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

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7 The Basics of Commodity Price Risk Management Commodity price risk management strategies are designed to mitigate fuel price volatility caused by fluctuations in global oil markets and regional refining markets. This price volatility is caused by global and regional supply and demand factors, as well as other factors that are beyond the control of the consumer. The practice of commodity price risk management is commonly called hedging and the financial products used are often called hedges because they involve tak- ing an offsetting financial position (i.e., entering a contract that pays off when prices rise) in order to counter the effect of rising fuel prices on the consumer’s budget. The terms commodity price risk management and hedging are used interchangeably in this guidebook. 2.1 Goals of Hedging The primary goal of hedging is to obtain budget certainty. As mentioned in the previous sec- tion, budget volatility is particularly difficult for public transit agencies because often they have limited operational and budget flexibility. Public transit agencies cannot easily pass increased fuel costs to customers, cut service, or borrow money to cover shortfalls in the budget. The goal of budget certainty as achieved through hedging does not assure lower overall fuel expenses. In other words, for a hedge to be effective, the average price paid by a hedged transit agency does not have to be lower than the average market price, it must only be more predictable. In theory, a transit agency that is primarily concerned with budget certainty would not care whether it pays an above-the-market price for fuel as long as that price is predictable at the beginning of year so that money can be allocated with certainty. In practice, however, using hedging strategies to lower the price of fuel, or at least to avoid overpaying for fuel, is also an important consideration for transit agencies. Other considerations include minimizing the resources and effort needed to develop and implement a hedging program, minimizing or avoiding collateral requirements required by the hedging program, and managing other risks associated with hedging. In order to achieve the goal of budget certainty subject to these considerations, a transit agency must care- fully evaluate every component of its hedging strategy. 2.2 Components of Hedging Strategy The primary goal of commodity price risk management is to achieve fuel budget certainty by fixing or capping fuel prices. The plan of action designed to achieve this goal is set out in the transit agency’s hedging strategy and is executed through the agency’s hedging program. A hedging strategy is defined by four key components that are presented graphically in Figure 2.1. Decisions made along these four coordinates govern the nature of the hedging strategy. The choice of the hedging instrument governs the type of price protection: forward-price protection, S e c t i o n 2

8 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies which fixes the price of fuel today for the delivery in the future, or cap-price protection, which sets a cap or ceiling on upward price movements in exchange for a premium payment. The choice of hedging level determines the percentage of the agency’s fuel consumption that will be pro- tected from price increases. The choice of hedging duration determines how far into the future the price is protected. The choice of hedging timing governs how the transit agency executes purchases and sales of hedging instruments and is a key determinant of whether the agency will pay a hedged price that is higher or lower than eventual market price. These four components form the core of a fuel price risk management strategy. 2.3 Hedging Instruments Hedging instruments are generally applied to only a portion of projected fuel purchases; hence, the potential benefits and risks of these strategies apply to only the portion of purchases made with these instruments. The two main hedging instruments are forward-price instruments and cap-price instruments. Forward-price instruments fix the price of fuel that will be purchased in the future and fix the amount of fuel to be purchased under the instrument. If fuel prices in the future are above the fixed price, the hedge is advantageous; if they are below the fixed price, the hedge is unfavorable, except for gains in budget certainty. Cap-price instruments, on the other hand, place a ceiling on future fuel prices while allowing the buyer to benefit from future price declines. As a result, the hedge is advantageous if fuel prices rise above the cap but has no disadvantage if prices are below the cap. However, this win-win risk profile is not free; the purchaser of the cap-price instrument must pay an upfront premium to compensate the seller. One innovative variant of cap-price protection is collar-price protec- tion, which creates a band (a price ceiling and a price floor) within which prices can fluctuate. If structured properly, this strategy does not require a premium payment. Forward-price and cap/collar-price protection can be obtained through several instruments. One type of forward-price instrument can be purchased and traded on an exchange, such as the New York Mercantile Exchange (NYMEX), where it is called a futures contract. A second type of forward-price instrument, over-the-counter (OTC) swap contracts, can be negotiated directly with a counterparty, such as a bank or financial institution. Cap-price protection can be pur- chased as options on both futures contracts and OTC swap contracts. Firm, fixed-price (FFP) supply contracts, another type of forward-price instrument, are gen- erally arranged with an agency’s physical fuel supplier. Cap-price protection can be purchased Source: SAIC Hedging Instrument Hedging Level Hedging Duration Hedging Timing Figure 2.1. Components of a hedging strategy.

the Basics of commodity Price Risk Management 9 from fuel suppliers via cap-price supply contracts. For those with smaller fuel purchase volumes, a number of web-based programs have been developed to provide cap-price protection. Table 2.1 classifies the various hedging instruments according to the type of price protection and method of obtaining. The most popular instruments for fuel price hedging—NYMEX futures, OTC swaps, and FFP supply contracts—provide forward-price protection. The advantages, disadvantages, costs, and risks of each of these instruments are discussed in Section 3. The process of constructing cap- price instruments (and variants such as collars) with NYMEX and OTC options are discussed together in Section 4 as these instruments share many of the same advantages and disadvantages. Section 4 also discusses web-based fuel price protection programs, a fairly new hedging method that seeks to provide cap-price protection to smaller volume fuel consumers. Section 5 provides an overall evaluation of each of the instruments discussed, and Section 6 discusses hedging level, duration, and timing. Protection Type: Obtained Through: Forward-Price Cap-Price Exchange (NYMEX) Futures Purchased NYMEX Call Option Over-the-Counter (OTC) Transaction OTC Swap Purchased OTC Call Option Fuel Supplier Firm, Fixed-Price (FFP) Contract Firm, Cap-Price Contract Web-based Fuel Price Protection Program P ricelock, Fuel Bank, MoreGallons, etc.* * The listed web-based programs are provided as examples—there is no intent to promote these programs over other, unlisted programs. Source: SAIC Table 2.1. Hedging instruments by protection type and method of obtaining.