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.