What You Should Know About Diesel Hedging and Swaps
If there’s one thing that is certain in fleet operations, it’s that fuel prices constantly fluctuate. Prices can drop for weeks, then spike overnight, making budgeting and cost control challenging even for experienced fleet operators.
Since fuel is one of the largest operational expenses, even small shifts in fuel prices can substantially impact business operations and profitability. So, what can you do to manage fuel cost fluctuations, stabilize budgets, and protect your bottom line?
Simple: Talk to your fuel provider or financial institution about diesel hedging and swaps.
Understanding Diesel Hedging and Swaps
You can’t control fuel price volatility caused by events, seasonal demand, and supply chain disruptions. But diesel hedging and swaps can help you mitigate the impact of price volatility on fleet operations.
What Is Diesel Hedging?
Diesel hedging is a financial strategy to protect against fuel price volatility. It reduces the risk associated with fuel price fluctuations and creates cost stability. Fleet operators can lock in fuel prices for a predetermined period to protect fleet operations from unpredictable price shifts. They can do this by using financial instruments such as fuel swaps.
What Is a Fuel Swap?
A fuel swap is a contract between a fleet operator and their fuel provider or financial institution that sets a fixed price for an exact volume of diesel fuel over a specified period. The price may rise or fall during that time, but whatever the outcome, the fleet operator pays the price agreed upon in the contract.
Let’s look at a diesel hedge scenario using a fuel swap.
Say you operate a utility fleet and consume 50,000 gallons of diesel per month. You’re concerned about fuel price volatility and how it might affect your budget. You contact your fuel provider and enter a two-month fuel swap contract to hedge against price fluctuations. Locked in at $3.75 per gallon, you continue buying diesel as needed at the current market price.
There are two possible outcomes:
- Diesel Prices Rise: The market price spikes in Month 1 to $4.00 per gallon and $4.20 per gallon in Month 2. You receive a total hedge payment from your fuel provider for $35,000.
Month 1: ($4.00 - $3.75) x 50,000 = $12,500
Month 2: ($4.20 - $3.75) x 50,000 = $22,500
If prices rise, the hedge protects you from higher fuel costs and ensures budget predictability.
- Diesel Prices Drop: The market price drops in Month 1 to $3.50 per gallon and $3.40 per gallon in Month 2. You pay your fuel provider $30,000 to settle the hedge contract.
Month 1: ($3.75 - $3.50) x 50,000 = $12,500
Month 2: ($3.75 - $3.40) x 50,000 = $17,500
If prices fall, you pay more than the market price, which means a missed opportunity for cost savings.
Weighing the Advantages and Risks
While hedging removes uncertainty, it’s not without risk, especially if prices drop significantly. Careful planning and working with the right partner are crucial to a well-executed strategy that provides long-term cost and operational advantages, including:
- Cost and Budget Stability: Locking in fuel costs makes forecasting, budgeting, and long-term planning easier and more predictable.
- Protection Against Market Volatility: When prices spike unexpectedly, fuel operations are protected from sudden cost increases that could affect profitability.
- Better Financial Planning: Stable fuel costs mean better financial management, allowing assets to be allocated efficiently and strategic investments made without concern over sudden price spikes.
- Competitive Advantage: When fuel prices are stable, fleet operators can offer consistent pricing to customers, ensuring their reputation as reliable and cost-effective operators.
To Hedge or Not to Hedge … That’s a Very Big Question
If you’re considering diesel hedging and swaps, the first step is to talk with your fuel provider. Ask if they offer risk management solutions or can connect you with a financial institution that facilitates hedging contracts.
Before talking with anyone, answer these questions:
- What is your fleet's monthly and annual fuel consumption?
- What impact can price fluctuations have on your operations?
- What level of risk are you willing to take on?
You can also hedge a portion of your fuel needs to test the strategy or enter into a short-term contract to assess feasibility. Starting small allows you to measure the benefits without making a big commitment.
Diesel hedging and swaps are not for every fleet. You must evaluate your financial situation, operational needs, and risk tolerance. Asking the right questions is key in deciding if a diesel hedging and swap strategy benefits operations and helps you manage fuel costs, stabilize budgets, and maintain predictable expenses.
Download our Fuel Hedging 101 guide to learn more.