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

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10 Hedging with Forward-Price Instruments The most common instrument for fuel price hedging is the forward-price instrument, com- monly called a forward contract. Forward contracts allow consumers to lock-in the price of a specific volume of fuel that will be consumed in the future. All forward contracts have both a buyer and a seller, although forward contracts are typically costless at initiation (i.e., the buyer does not actually pay the seller for the forward contract). Instead, all profits and losses are determined by the results of the “bet” that the buyer and seller have agreed to. The buyer of a forward contract is long fuel, which means that the buyer profits if the market price exceeds the contract’s forward price at maturity, and loses money when market prices are lower than the forward price at maturity. Con- versely, the seller of a forward contract is short fuel, which means the seller loses money when the market price exceeds the forward price at maturity and profits when the opposite is true. As a fuel consumer, public transit agencies are naturally short fuel; they must periodically pur- chase fuel in order to keep their operations running, which means they lose money (go over budget) when fuel prices increase. In order to effectively hedge this exposure, the agency must take the oppo- site position—it must take a long position on fuel prices by buying forward contracts. When prop- erly executed, the gains and losses on the long forward contracts will offset the gains and losses on the transit agency’s naturally short position as a fuel consumer, thus creating a synthetic fixed price. This payoff structure is illustrated in Figure 3.1. In this diagram the horizontal axis represents the price of fuel in dollars per gallon, increasing from left to right. The vertical axis represents the impact to the transit agency’s fuel budget on a per gallon basis. The dark line, which slopes downward from left to right, represents the agency’s natural profit function; as fuel prices increase, the agency loses money per gallon of fuel consumed. The lighter line, which slopes upward from left to right, represents the profit function of the purchased (long) forward contract; as fuel prices increase, the transit agency gains money. The horizontal dotted line shows the combination of these two payoff functions: the profits or losses of the transit agency are zero regardless of the direction of market price movements. For example, suppose that a transit agency wanted to hedge its October fuel consumption of 84,000 gallons of diesel fuel. For the sake of the example, assume forward contracts could be obtained with a forward price of $2.50 per gallon, the exact spot price in the current month. The agency would buy (take the long position) enough forward contracts to cover 84,000 gallons of fuel at a price of $2.50 per gallon. Say in October that the price increased by $0.25 to $2.75 per gallon. Because the transit agency buys fuel to run its fleet, this would increase fuel expenditures (cash outflows) by $0.25 × 84,000 gallons = $21,000. However, because the price increased, the agency’s forward contracts would pay out and the agency would receive a cash inflow of $0.25 × 84,000 gallons = $21,000, which is enough to exactly offset the loss on the physical fuel contract and create a zero net payoff. Thus, the forward contract effectively protected the agency from the increase in fuel prices. On the other hand, locking-in a fuel price with a forward contract also prevents the agency from benefiting from a fall in prices. If prices fall by $0.25, the agency would pay $21,000 less for physical fuel (a cash inflow), but would lose $21,000 on its forward contracts S e c t i o n 3

Hedging with Forward-Price instruments 11 (a cash outflow). The result of this hedge is that the transit agency would pay the same price for fuel ($2.50 per gallon) regardless of whether fuel prices increased or decreased. Figure 3.2 shows a forward-price curve for diesel fuel (the line that runs nearly horizontally through the graph) obtained in November 2010 versus a hypothetical range of future fuel prices (black sine curve). If forward contracts were purchased in November 2010 covering all fuel consumption in these future months, the agency’s fuel prices would follow the nearly horizontal line regardless of what happens to actual spot prices. In Figure 3.2, the bars above the horizontal line and below the black line show gains from hedging versus the market and the bars below the horizontal line but above the black line show losses from hedging versus the market. The three primary forms of forward-price contracting are: 1) futures contracts that are traded on a central exchange such as NYMEX; 2) custom OTC swap contracts that are negotiated off- exchange with counterparties such as banks, financial institutions, and the trading desks of large energy companies; and 3) FFP supply contracts arranged by the transit agency’s fuel supplier. 3.1 Futures Contracts Futures contracts are forward-price instruments that are traded on an exchange for standard- ized products with standardized volumes, delivery dates, and delivery locations. The futures con- tract most commonly used to hedge diesel fuel and jet fuel prices is No. 2 fuel oil (also known as heating oil), which is traded on the NYMEX. For futures contracts beyond April 2013, heating oil Source: SAIC ($1.00) ($0.75) ($0.50) ($0.25) $0.00 $0.25 $0.50 $0.75 $1.00 $1.50 $1.75 $2.00 $2.25 $2.50 $2.75 $3.00 $3.25 $3.50 $3.75 Pr of its / Lo ss es (p er ga llo n) Payoff Fwd Contract Natural Payoff Net Payoff Market Price ($ per gallon) Fwd Price Long (payoff increases with price) Short (payoff decreases with price) Figure 3.1. Forward (long) versus natural (short) payoff profiles.

12 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies will be replaced with ultra low sulfur diesel (ULSD) as NYMEX responds to environmental regu- lations in New York State requiring lower sulfur standards for heating oil.4 Gasoline is typically hedged with futures contracts tied to reformulated blendstock for oxygenate blending (RBOB) gasoline, an unfinished gasoline that has not been blended with oxygenates such as ethanol. Both No. 2 fuel oil and RBOB contracts specify the future delivery of 42,000 gallons (1,000 barrels) of product in New York Harbor. This means that in order to effectively hedge, a transit agency’s annual fuel consumption must be at least 42,000 gallons × 12 months = 504,000 gallons on an annual basis. Under some futures contracts, the buyer actually takes delivery of the physical fuel in New York Harbor at the month of maturity. However, the vast majority of futures are paper contracts that are cash settled at the end of the month before the delivery month. If the spot price at maturity is higher than the price at which the futures contract was entered, the Exchange pays the buyer of the contract the difference between the two prices. If the price is lower, then buyer of the contract pays the Exchange the difference. NYMEX is technically the counterparty for every futures contract traded on its trading platform, but every contract has both a buyer and a seller. Because of the size and popularity of NYMEX futures contracts covering gasoline and heating oil, there is sufficient liquidity for futures contracts to always be bought or sold at a price. Prices are discovered by bid and ask prices made by buyers and sellers with the NYMEX acting as the market maker. No. 2 fuel oil futures contracts (the diesel correlate) are listed for 22 consecutive months commencing in the next calendar month.5 RBOB (the gasoline correlate) futures con- 4Burkhardt, Paul, July 27, 2011. “Nymex Heating Oil Contracts to Be Replaced by ULSD in 2013,” Bloomberg Press. As viewed at: http://www.bloomberg.com/news/2011-07-27/nymex-heating-oil-contracts-to-be-replaced-by-ulsd-in-2013-1-.html 5“Heating Oil Futures.” CME Group Website. http://www.cmegroup.com/trading/energy/refined-products/heating-oil_ contract_specifications.html. (April 14, 2011). Source: SAIC, CME Group $1.50 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 $1.75 $2.00 $2.25 $2.50 $2.75 $3.00 $3.25 $3.50 Forward Price Time Unit Market Price Gains versus market price Losses versus market price Figure 3.2. Forward contract: gains and losses versus hypothetical market (spot) prices.

Hedging with Forward-Price instruments 13 tracts are traded for 36 consecutive forward months.6 For both products, contracts that cover near months (one to six months forward) are more heavily traded—and thus more liquid—than contracts covering further out months. Hedging further into the future than 22 months for diesel or 36 months for gasoline requires the use of light sweet crude oil (also known as West Texas Intermediate [WTI]) futures, which extend in consecutive months for the five forward years and can be obtained for select months as far as nine years forward.7 Although hedging forward with crude oil futures could manage much of the commodity price risk associated with diesel and gasoline, doing so would increase exposure to basis risk (see Info Box: Basis Risk). Futures contracts for other fuels and other delivery locations are also available on NYMEX. Other popular futures contracts by trading volume include natural gas futures for delivery at the Henry Hub in Louisiana, bunker fuel (No. 6 fuel oil) for delivery in the Gulf Coast, and ethanol for delivery in Chicago. Electricity futures are also available for peak and off-peak electricity at popular trading hubs within regional transmission organizations across the country, such as the PJM Interconnection that covers parts of the East Coast and Midwest. Natural gas and electricity markets in the United States are highly regional because they are based on fixed supply networks and are highly sensitive to regional weather patterns. As a result, hedging instruments for electricity and natural gas can hold significant basis risk (see Info Box: Basis Risk). The futures contract price represents the expected spot price of the product at a future date. At expiration, the futures price converges with the spot price of the fuel. Futures contracts may exhibit premiums or discounts to the current spot price due to seasonal supply and demand variations. For instance, heating oil prices typically peak in the winter heating season whereas gasoline prices typically peak during the summer driving season. Figure 3.3 shows the term structures of June No. 2 fuel oil futures contracts with the average, low, and high term structures identified for contracts between 2005 and 2010. 6“RBOB Gasoline Futures.” CME Group Website. http://www.cmegroup.com/trading/energy/refined-products/rbob-gasoline_ contract_specifications.html (April 14, 2011). 7“Light Sweet Crude Oil Futures.” CME Group Website. http://www.cmegroup.com/trading/energy/crude-oil/light- sweet-crude_contract_specifications.html. (April 14, 2011). Source: SAIC, CME Group 95% 100% 105% 110% 115% 120% 125% JUN JUL AUG SEP OCT NOV DEC JAN FEB MAR APR MAY JUN JUL AUG SEP OCT NOV DEC Fu tu re s Pr em iu m /D is co un t t o Sp ot HIGH AVERAGE 2005 - 2010 LOW Figure 3.3. Average, low, and high term structure of June futures contracts as percentage of spot price (2005–2010).

14 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies Transit agencies can hedge using futures contracts by making an arrangement with a futures bro- ker who has a seat on the NYMEX. When buying or selling futures contracts on NYMEX, the transit agency must post collateral in the form of a margin account (also known as a performance bond). The size of this account is set by formula and is a function of the price volatility in the market, but it is typically around 15% to 20% of the contract value. This account is marked-to-market every day and sometimes multiple times per day during periods of high volatility. Marking-to-market means that if prices for outstanding futures contracts rise, the Exchange will credit the difference to the buyer’s account even though the contracts have not yet reached maturity. This surplus money (the amount over the minimum balance) can be withdrawn from the margin account at any time or can be left in the account and collected at maturity. Conversely, if prices fall, NYMEX will debit money from the buyer’s margin account. If the buyer’s margin account falls below the minimum balance, then the Exchange makes a margin call meaning the buyer must add money to the margin account to restore the minimum balance. If the buyer fails to make the margin call, the Exchange sells off the contract and absorbs all losses with the money remaining in the margin account. 3.1.1 Advantages One of the most attractive aspects of hedging with futures is its cost advantage relative to other hedging instruments. Contracts with NYMEX brokers are fairly standard and easy to negotiate. Typically contracts stipulate a brokerage fee of 0.1 to 0.15 cents per gallon for each futures purchase, or roughly $42 to $63 for each 42,000-gallon contract, with no fee for settling contracts at maturity. Furthermore, because NYMEX futures prices are readily observable and brokerage fees clearly stated, futures prices and premiums are relatively transparent compared to other hedging instruments. Another advantage of futures contracts is that they involve no counterparty risk. The NYMEX has never defaulted on a contract and all positions are backed by marked-to-market margin accounts with gains and losses realized on a daily basis. Because NYMEX contracts are so liquid, it is almost always possible to exit a position by either prematurely selling a purchased futures contract or enter- ing an offsetting position by taking a short position (i.e., selling) a new futures contract. This flex- ibility may be particularly advantageous for an agency executing a managed strategy (see Section 6.3 on Hedge Timing) or for an agency that has an unexpected reduction in future fuel consumption. Finally, like all financial hedging instruments, futures can be bought and sold independent of the physical fuel contract, thus allowing the agency to continue its best practices for fuel procurement. 3.1.2 Disadvantages Futures contracts have two main disadvantages that make them potentially risky for some transit agencies: adverse basis risk and margin call risk. Basis risk is explained in detail in the Info Box: Basis Risk. 8“Basis Risk.” Investopedia.com. http://www.investopedia.com/terms/b/basisrisk.asp. (April 14, 2011). Info Box: Basis Risk In a hedging strategy, basis risk is the risk that fuel price changes in the hedging instrument (futures or swap contract) will not move in an entirely opposite direction than the transit agency’s physical fuel price. This imperfect inverse correlation between the two prices creates the potential for excess gains or losses in the hedging strategy, thus adding to risk.8 Excess gains are not necessarily bad, so fuel consumers that hedge

Hedging with Forward-Price instruments 15 9“The Basics of Basis Risk.” Mercatus Energy Pipeline. Mercatus Energy Advisors. Posted April 14, 2010. http://www. mercatusenergy.com/blog/bid/38368/The-Basics-of-Basis-and-Basis-Risk. (April 14, 2011). 10Note: for futures contracts beyond April 2013, NYMEX will replace No. 2 Fuel Oil with Ultra Low Sulfur Diesel (ULSD), as reported at: http://www.bloomberg.com/news/2011-07-27/nymex-heating-oil-contracts-to-be-replaced-by-ulsd-in-2013-1-.html are primarily concerned with adverse basis risk, which refers to the risk of excess losses from imperfect price correlations. Mercatus Energy Advisors, a consulting firm, identifies three forms of basis risk: locational, product/quality, and calendar (spread).9 Locational basis risk occurs due to differences in the delivery point of the transit agency’s physical fuel supply and the delivery point specified in the hedging instrument. In the case of NYMEX futures contracts, the deliv- ery point is New York Harbor. Unless a transit agency purchases its physical fuel supply in New York Harbor or is able to purchase fuel at a price linked to the New York Harbor price, there is a risk that the NYMEX New York Harbor price will not correlate perfectly with the transit agency’s physical fuel price, which usually tracks a local or regional index price as reported by an accepted pricing reference agency such as Oil Price Information Ser- vice (OPIS) or Platts. If the local index price increases while the NYMEX price declines, the agency pays a higher price for its physical fuel and has to pay money to the Exchange to satisfy its obligations under its futures con- tracts, thus realizing losses on both positions. Prior to selecting futures as a hedging instrument, most agencies run historical correlations between the NYMEX price and the selected local rack price to ensure that there is a sufficient correlation to make the strategy an effective hedge. Locational basis risk is a particular concern for agencies outside the Northeast and especially for agencies in West Coast and Rocky Mountain states where fuel markets are largely isolated from the interconnected refinery and pipeline systems serving the Gulf Coast, Midwest, and Northeast. Even if historical correlations are adequate to justify the use of futures contracts, there is always a chance that price correlations will break down in the future, or that a particular occurrence (such as a refinery outage that increases local prices while NYMEX prices decrease) could drive a wedge between futures and physical fuel prices. 1. Figure 3.4 shows the correlation coefficient of the percent change in the monthly average NYMEX No. 2 fuel oil price10 and the percent change in the monthly average local retail price of ULSD fuel by region and year. The correlation coefficient is a statistical measure that shows how much the change in one variable is dependent on a second variable. A correlation coefficient of zero indicates no relationship between the two variables. A correlation coefficient of one indicates a perfect relationship between the variables. If a transit agency’s local fuel price has a high correlation with the NYMEX fuel price, it will take on low basis risk when hedging with NYMEX futures. Figure 3.4 indicates that ULSD prices in the Northeast (New England and Central Atlantic) are fairly well correlated with the NYMEX No. 2 fuel oil price. Lower Atlantic, Midwest, and Gulf Coast ULSD prices also tracked NYMEX fairly closely for most years, but all showed lower correlations in 2007. The Rocky Mountain and West Coast prices were the least correlated with the NYMEX price in most years. In recent years (2008 through 2010) product prices around the country have been highly correlated with the NYMEX price primar- ily due to volatility in the global crude oil prices (the primary input in the production of ULSD). 2. Product/quality basis risk occurs due to differences between the type of physical fuel purchased by the transit agency and the type of fuel specified in the futures contract traded on NYMEX. Most transit agen- cies hedge diesel consumption with NYMEX No. 2 fuel oil futures due to the historically high price correla- tion between the two fuels. Hedging with heating oil has historically been effective for diesel consumers, but if this correlation breaks down, product/quality basis risk could become a concern. Figure 3.5 shows the Basis Risk, cont’d (continued on next page)

16 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies Basis Risk, Cont’d. Region Definitions: http://www.eia.doe.gov/oog/info/twip/padddef.html Source: SAIC, Energy Information Administration: http://www.eia.doe.gov/dnav/pet/pet_pri_dist_dcu_nus_m.htm and http://www.eia.doe.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=EER_EPD2DXL0_PF4_Y35NY_DPG&f=D New England Central Atlantic Lower Atlantic Midwest Gulf Coast Rocky Mountains West Coast 2007 0.92 0.89 0.77 0.72 0.71 0.50 0.74 2008 0.99 0.98 0.98 0.98 0.99 0.96 0.98 2009 0.98 0.93 0.98 0.97 0.95 0.95 0.82 2010 0.93 0.89 0.94 0.95 0.92 0.83 0.93 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Co rr el at io n Co ef fic ie nt Figure 3.4. Correlation between spot NYMEX No. 2 fuel oil price and regional ULSD price by region and year. NYH No. 2 Fuel Oil WTI 2007 0.95 0.83 2008 0.97 0.71 2009 0.98 0.72 2010 0.97 0.84 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Co rr el at io n Co ef fic ie nt Figure 3.5. Daily correlation of NYH ULSD spot price to NYMEX price indices by fuel and year. c t’

Hedging with Forward-Price instruments 17 11“Gulf Coast ULSD (Platts) Up-Down Spread Swap Futures.” CME Group Website. http://www.cmegroup.com/trading/ energy/refined-products/up-down-gulf-coast-ultra-low-sulfur-diesel-ulsd-vs-nymex-heating-oil-ho-spread-swap-futures_ contract_specifications.html. (April 14, 2011). daily correlation of the New York Harbor (NYH) ULSD spot price to the New York Harbor No. 2 fuel oil price and the WTI price. Figure 3.5 shows that NYH No. 2 fuel oil is highly correlated with the NYH ULSD prices, and thus futures or swap contracts referencing the No. 2 fuel oil price index are appropriate hedging instruments for fuel buyers that purchase NYH ULSD. The correlation of NYH ULSD prices with the WTI spot price is not as strong, and thus hedging NYH ULSD fuel purchases with hedging products that reference NYMEX WTI crude oil futures would be a less effective hedge. 3. Calendar (spread) basis risk occurs when the settlement dates for the transit agency’s physical fuel purchases do not match the settlement dates for the NYMEX futures contracts that it uses to hedge. NYMEX futures con- tracts settle on the last trading day of the month before the contract month (i.e., the May contract settles on the last trading day in April). Often, transit agencies will purchase physical fuel in small (less than 42,000-gallon increments) multiple times per month. These purchases will often not take place at the end or beginning of the month. As a result, there is some risk that the market price for physical fuel purchased in the middle of the month will be different than the price on the settlement date for the current month contract or the near-month contract. To some degree, locational, product/quality, and calendar basis risk can be mitigated through the use of exchange-traded or OTC basis swaps. A fuel price basis swap operates similar to an interest rate basis swap. For example, a transit agency that consumes gasoline in the Gulf Coast can buy a “Gulf Coast ULSD (Platts) Up-Down Spread Swap Futures” contract on NYMEX under which the agency pays a fixed differential between the Platts Gulf Coast ULSD price and the NYMEX No. 2 fuel oil price and receives a floating differential between the two indices.11 This floating differential can be used to hedge the basis risk on the standardized NYMEX product. Basis Risk, cont’d The second major disadvantage of hedging with futures contracts is the risk that rapidly falling fuel prices will lead to excessive margin calls on outstanding future contracts, which will drain the agency’s cash balance and force the agency to borrow funds. NYMEX’s margin account requirements are set by formula and the more volatile fuel prices are, the larger the margins will be as a share of the contract value. If prices drop rapidly (as they did in the second half of 2008) not only may NYMEX issue a margin call, but it might also require a larger minimum margin account balance. This could potentially put a cash-strapped transit agency in a difficult situation. Some large agencies attempt to avoid this risk by hedging only part of their fuel consumption with futures while hedging the remainder with swaps or other hedging instruments. Futures contracts also share many disadvantages with other financial hedging instruments. Receiving authorization to hedge with futures may be difficult since some state and local governments have restrictions on investment activity by public entities. Board members may be suspicious of financial products and reluctant to approve a fuel price hedging program. Additionally, an agency’s accounting department may need to learn how to properly account for the gains and losses from futures contracts.

18 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies 3.1.3 Summary Futures contracts can be an effective, low-cost way to hedge fuel prices for gasoline and diesel fuel use. These products are easy to understand, relatively inexpensive to arrange, and hold very little counterparty risk because they are arranged through NYMEX. However, because futures contracts are standardized, they expose hedgers to adverse basis risk and the margin account sys- tem that eliminates counterparty risk creates margin call risk. Adverse locational basis risk may be a concern for transit agencies located on the West Coast or Rocky Mountain states. Table 3.1 summarizes the advantages and disadvantages of hedging with futures. 3.2 Over-the-Counter Swap Contracts Over-the-counter (OTC) swap contracts are several consecutive months of forward contracts that are negotiated between two counterparties. Over-the-counter is a financial term that denotes that the trading takes place outside of an exchange (such as NYMEX). Counterparties that trade OTC swap protection are typically banks, financial institutions, or the commodity trading desks of large energy companies. Because they are negotiated off-exchange, swaps can be customized to suit the needs of the parties involved. This means a local fuel price index can be used as a refer- ence price and contracts can be set with any range of fuel types, volumes, maturities, settlement frequencies, and collateral requirements. As with futures contracts, swap contracts pay out if the index price is above the forward price of the swap contract. Although OTC swaps are customizable, general limits typically hold. Because negotiating and arranging swap agreements can be time-intensive, swap dealers rarely have an appetite for vol- umes less than one to two million gallons per year. Furthermore, although swaps can typically be obtained in large cities with liquid price indices, it may be more difficult to obtain swaps based on local indices in some small and mid-sized cities. As a result, many swaps often use NYMEX or another large-market price index rather than the local index. The counterparty in the swap agreement (the swap seller) takes the short side of the swap, which means the seller profits when prices decline below the swap price. The counterparty may wish to have this exposure because it believes that oil prices will decline and hopes to earn money on the swap. More likely, however, the swap seller is using the swap to hedge oil price exposure elsewhere in its portfolio. Thus, some swap sellers may only sell swaps until they have sufficiently hedged their portfolios. These swap volumes may or may not be enough to meet the transit agen- cy’s desired coverage. Alternatively, a swap seller may agree to a swap and then go to the futures market to hedge the swap in order to make money off the spread between the futures price and the swap price. In this case, the swap price may be based on NYMEX or on the local index price. Which price is used will determine which party (the buyer or seller) holds the basis risk. Advantages Disadvantages Low costs compared to other hedging instruments No premiums No counterparty risk Flexibility to exit contracts at any point Fuel procurement best practices can continue Adverse basis risk Risk of excessive margin calls No benefit if fuel prices fall Requires approval from board Requires adjustments for hedge accounting Minimum hedge volumes of roughly 0.5 million gallons per year Table 3.1. Hedging with futures: advantages and disadvantages.

Hedging with Forward-Price instruments 19 3.2.1 Advantages OTC swaps hold two advantages over futures contracts. The first is that OTC swaps can use a local pricing index instead of NYMEX, thus eliminating or reducing adverse basis risk for the fuel buyer. However, it may not always be possible to enter a swap contract based on a local index, or if it can be achieved, the swap dealer may require a significant premium to compensate for hold- ing the basis risk. Nevertheless, large cities or small cities that base their purchasing contracts on a local or nearby index can take advantage of OTC contracts to eliminate, or at least reduce, basis risk relative to hedging with futures. This is particularly important for transit agencies in Rocky Mountain or West Coast markets where correlations with the NYMEX price are not as strong (see Info Box: Basis Risk). A second advantage of OTC swaps is that these instruments can be negotiated without any col- lateral or with custom collateral. Many transit agencies have solid finances (predictable farebox and tax revenues) and thus have good credit ratings. As a result, it is often possible to enter swap agree- ments without posting collateral or by pledging general obligation dollars or physical assets, such as buses and trains, as collateral. Some counterparties may only require collateral for hedging volumes above a certain threshold. Negotiable collateral may be particularly valuable for an agency that has low cash availability at any given time. OTC swaps preclude the need to move money into and out of margin accounts on a daily basis. Because all settlements are exchanged at maturity, there is no risk that excessive margin calls will put the transit agency in a difficult position. Other advantages of OTC swaps are largely contingent on how the swaps are structured. OTC swaps if based on NYMEX prices are relatively transparent, but less so if based on an index without a readily observable forward price curve. Most agencies that hedge with swaps work with two or more swap counterparties and report that swap prices are reasonably competitive. Finally, like all financial hedging instruments, swaps can be bought and sold independent of the physical fuel contract, thus allowing the agency to continue its best practices for competitive fuel procurement. 3.2.2 Disadvantages Although OTC swaps remove or reduce some of the risks associated with futures contracts— primarily basis risk and the risk of excessive margin calls—these risks are often transferred to the swap counterparty and often come at a cost. Premiums for swaps based on price indices without forward curves are difficult to estimate. However, swaps based on NYMEX prices (that have no basis risk for the swap dealer) are typically priced one to five cents per gallon above the NYMEX price. This is significantly higher than the cost of buying futures directly (0.1 to 0.15 cents per gallon), but much less than the premium on firm, fixed-price supply contracts (an estimated 15 to 25 cents per gallon). Entering a hedging relationship with a counterparty can often be lengthy and expensive. Doing so often requires that the transit agency hold a request for proposals (RFP), run due diligence (credit checks, etc.) on potential counterparties, and negotiate master swap agree- ments with the approved counterparties. A master swap agreement sets the legal structure for conducting swaps between the two parties, including identifying the risks and who will bear them. Because master swap agreements are custom agreements, each detail must be agreed upon by both sides. Transit agencies that hedge with swaps indicate that the negotiation of the master swap agreement is a lengthy process that takes from three to six months and involves several expensive reviews by outside legal advisors on both sides. Furthermore, the transit agency must negotiate a separate master swap agreement with each counterparty, so while increasing the number of counterparties may increase competition, it also requires a larger upfront investment in time and legal fees.

20 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies OTC swaps are also subject to the risk that the swap counterparty will go bankrupt and default on its end of the obligation (or choose to strategically default on its obligation). The lower the swap price compared to the spot price, the higher the probability that the counterparty will default. Most transit agencies that hedge with OTC swaps choose creditworthy counterparties based on ratings provided by major ratings agencies. However the methods of ratings agencies have been questioned since the 2008 financial crisis. Although no transit agency interviewed for this guidebook had experi- ence with a defaulting counterparty, one agency was in the process of negotiating a swap agreement with Lehman Brothers prior to its bankruptcy in 2008. The risk of bankruptcy or incomplete deliv- ery of a contract can be mitigated by requiring appropriate bonding of each party in the contract. OTC swap contracts also share disadvantages with other financial hedging instruments. It may be difficult to get authorization to hedge with swaps given that some state and local governments have restrictions on investment activity by public entities and it may be difficult to convince board members who may be suspicious of financial products in general. However, swaps are often easier than futures for management boards to understand because many agencies already have experi- ence hedging their variable-rate debt with interest rate swaps. Additionally, the agency’s accounting department may need to learn how to properly account for gains and losses from swap contracts. 3.2.3 Summary OTC swaps essentially provide the same forward-price protection as exchange-traded futures contracts. However, because the transactions take place off-exchange, they are customizable and can reduce or eliminate adverse basis risk, and often do not require collateral. On the other hand, OTC swaps are typically priced at a premium compared to similar futures contracts, require more time and money to arrange, and expose the purchaser to counterparty risk. Table 3.2 summarizes the advantages and disadvantages of hedging with OTC swaps. 3.3 Firm, Fixed-Price Supply Contracts Employing a firm, fixed-price (FFP) fuel supply contract is the simplest form of achieving forward-price protection. Under an FFP supply contract, a fuel buyer agrees to buy fixed fuel volumes for future delivery at a fixed price for the duration of the contract. The particular fixed- price services offered will vary from supplier to supplier, but typically they require minimum volumes of one to two million gallons per year with durations ranging from three months to one year. Some large fuel suppliers may provide FFP contracts to smaller volume consumers if they already have at least one large volume customer with an FFP contract. In addition, some fuel suppliers offer cap-price or collar-price contracts. Although obtaining an FFP supply contract is a convenient way to hedge, fuel suppliers are not always well equipped to provide these contracts. Fuel suppliers typically operate a relatively simple Advantages Disadvantages No basis risk if swaps based on local index Collateral or margin requirements are negotiable Fuel procurement best practices can continue No benefit if fuel prices fall Higher costs than futures contracts May not protect from basis risk if swaps based on NYMEX prices Counterparty risk exists Minimum hedge volumes of one to two million gallons Table 3.2. Hedging with OTC swaps: advantages and disadvantages.

Hedging with Forward-Price instruments 21 retail business model: suppliers buy fuel from refiners or importers and then resell the fuel to buyers (such as transit agencies) with a markup to account for delivery costs and profits. Thus, fuel suppliers are naturally hedged because they both buy and sell fuel. If the supplier’s fuel prices increase, it sim- ply passes those increases on to the buyers. The fuel buyer holds all the price risk. Under fixed-price (or cap-price) supplier contracts, the fuel buyer’s price risk is transferred from the fuel buyer to the fuel supplier and disturbs the fuel supplier’s natural hedge. If oil prices increase, the fuel supplier cannot pass those increases on to the fuel buyer. Often the fuel supplier, which operates under a simple retail model, cannot afford to hold this price risk and must turn to financial markets to hedge its position through swaps or futures in order to provide FFP contracts to its customers. 3.3.1 Advantages FFP supply contracts allow the transit agency to hedge without devoting significant internal resources to a hedging program. The transit agency does not need to educate its staff about finan- cial instruments, does not need to negotiate agreements with swap counterparties or NYMEX brokers, does not need to manage margin accounts or pay upfront premiums, does not need to adjust its accounting system, and, perhaps most importantly, does not need to change state laws or local statutes in order to obtain authorization to use FFP supply contracts. FFP contracts are also easier for the agency’s board of directors to understand and do not appear to be investment activity or speculation. Furthermore, because FFP contracting is similar in nature to standard variable-price contracting, it is easier for an agency’s procurement department to understand and negotiate. FFP contracts shift virtually all the costs and risks associated with hedging (partic- ularly basis risk) to the fuel supplier and allow the transit agency to benefit from relatively hassle- free hedging. However, this transfer of costs and risks to the fuel supplier comes at a high cost. 3.3.2 Disadvantages Hedging with FFP supply contracts costs significantly more than hedging with other forward- price instruments. Transit agencies that have used FFP contracts complain that pricing for FFP contracts is not transparent and that premiums vary significantly from supplier to supplier. Energy consultants in the Midwest and Texas interviewed for this guidebook estimated that a transit agency would pay a premium of 15 cents per gallon for an FFP contract in 2010, roughly three times as much premiums on over-the-counter swaps. One West Coast transit agency estimated that it paid a premium of 20 cents to 25 cents per gallon for its FFP contract. It is difficult to assess the fairness of these premiums. Fuel suppliers claim that high premiums on FFP contracts are needed because providing such contracts requires the fuel supplier to hedge with financial products and take on considerable risks (including basis and counterparty risk). Fuel suppliers are not well suited to take on the risks and costs of hedging. Many fuel suppliers have credit ratings that are lower than those of transit agencies and therefore, may be required to pay higher premiums when hedging. FFP contracts are single-point decisions that may result in contracts that are extremely favor- able or extremely unfavorable depending on how market prices actually develop. The timing of these contracts dictates whether they are advantageous compared to market prices, which pre- sents a significant energy price risk. (Hedge timing is discussed in Section 6.3.) Hedging with FFP supply contracts might force a change in a transit agency’s fuel procure- ment best practices. Transit agencies typically procure fuel under contracts based on the local rack (OPIS) price of fuel plus a fixed margin to account for delivery costs and the supplier’s profit margin. Often a transit agency will compete its fuel procurement contract to achieve the lowest margin over the OPIS price. Requiring potential fuel suppliers to have the ability to provide FFP contracts may reduce the number of fuel suppliers that qualify to compete for the lowest margin. In larger metropolitan areas with many fuel suppliers, this may not be a concern, but for small

22 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies and mid-sized cities, competition in the fuel procurement process could be reduced. Further- more, fuel suppliers in smaller markets may not offer FFP services, or may require an exorbitant premium in order to start a fuel hedging program and offer a fixed price. Hedging with FFP contracts limits the hedge duration and hedge coverage of an agency’s hedging strategy because it does not separate price hedging decisions from physical fuel pro- curement. For instance, some transit agencies prohibit physical fuel procurement contracts from spanning budget periods. Thus, the maximum duration that an agency can hedge is the duration of the budget period (usually 12 months) if the contract was locked at the very beginning of the budget period. This limits the ability of the transit agency to take advantage of relatively low price environments by hedging further into the future. FFP contracts also limit the maximum hedge coverage. Because pricing and physical delivery remain linked, an agency will be reluctant to hedge a high percentage of its anticipated fuel consumption. If a snowstorm or other event causes the transit agency to cut service (and therefore fuel consumption) during a particular month, high levels of coverage could lead to overdelivery of fuel. Thus, transit agencies that hedge with FFP contracts typically hedge a lower percentage of fuel than they optimally would choose. With financial hedging instruments, an agency can simply exit the contract at the mark- to-market price without worrying about storing surplus fuel. A final disadvantage of FFP contracts is counterparty risk—the risk that the fuel supplier will go bankrupt and default on its end of the obligation or strategically default on its agreement. The lower the FFP contract guaranteed by the fuel supplier is compared to the market price, the higher the probability that the fuel supplier will default. A transit agency interviewed for this guidebook had a FFP natural gas contract with Enron prior to its bankruptcy in late 2001, exemplifying this risk. 3.3.3 Summary Firm, fixed-price supply contracts are a relatively easy forward-price instrument to implement because the majority of the resources and risks needed to develop a financial hedging program are simply outsourced to the fuel supplier. However, this benefit comes at a significant cost in terms of high premiums for providing hedging services and changes to the transit agency’s pro- curement best practices. Table 3.3 summarizes the advantages and disadvantages of hedging with FFP supply contracts. Advantages Disadvantages Few internal staff need to be devoted to hedging No collateral No basis risk Easy to get authorization under existing state and local laws Easy for board of directors to understand Extremely high premiums relative to hedging with financial products Availability of fixed-price fuel suppliers may reduce competition for the agency’s fuel procurement contracts Duration of the physical fuel contract limits the maximum hedge duration. Counterparty risk with fuel supplier Minimum hedge volumes of one to two million gallons Cannot exit hedge if prices collapse Table 3.3. Hedging with firm, fixed-price supply contracts: advantages and disadvantages.