is an example that shows why.
Assume buyer (B) uses 10,000,000 gallons of diesel per year.
Here are historical prices of diesel
If B purchased the year’s supply of diesel on the dates shown beginning in 2016, the purchases would cost as follows.
2018 $20,580,000 Total all years $48,610,000
If B uses VLS to insure against rises in fuel cost, the purchases would cost as follows.
2018 $18,447,000 Total all years $43,889,000
Using VLS saved B $4,721,000 net, for the premium is included in the outcome.
What does this tell us? That VLS performs as an insurance policy would. There is no limit to the compensation that will arise from price increases. There no effect on beneficial downward price moves. There is a premium which in this example is 10%. This is known prior to the purchase of the protection.
Boiling it down further, the premium pays for unlimited insurance. If diesel prices went from $2.00 to $2000.00, admittedly unlikely, the contract will pay the difference, which is $1998.00. This is bona-fide protection from financial adversity.
Think of the news from the airlines industry, where we read of great gains from a hedge one year followed by a hedging disaster in years following. With a strategy performing as VLS does, none of the bad news would have been part of the story.
Another benefit of VLS is that it can be built into physical fuel purchasing. For those firms who do not wish to purchase a financial contract, the operations of VLS can be bolted onto a physical fuel contract so that VLS becomes part of the fuel procurement program.
So, to address the title of this article, it is possible to have transparent and unlimited insurance against fuel price adversity at a known and unchanging price and to enjoy this protection without any downside. Thus, as a hedger, you can have your cake and eat it, too!
I believe that VLS is the best risk-limiting strategy available. It is transparent and flexible. Those who use it have no fear of radical moves in the commodity’s price. And, it can be built into existing physical purchasing activities. Please contact me for more information.
In the shipping and trucking industries, fuel surcharges are commonplace, and have become the answer to dealing with fuel price volatility. The charges are pushed down the line to the customer. This leaves the transporter largely immune from the effects of price change.
Does the fuel surcharge do the job entirely? Are there risks and opportunities within the fuel surcharge economy that warrant a financial hedge? There indeed may be. This article examines a few of them and makes a case for adding a right-sized layer of financial hedging into the mix.
The Risk - Fuel surcharges are designed to handle the normal ebb and flow of fuel price changes. In the low-margin (compared to say, software) transportation business, any change in the primary input's price has profound consequences. Surcharges smooth this out. Yet, if prices shift upwards in response to non-recurring events such as currency problems, supply problems, or war, then the magnitude of the required surcharge creates its own consequences. Customers faced with a rapid change in the price of the service will do all they can to reduce the use of it for at least as long as it takes to push this through their supply chains. This introduces a negative effect, customer aversion, that cannot be mitigated with surcharges. Customer aversion caused many bankruptcies in the offshore service industry during the last oil price downturn as wells were shut in and new drilling slowed. A financial hedge can soften the blow from customer aversion by providing money to the transporter to fill the gap between the initial aversion and the later recovery of service purchasing. Here is a quick generic example of how this would work.
A transporter buys 200 12-month diesel 2.55 calls at .0185. Each call represents 42,000 gallons of diesel. Diesel is currently $1.85, so the calls cost 1% of the cost of fuel. The total cost of the calls is $155,400.
An economic event occurs which sends the price of diesel up to $2.55. Six months have passed since the call purchase. Customers are doing what they can to reduce their service purchase because of the higher fuel surcharge. The transporter decides to liquidate the calls for needed working capital. The calls are now worth .2260. The liquidation yields $1,906,000 in working capital.
Keep in mind that the fuel surcharge is still in effect. The majority of the transporter's customers are disgruntled yet are paying the surcharge. The minority that temporarily left the transporter created a financial hole that the transporter needed to fill with down-sizing and other efficiencies. The yield from the financial hedge gave the transporter the time and working capital necessary to adjust in a crisis-free manner.
Another Application - The average truck MPG is 6 MPG loaded and this average is factored into most fuel surcharge calculations. Our example is a truck transporter who runs a fleet averaging 4 MPG. This less-efficient fleet costs less to own than the newer fleets so at today's diesel price of $1.85 it makes sense to continue to use the lower-efficiency gear.
Knowing that a rise in the price of diesel will hurt the low-efficiency transporter because of the surcharge being based on a higher assumed MPG, the transporter decides to purchase a financial tail hedge. The transporter uses 2.5 million gallons of diesel per year. 60 12-month $2.55 calls are purchased at $.0185 per gallon for a total cost of $46,620.
Within six months, diesel prices have risen to $2.55 because of unexpected inflation. Now, the surcharge economics based on mileage differences are costing this transporter $12,166 per month. The calls are liquidated, yielding $571,800. The net return of the financial hedge will cover the mileage penalty for 43 months, giving the transporter enough time to wait out the price change or retool its fleet.
Many transporters resist hedging; relying on the assumption that fuel surcharges offload the risk to the consumer. They may be 80% correct. The remaining 20%, the area in which cash-flow is hurt, can be economically mitigated with a financial tail hedge: Insurance for business continuity.
by JAY PIERCE
Interval Purchasing is the practice of buying or selling swaps or forwards to financially purchase a supply chain for a specific period. It is not hedging – it is procurement. For example, a commodity user buys 90 days of Nat Gas futures on January 2, April 2, July 2, and October 2 and so on. Even though it looks like the buyer covered his supply chain for a year, he did not. Rather than a full year of coverage, there were four consecutive three-month periods covered. The purchasing coverage is only effective for the three-month period currently active and nothing more. A simple numerical example illustrates this.
On January 2, the price was 5 when the three-month forward is bought. On April 2, the price was 10 when the forward is bought, on July 2 the price was 15, and on October 2 the price was 20. The average price paid by the interval purchaser for the year was 12.5, much better than the final price of 20. Looking closer we find -
Let us now compare this scenario using Continuous Hedging and observe the differences.
Continuous Hedging views the commodity supply chain as a permanent recurring cost center and seeks to insure it against price shocks in a recurring, never-ending, manner. Continuous Hedging’s goal is to protect the firm. It is not procurement, it is financial insurance.
Looking back at our last example, the year’s requirements (10,000mmcf) would cost $50mm if purchased at once. The Continuous Hedger would buy calls covering the entire period. The cost of the calls is 10% in this example. Adding the cost of calls, the year’s requirement cost is now $55mm.
On January 2, the price was 5 when the Continuous insurance is bought. On April 2, the price was 10, on July 2 the price was 15, and on October 2 the price was 20. The average price paid by the Continuous Hedger for the year was 5.5, dramatically better than the final price of 20. Looking closer we note the following:
If the price level had gone down instead of up, the calculation is easy. The commodity supply chain cost will be over-all lower than the year before, a benefit to the firm, but will be higher than doing nothing by no more than $5mm, the cost of the hedge. Taken another way – here are two scenarios, one is a savings of $70mm and the other is a cost of insurance of $5mm. One only needs to see the first scenario once every 14 years for it to be better for the corporation to continuously hedge rather than not.
Let’s frame this further – on the chart below using the previous 10000mmcf supply chain example, since 2000, there have been six price events. Please compare the costs of the Continuously Hedged position and that of the position using interval procurement or similarly, no hedge. The premium cost assumption of 10% is embodied in the calculation.
There is no complex derivative or cost-saving strategy that can come anywhere close to these results. Clearly, for the hedger not using this strategy, the extra cost on 10,000mmcf/yr. is at least $144,200,000 over the 17-year period. For many readers, this may be your scenario.
Many Boards have said that the initial cost of Continuous Hedging is burdensome. Insurance does have a cost. But that burden is not relevant any longer because non-bank, non-secured margin financing, that will pay the cost of the insurance up-front, is available to corporations at very competitive rates. We facilitate this as part of our value.
Here is the call to action to corporate Boards of Directors, CEOs, and CFOs – Do not confuse procurement with insurance. For the best practice of protecting your company’s financial health, employ Continuous Hedging to protect your commodity supply chain against price shocks. We are experts in Continuous Hedging. Call on us to assist you!
THE HEDGING DECISION
The issue of whether to hedge risk continues to baffle many corporations. At the heart of the confusion are misconceptions about risk, concerns about the cost of hedging, and fears about reporting a loss on derivative transactions. A lack of familiarity with hedging tools and strategies compounds this confusion. Corporate risk managers also face the difficult challenge of getting hedging tools (i.e., derivatives) approved by the company's board of directors. The purpose of this newsletter is to clarify both some of the basic misconceptions surrounding the issue of risk as well as the tools and strategies used to manage it. "Derivations" is part of our commitment to work with you to create financial solutions.
An effective hedging program does not attempt to eliminate all risk. Rather, it attempts to transform unacceptable risks into an acceptable form. The key challenge for the corporate risk manager is to determine the risks the company is willing to bear and the ones it wishes to transform by hedging. The goal of any hedging program should be to help the corporation achieve the optimal risk profile that balances the benefits of protection against the costs of hedging.
This article will outline seven steps designed to help risk managers determine whether their companies stand to benefit from a hedging program.
STEP 1: IDENTIFY THE RISKS
Before management can begin to make any decisions about hedging, it must first identify all the risks to which the corporation is exposed. These risks will generally fall into two categories: operating risk and financial risk. For most non-financial organizations, operating risk is the risk associated with manufacturing and marketing activities. A computer manufacturer, for example, is exposed to the operating risk that a competitor will introduce a technologically superior product which takes market share away from its leading model. In general, operating risks cannot be hedged because they are not traded.
The second type of risk, financial risk, is the risk a corporation faces due to its exposure to market factors such as interest rates, foreign exchange rates and commodity and stock prices. Financial risks, for the most part, can be hedged due to the existence of large, efficient markets through which these risks can be transferred.
In determining which risks to hedge, the risk manager needs to distinguish between the risks the company is paid to take and the ones it is not. Most companies will find they are rewarded for taking risks associated with their primary business activities such as product development, manufacturing and marketing. For example, a computer manufacturer will be rewarded (i.e., its stock price will appreciate) if it develops a technologically superior product or for implementing a successful marketing strategy.
Most corporations, however, will find they are not rewarded for taking risks which are not central to their basic business (i.e., interest rate, exchange rate, and commodity price risk). The computer manufacturer in the previous example is unlikely to see its stock price appreciate just because it made a successful bet on the dollar/yen exchange rate.
Another critical factor to consider when determining which risks to hedge is the materiality of the potential loss that might occur if the exposure is not hedged. As noted previously, a corporation's optimal risk profile balances the benefits of protection against the costs of hedging. Unless the potential loss is material (i.e., large enough to severely impact the corporation's earnings) the benefits of hedging may not outweigh the costs, and the corporation may be better off not hedging.
STEP 2: DISTINGUISH BETWEEN HEDGING AND SPECULATING
One reason corporate risk managers are sometimes reluctant to hedge is because they associate the use of hedging tools with speculation. They believe hedging with derivatives introduces additional risk. The opposite is true. A properly constructed hedge always lowers risk. It is by choosing not to hedge that managers regularly expose their companies to additional risks.
Financial risks - regardless of whether they are managed - exist in every business. The manager who opts not to hedge is betting that the markets will either remain static or move in his favor. For example, a U.S. computer manufacturer with French franc receivables that decides to not hedge its exposure to the French franc is speculating that the value of the French franc relative to the U.S. dollar will either remain stable or appreciate. In the process, the manufacturer is leaving itself exposed to the risk that the French franc will depreciate relative to the U.S. dollar and hurt the company's revenues.
A reason some managers choose not to hedge, thereby exposing their companies to additional risk, is that not hedging often goes unnoticed by the company's board of directors. Conversely, hedging strategies designed to reduce risk often receive a great deal of scrutiny. Corporate risk managers who wish to use hedging techniques to improve their company's risk profile must educate their board of directors about the risks the company is naturally exposed to when it does not hedge.
STEP 3: EVALUATE THE COSTS OF HEDGING CONSIDERING THE COSTS OF NOT HEDGING
The cost of hedging can sometimes make risk managers reluctant to hedge. Admittedly, some hedging strategies do cost money. But consider the alternative. To accurately evaluate the cost of hedging, the risk manager must consider it considering the implicit cost of not hedging. In most cases, this implicit cost is the potential loss the company stands to suffer if market factors, such as interest rates or exchange rates, move in an adverse direction. In such cases the cost of hedging must be evaluated in the same manner as the cost of an insurance policy, that is, relative to the potential loss.
In other cases, derivative transactions are substitutes for implementing a financing strategy using a traditional method. For example, a corporation may combine a floating-rate bank borrowing with a floating-to-fixed-rate swap as an alternative to issuing fixed-rate debt. Similarly, a manufacturer may combine the spot purchase of a commodity with a floating-to-fixed swap instead of buying the commodity and storing it. In most cases where derivative strategies are used as substitutes for traditional transactions, it is because they are cheaper. Derivatives tend to be cheaper because of the lower transaction costs that exist in highly liquid forward and options markets.
STEP 4: USE THE RIGHT MEASURING STICK TO EVALUATE HEDGE PERFORMANCE
Another reason for not hedging often cited by corporate risk managers is the fear of reporting a loss on a derivative transaction. This fear reflects widespread confusion over the proper benchmark to use in evaluating the performance of a hedge. The key to properly evaluating the performance of all derivative transactions, including hedges, lies in establishing appropriate goals at the onset.
As noted previously, many derivative transactions are substitutes for traditional transactions. A fixed-rate swap, for example, is a substitute for the issuance of a fixed-rate bond. Regardless of market conditions, the swap's cash flows will mirror the bond's. Thus, any money lost on the swap would have been lost if the corporation had issued a bond instead. Only if the swap's performance is evaluated considering management's original objective (i.e., to duplicate the cash flows of the bond) will it become clear whether the swap was successful.
STEP 5: DON'T BASE YOUR HEDGE PROGRAM ON YOUR MARKET VIEW
Many corporate risk managers attempt to construct hedges based on their outlook for interest rates, exchange rates or some other market factor. However, the best hedging decisions are made when risk managers acknowledge that market movements are unpredictable. A hedge should always seek to minimize risk. It should not represent a gamble on the direction of market prices.
STEP 6: UNDERSTAND YOUR HEDGING TOOLS
A final factor that deters many corporate risk managers from hedging is a lack of familiarity with derivative products. Some managers view derivatives as instruments that are too complex to understand. The fact is that most derivative solutions are constructed from two basic instruments: forwards and options, which comprise the following basic building blocks:
STEP 7: ESTABLISH A SYSTEM OF CONTROLS
As is true of all other financial activities, a hedging program requires a system of internal policies, procedures and controls to ensure that it is used properly. The system, often documented in a hedging policy, establishes, among other things, the names of the managers who are authorized to enter hedges; the managers who must approve trades; and the managers who must receive trade confirmations. The hedging policy may also define the purposes for which hedges can and cannot be used. For example, it might state that the corporation uses hedges to reduce risk, but it does not enter hedges for trading purposes. It may also set limits on the notional value of hedges that may be outstanding at any one time. A clearly defined hedging policy helps to ensure that top management and the company's board of directors are aware of the hedging activities used by the corporation's risk managers and that all risks are properly accounted for and managed.
A well-designed hedging program reduces both risks and costs. Hedging frees up resources and allows management to focus on the aspects of the business in which it has a competitive advantage by minimizing the risks that are not central to the basic business. Ultimately, hedging increases shareholder value by reducing the cost of capital and stabilizing earnings.
This article has been re-formatted. It is reproduced through the generous permission of the estate of Dr. Ian H. Giddy, Professor of Finance, New York University
There is a big change taking place in pension plan management. Historically, professional stock pickers were engaged to actively trade the plans’ cash and create returns. Over time, it became clear that the active professional stock pickers, no matter how skilled, had their days in the sun and then had their failures – human nature. Then came indexation, or passive management, where managers oversaw an algorithmic process that keeps the plans’ cash invested without emotion and with less trading. Today the passive approach is gaining adherents while the active approach is falling out of favor as results show the passive approach having greater returns with less volatility.
The evolution in pension plan management predicts an evolution in commodity supply chain hedging. Currently, hedgers embrace an event driven strategy. Commodity traders and brokers analyze the current and near future market circumstances and then recommend strategies to reduce or alter risk. This works well for the most part, but requires a relationship with a “hot” market operator who has figured out the turn of events. This breaks down when the operator begins a cold streak. Then, the hedger must endure sub-optimal results or worse, a period of excess loss, while the market operator regains footing. This complete scenario is analogous to the active professional stock-picker model in both its benefits and detriments.
The comparison to pension plans’ passive approach takes the form of an option-based structure built around a time line. With knowledge of the hedger’s time-related commodity needs, that is its supply chain, a structure is built that employs unique transactions for discrete time periods which are modified by the relation of price to historical price tranches. It appears much like a grid, where position in time and price calls for a pre-determined transaction that is tuned to size of the supply chain at that point in time. Once the grid is employed, then future supply needs turn into nearer supply needs as time passes. This leaves the furthest out part of the grid to be replaced as time passes. Adjustment to the transactions are pre-ordained and are dictated by changes in time, price, and size of supply need.
Use of the passive approach takes the hot or cold operator out of the equation. The hedger is now not event driven, but supply chain driven. If the supply chain is unbroken, the hedge is continually delivering market based price protection in a transparent and predictable fashion.
What are the benefits and detriments of the passive approach vs. the active approach to commodity hedging?
Effect on hedger’s capital structure
The upshot is that just as there are two schools of approach in evolving pension plan management, there are similarly two schools in commodity supply chain hedging. It’s reasonable to expect that the increased predictability and the lower human operator X factor will favor an increasing use of the passive approach in supply chain hedging.