Guidebook for Evaluating Fuel Purchasing Strategies for Public Transit Agencies (2012)

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1 S e c t i o n 1 Energy is one of the largest and most variable costs for organizations that operate in the trans- portation sector. The importance of managing fuel price risk has grown in recent years as higher fuel prices have increased energy’s share of overall costs and greater price volatility has made fuel costs increasingly difficult to predict. Following the energy crisis and price deregulation of the 1970s, private companies in the transportation sector—including airlines and other large fuel consumers—began using financial products to manage energy price risk when new risk manage- ment tools were introduced. Although the popularity of these instruments has grown tremen- dously since their inception, public transit agencies have been slow to adopt these innovations in risk management. Throughout much of the 1990s, low and largely stable fuel prices made managing fuel price risk mostly unnecessary. Since the early 2000s, however, extreme volatility in energy markets has led to a renewed interest in fuel price risk management, particularly after the severe oil price spikes of 2007 and 2008 (see Figure 1.1). This guidebook is designed to introduce the topic of fuel price risk management to public transit agencies. It should be noted that risk management is distinct from removal of risk and does not assure the lowest fuel prices; rather, risk management seeks to control the impact of price swings. This guidebook describes and evaluates different fuel purchasing strategies avail- able to transit agencies and outlines the steps that an agency needs to follow to implement an effective risk management program. This guidebook is not a “do-it-yourself” manual, but is designed to provide an understanding of key concepts on which the reader can build. 1.1 Why Manage Fuel Price Risk? The primary reason that public transit agencies manage fuel price risk is to achieve budget certainty. In recent years energy prices have risen tremendously and have grown increasingly volatile. This scenario has had two major effects on public transit agencies. First, higher energy prices have increased the share of energy costs in transit agencies’ overall budgets. As a result, the overall budgets are more sensitive to the changes (either up or down) in the price of energy. Figure 1.2 shows how a typical transit agency’s fuel prices would have increased as a share of total operating expenses over the past decade, assuming that fuel accounted for 5% of the agency’s budget in 2000. Figure 1.2 shows that fuel costs as a share of total operating expenses would have more than doubled from 5% to 12% from 2000 to 2008 if fuel costs increased at the same rate as oil, and non-fuel expenses grew at the general inflation rate. A 2008 study by the American Public Transportation Association (APTA) showed fuel and power costs increased from 6.13% of the operating budget in 2004 to 10.88% of the operating budget in 2008.1 The second effect Introduction 1 “Impact of Rising Fuel Costs on Transit Services.” American Public Transportation Association. May 2008. http://www.apta. com/resources/reportsandpublications/Documents/fuel_survey.pdf

2 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies Source: SAIC, Energy Information Administration: http://www.eia.doe.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=RWTC&f=D 0 20 40 60 80 100 120 140 160 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 20 09 20 10 20 11 $ p er B ar re l Relative Stability Strong Upward Trend Extreme Spike & Crash Figure 1.1. West Texas Intermediate (WTI) crude oil spot price, 1991–2011. Source: SAIC 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Fu el C os t a s Pe rc en t o f T ot al O pe ra tin g Ex pe ns es Figure 1.2. Hypothetical growth of fuel costs as a share of total operating expenses (2000–2010).

introduction 3 of higher prices and greater volatility on public transit agencies is that it has made it increasingly difficult to predict energy costs over the course of a year. The overall result of these two effects is that the budgets of public transit agencies have grown increasingly uncertain. Budget uncertainty is a concern for public transit agencies because they have little leeway to manage higher energy costs. Most transit agencies operate under fixed budgets with funding coming from a combination of farebox receipts and contributions from state and local tax rev- enue. When costs rise, some transit agencies pass through costs in the form of higher fares, but this may be politically difficult if a large share of the agency’s ridership is lower income. Manag- ing the budget in other ways—such as cancelling or delaying capital improvements, delaying or cancelling service increases and operating improvements, and cutting existing services—might also be painful and could impact the long-run health of the agency’s transit system. Borrowing funds for operations or increasing local or state contributions to fill the budget gap are other possibilities, but these options may be politically difficult and might violate the balanced budget requirements of many state and local governments. Given the limited operational and budget flexibility of many public transit agencies, budget certainty is a very desirable goal and is a strong reason to manage fuel price risk. Opponents to using financial products to lock-in fuel prices (a practice called hedging) feel that the practice is too risky and akin to gambling. However, hedging consultants and transit agencies that hedge make the opposite argument: agencies that buy fuel at the market price with- out hedging are taking a greater risk than agencies that use hedging instruments to lock-in or cap future fuel prices. They suggest that buying fuel at the volatile market price is more of a gamble because the transit agency doesn’t know if it will pay more or less than originally budgeted. If executed properly, hedging significantly reduces the probability that a transit agency will exceed its planned fuel budget over a given fiscal year. Other hedging proponents compare hedging to buying insurance: it may not be necessary every year, but not having it one day could financially ruin a transit agency.2 Overall, hedging does not remove risk; rather, it changes the risk from day-to-day variations in prices—and associated difficulties in establishing firm budget allocations—to variations in average prices over a longer term. While a longer-term future price projection will sometimes prove to be too high, locking into a longer-term price allows confident budget allocations. A key objective of hedging is that over the course of many long-term contracts, the higher-than-actual contract prices and lower-than-actual contract prices balance out and the agency gains certainty for adequate budgeting. 1.2 Types of Energy Price Risk The main types of energy price risk are commodity price risk, delivery price risk, and tax price risk. Before these risk types are described in detail, it important to first explain the cost components that make up the price of fuel. The price of fuel paid by a public transit agency is the final product of costs and profit-taking across a long and capital-intensive supply chain that includes producers, shippers, refiners, and distributors. An increase in costs across any one of these segments will pass through to the final consumer. Figure 1.3 shows the breakdown by component of a gallon of diesel in 2010, as well as the average breakdown from 2002 to 2009. In 2010, taxes (including federal and average state taxes) accounted for 16% of the price of a gallon 2 Vitale, Robert. “Hedging eases pain of rising fuel prices for COTA.” The Columbus Dispatch. April 10, 2011. http://www. dispatchpolitics.com/live/content/local_news/stories/2011/04/10/copy/hedging-eases-pain-of-rising-fuel-prices-for- cota.html?sid=101 (April 14, 2010).

4 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies of diesel, distribution and marketing accounted for 12%, refining accounted for 9%, and crude oil accounted for 63%. The price component breakdown in Figure 1.3 outlines the three types of energy price risk (i.e., delivery, commodity, and tax risk). Delivery price risk corresponds with the distribution and marketing segment; commodity price risk corresponds with the crude oil and refining seg- ments; and tax risk, of course, corresponds with the tax segment. Commodity price risk is the biggest of the three risks that transit agencies face, because it makes up the lion’s share of the cost of fuel. Together, crude oil and refining accounted for roughly two-thirds of the cost of fuel between 2000 and 2009 and nearly three-fourths of the cost of in 2010. Commodity price risk is the risk that crude oil and/or refining costs will increase significantly and put pressure on the transit agency’s budget. The price of crude oil—the major input for petroleum products—is driven at the macrolevel by global supply and demand characteristics. Among other factors, crude oil prices have been driven sharply higher in recent years as a result of a surge in demand from developing countries, slow growth in global production, an erosion of global spare production capacity, geopolitical instability in oil producing regions, the devalu- ation of the dollar, and a growing interest in oil derivatives as an alternative investment product. Risks in the refining sector are associated with local or regional petroleum product markets, including unplanned refinery shutdowns that curtail supply or weather-related increases in demand for petroleum products such as heating oil. Commodity price risk is extremely difficult for a transit agency to manage because it is based on events that are largely out of the agency’s control (instability in the Middle East, hurricanes in the US Gulf Coast, etc.). A lower or more stable commodity price cannot simply be negotiated with a supplier. As a result, more sophisti- cated risk management tools are needed. Since the 1980s, financial derivative products such as futures, swaps, and options have emerged to help energy consumers to hedge their risk expo- sures. Adopting these risk management tools will give public transit agencies the best opportu- nity to reduce energy price volatility and achieve their goal of budget certainty. These strategies are discussed in depth in Sections 2 through 5 of this guidebook. Source: SAIC, Energy Information Administration: http://www.eia.gov/oog/info/gdu/dieselpump.html Figure 1.3. Diesel fuel pump price by cost component.

introduction 5 A lesser but not insignificant concern is delivery price risk. Delivery price risk is the risk that a local fuel distributor will charge a high and unreasonable margin price for fuel. This situation may arise in an uncompetitive market in which the fuel distributor has monopoly power. While it is unlikely that any one distributor will be able to dominate large fuel markets, smaller markets may have just one supplier. Nevertheless, delivery price risk is often not a major driver of price volatility for most transit agencies. This is because the distribution and marketing component makes up a relatively small share of the total price of fuel. Transit agencies and other end users typically purchase fuel from local distributors at a rack plus margin price. Distributors purchase fuel at a floating rack price at a refinery or a product pipeline terminal and then resell that fuel to consumers at a higher price that takes into account the cost of transporting the fuel and profit for the company. The difference between the rack price and the price charged to the consumer is the supplier’s margin, which is often a fixed amount quoted in cents per gallon. In 2010, this mar- gin accounted for only 12% of the final cost of diesel for the average consumer (see Figure 1.3). While its margin remains fixed, the distributor simply passes through increases or decreases in the rack price of fuel to the consumer. Fuel purchasing strategies designed to manage delivery price risk might lower the supplier’s margin, but are unlikely to reduce volatility in the rack price of fuel. Strategies to counter delivery price risk are discussed in Section 7 of this guidebook. The third type of energy price risk is tax risk. This is the risk that the federal, state, or local government will increase taxes on energy products or introduce a carbon tax that increases the transit agency’s cost of doing business. In 2010, the federal tax was 18.4 cents per gallon on motor gasoline and 22.4 cents per gallon on diesel fuel. State taxes for both gasoline and diesel ranged from 7.0 cents to 37.5 cents per gallon.3 For the most part, tax risk is unavoidable, although it may be possible for public transit agencies to receive an exemption from state fuel taxes because they are government-owned entities. This guidebook does not address strategies for reducing tax risk. 1.3 Classification of Fuel Purchasing Strategies In this guidebook, fuel purchasing strategies are divided into two major categories: 1) those aimed at reducing commodity price risk, (i.e., risk caused by volatility in global oil and regional refining markets); and 2) those aimed at reducing delivery price risk, (i.e., risk associated with the local fuel delivery and markets). Figure 1.4 broadly classifies each strategy that is discussed in this guidebook along these two risk management categories and several subcategories. Commodity price risk management strategies are divided into two subcategories: 1) forward- price hedging strategies, which are strategies that fix the price of fuel for future consumption; and 2) cap-price hedging strategies, which are strategies that put a ceiling on the price of fuel in exchange for an upfront premium payment. Forward-price hedging strategies include the use of firm, fixed-price (FFP) supply contracts, exchange-traded futures contracts, and over-the-counter (OTC) swap contracts. Cap-price hedging strategies include the use of financial options (traded on an exchange or over-the-counter) and web-based price protection programs. Options can be further arranged in ways that provide customized risk management profiles, such as caps, collars, participating caps, and price corridors. These commodity risk management strategies and others are discussed in detail in Sections 2 through 5 of this guidebook. Other elements of hedging strate- gies are discussed in Section 6, including the level of hedging in relation to total fuel consumption, the duration of hedging programs, and the timing of the purchase of hedging instruments. 3 Table EN1. Federal and State Motor Fuels Taxes. Energy Information Administration/Petroleum Marketing Monthly. April 2011. http://www.eia.gov/pub/oil_gas/petroleum/data_publications/petroleum_marketing_monthly/current/pdf/ enote.pdf (April 14, 2011).

6 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies Delivery price risk management strategies are discussed in Section 7 of this guidebook. These strategies are divided into three categories: long-term contracting, competition strategies, and market power strategies. Long-term contracting strategies are designed to fix the fuel supplier’s margin to protect the transit agency from temporary price spikes caused by local supply and demand imbalances that cause price volatility in retail markets. Competition strategies, such as holding a call for tenders or a reverse auction, are designed to reduce the fuel supplier’s mar- gin by increasing competition among fuel suppliers. Finally, market power strategies, such as demand pooling, can reduce suppliers’ margins by increasing the transit agency’s bargaining power and enabling small consumers to acquire volume-discount pricing. The final section, Section 8, introduces a step-by-step guide to implementing a commodity price risk management program (a hedging program). Launching a hedging program is a com- plicated task and will often require the assistance of an outside adviser or consultant. Section 8 is not designed to be a replacement for those services, but it provides a brief overview of the steps and challenges involved in starting a hedging program. This guidebook has been designed for the public transit agency professional. The vast major- ity of public transit agencies use diesel or gasoline to power transit fleet operations, and this guidebook presents fuel purchasing strategies in the context of these fuels. Where appropriate, the limitations of extending particular strategies and instruments to alternative fuels, such as biodiesel, natural gas, or electricity, are noted. Source: SAIC FUEL PURCHASING STRATEGIES Commodity Price Risk Management Delivery Price Risk Management Long-Term Contracts Competition Strategies Market Power Strategies Forward-Price Hedging Cap-Price Hedging Futures OTC Swaps Fixed-Price Contracts Options Web-based Price Protection Caps Collars Particip- ating Caps Price Corridor Pooling Call for Tenders Reverse Auction (The Level, Duration, and Timing of Hedging are elements of hedging strategy) Figure 1.4. Classification of fuel purchasing strategies.