With fuel being the largest operating expense for fleets, controlling fuel costs is a top priority for fleet managers and one that can often seem like a full-time job. Fuel price volatility and unpredictable economic environments don’t make controlling fuel costs any easier, but what can help are proven strategies that ease fuel cost management regardless of fluctuating fuel prices.
Downsizing, rightsizing, preventative maintenance, telematics, and fleet fuel cards are just a few of the various strategies that can help combat price instability and control fuel costs. While all of these can be beneficial, one thing they don’t address is the actual price of fuel. However, a fuel hedging strategy does.
So, let’s take a closer look.
Fuel Hedging Basics
Fuel hedging is a strategy used by companies, including trucking companies and airlines, to reduce their exposure to volatile or potentially rising fuel costs. Alternatively known as price risk management, fuel hedging is a contractual tool that allows a company to fix or cap a fuel price at a certain level and for a certain amount of time — from one to three months or for several years. It can be utilized for various fuel types, including diesel and gasoline.
While there are a vast number of financial instruments available for fuel hedging, commercial fleets typically utilize three….call options, swaps, or futures contracts.
Here’s a brief overview of each.
Call Options — also called caps or ceilings — are the least risky hedge instrument and provide payouts to a company when prices rise above the cap price. If prices fall below the cap price, a company receives no payout. Fleets acquire the cap as a premium, and it functions like insurance because only the premium is at risk. Fleets can also acquire put options, which provide a hedge against declining fuel prices. With a put option, the value grows when the fuel price falls. With a call option, the value grows when the fuel price rises.
A fuel swap is the riskiest hedge instrument and provides a payout when fuel prices rise above the fuel swap price. There isn’t a premium associated with the swap, but should prices fall below the swap price, the company must make payments to the underwriter who sold them the fuel swap.
A futures contract is an agreement between two parties to buy or sell a specific quantity of a commodity for a price agreed upon at the time of the transaction (the forward price), with delivery and payment occurring at a specified future date. Futures contracts are traded on exchanges such as CME/NYMEX or ICE and settle on the last trading day of each month. Typically, but not in all cases, futures contracts are sold in lots of 42,000 gallons per month — 42,000 gallons = 1,000 barrels.
Who Can Benefit from Hedging
Companies can benefit from hedging if they are sensitive to fuel price volatility and are looking for stabilization and predictability of fuel costs. Among the advantages are reduced vulnerability to price fluctuations, improved fuel planning and budgeting, improved cash flow, and insured profit margins.
Weighing major factors — such as fleet size and composition, tolerance to fluctuating oil prices, and current and future goals — is critical when determining if hedging would be an effective strategy for your company.
It’s best not to fly solo when making that determination. Instead, discuss fuel hedging options with a fuel risk management company that can help you better determine if hedging would be beneficial for your company in the long run.
Should you decide hedging would be beneficial to your operation, a price risk management company can prepare a plan, develop custom strategies, and keep you apprised of new hedging opportunities and products that can help lower your long-term energy costs and operating budget. Choose your price risk management company wisely and look for one with a proven track record in market experience, knowledge of energy markets, products, and resources offered by financial institutions and/or energy commodity exchanges.
Risk Versus Reward
One thing that is important to remember when making a hedging decision is that hedging should be viewed as a tool to help reduce risks and stressors that can be associated with trying to gauge fuel prices. Think of a hedging strategy more as an insurance policy that allows fleet managers to concentrate on what they do best — manage their fleet.
At the end of the day, implementing a hedging strategy comes down to carefully examining risk versus reward. You could save money by hedging, but it could also cost you in the long run. You may not be able to “lock in” at the lowest fuel prices, but you may avoid upward price swings. Hedging is certainly not risk-free. But, having no contract in place may be the biggest risk of all because fuel prices often change overnight, and a solid hedging strategy can keep the effects of price surprises to a minimum.