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.