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

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39 Hedging Level, Duration, and Timing 6.1 Hedge Level Determining the level of coverage is an important component of a hedging strategy. The level of hedging coverage is typically expressed as a percentage of total fuel consumption and ranges from 0% (no coverage) to 100% (full coverage). As noted earlier in this guidebook, hedging involves mitigating exposure to fuel price risk by taking an offsetting position by using financial instruments. If a transit agency chooses to take offsetting positions in excess of 100% of its fuel consumption, this activity would not be considered hedging and would instead be considered a speculative investment. The primary goal of hedging is to achieve budget certainty; therefore, the closer an agency’s protection ratio is to 100%, the greater the budget certainty. Thus, in theory, a 100% protection ratio maximizes budget certainty (see Info Box: Levels of Coverage and Fuel Price Variability). Although hedging 100% of fuel consumption minimizes budget variance and maximizes budget certainty, many organizations hedge less than 100% in order to avoid overhedging. Overhedging occurs when an organization consumes less fuel than it had originally anticipated, leaving it with more protection than it needs and exposing it to the risk that losses on some of its hedge positions will not be offset by gains in physical fuel purchases. The result of over- hedging is a net monetary loss and an increase in budgetary fuel spending. Overhedging not only adds variability to the organization’s fuel budget, but may also have accounting and legal implications if the surplus hedging positions can be considered speculative investments. Thus, fuel consumption variability and the potential for overhedging need to be considered when deciding the level of hedging coverage. As a conservative rule to avoid overhedging, an organization should not hedge more per month than its expected fuel consumption for the month less two standard deviations (a 95% confidence interval). Fuel consumption variability will differ from industry to industry and for some industries, may vary from month to month. An airline company that runs more flights when the economy is good and runs fewer flights when the economy struggles may experience significant fuel consumption variability from year to year or even month to month and may not be comfortable hedging a high percentage of its fuel consumption. A public transit agency, on the other hand, typically runs vehicles on fixed routes and schedules and has highly predictable fuel consumption on a monthly and annual basis. As a result, public transit agencies typically hedge a higher percentage of their fuel consumption. Many transit agencies interviewed for this guidebook reported levels of hedging coverage in the range of 80% to 90% of fuel consumption. Some transit agencies in northern climates reported hedg- ing a lower percentage of fuel consumption (50% to 60%) during winter months due to the chance that snow or ice storms could shut down public transportation for an extended period of time and reduce fuel volumes. S e c t i o n 6

40 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies 6.2 Hedge Duration The hedging duration is the length of time that the transit agency is protected from fuel price increases and is expressed in months of forward fuel consumption. Often, a transit agency will choose to align its hedge duration with the agency’s budget term (the period of time over which the agency’s budget is set and fixed). For instance, if an agency’s budget term is annual, the agency will seek to hedge 12 months of consumption. If the agency’s budget term is biannual, the agency may hedge 24 months forward. Setting the hedge duration in this way ensures budget certainty over the period when budget certainty is desired. Hedging over the budget term also protects Source: SAIC $1.50 $1.75 $2.00 $2.25 $2.50 $2.75 $3.00 $3.25 $3.50 10 11 12 13 14 15 16 17 18 19 20 1 2 3 4 5 6 7 8 9 21 22 23 24 A ve ra ge E ffe ct iv e Fu el P ric e ($ pe r G all on ) Months Forward No Hedge (Market Price) Avg. Price 80% Hedge Avg. Price 50% Hedge 100% Hedge (Forward Price) Coefficient of Variance No Hedge = 22.4% 50% Hedge = 11.2% 75% Hedge = 5.6% 100% Hedge = 2.0% Figure 6.1. Impact of percentage hedged on fuel price variability. Info Box: Levels of Coverage and Fuel Price Variability Figure 6.1 compares the volatility of a futures contract strategy with differing levels of hedging coverage (50%, 75%, and 100%) over a hypothetical range of prices covering two years forward. If the organization does not hedge and buys fuel at the market price, the organization’s average fuel prices would have a coefficient of variance of 22.4%. The coefficient of variance is measured as the standard deviation of the fuel price divided by the mean fuel price. Hedging 50% of fuel consumption reduces this variance by half to 11.2% and hedging 75% of fuel consumption reduces the variance to 5.6%. Hedging 100% of fuel consumption reduces the variance to just 2%, a level of variance that takes into account the seasonal variance in the futures curve.

Hedging Level, Duration, and timing 41 against overhedging in the event that the transit agency makes downward adjustments in its fuel consumption between budget periods (due to the cancellation of bus routes, for instance). Hedging durations may be set on either a fixed or rolling basis. Hedging over a fixed duration means hedging specifically within the budget period. For instance, if a budget ends in Decem- ber 2010, December 2010 is the furthest out month that can be hedged until the new budget period begins in January 2011. Hedging on a fixed basis means that the hedge duration shortens as hedge contracts mature within the budget period. Hedging on a rolling basis, on the other hand, means that the hedging duration continually moves forward as current month hedging contracts mature. For instance, an agency that hedges 12 months forward on a rolling basis can hedge out to December 2011 once the December 2010 contract matures and to January 2011 when the January 2010 contract matures. Table 6.1 compares the forward hedge profiles of two hedging policies that allow 12-month forward hedging of 95% of fuel consumption. One policy does allow hedging within a fixed term while the other allows hedging forward on a rolling basis. Table 6.1 shows that while both policies cover 12 forward months at the beginning of the year, the fixed-term hedging policy has shorter forward hedge duration for every month during the year except for January. The decision between hedging within a budget term and hedging forward on a rolling basis will have an impact on the types of hedge timing strategies that are employed. Another duration strategy that is sometimes used is a tapered approach that allows a higher level of hedge coverage in the near months and a lower level of hedge coverage for further out months. For instance, a transit agency may allow maximum hedge protection of 95% during the forward 12 months, maximum protection of 75% from 12 to 18 months, and maximum Month 12-Month Forward Hedge (Fixed Duration) 12-Month Forward Hedge (Rolling Duration) Jan 2011 Jun 2011 Nov 2011 Jan 2012 Source: SAIC 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% 0% 20% 40% 60% 80% 100% 20% 40% 60% 80% 100% 0% J M M J S N J M M J S N F A J A O D F A J A O D J M M J S N J M M J S N F A J A O D F A J A O D J M M J S N J M M J S N F A J A O D F A J A O D J M M J S N J M M J S N F A J A O D F A J A O D J M M J S N J M M J S N F A J A O D F A J A O D J M M J S N J M M J S N F A J A O D F A J A O D J M M J S N J M M J S N F A J A O D F A J A O D 20% 40% 60% 80% 100% 0% J M M J S N J M M J S N F A J A O D F A J A O D Table 6.1. 12-month forward hedge durations: budget constrained versus rolling.

42 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies protection of 50% from 18 to 24 months. A tapered approach allows for low prices to be locked- in further into the future when desirable, but avoids the risk of overhedging in the event that fuel consumption is reduced. Figure 6.2 shows a hedge profile that follows a tapered approach, with the amount that can be hedged declining based on hypothetical agency rules that limit the maximum percentage that can hedged beyond 12 months and 18 months into the future. Tapered approaches can be employed on either a fixed or rolling basis. Although 12-month to 24-month hedging durations are effective at achieving budget certainty over the budget term, they may not be optimal for minimizing fuel prices over the long run. Short hedging terms prevent a transit agency from taking advantage of low price environments when it may be advantageous to lock-in fuel prices for several years forward. This was a problem faced by Houston METRO in early 2009 when oil prices fell below $40 per barrel. Houston METRO saw an opportunity to purchase fuel price swaps for 2010 and 2011 at bargain prices. The agency’s hedging staff quickly began arranging swaps as far out as 24 months—the maximum horizon allowed under the agency’s hedging policy. As the current months matured, Houston METRO would purchase the next 24-month forward swap. In this depressed price environment, it would have been advanta- geous for Houston METRO to hedge further out—perhaps 36 or 48 months—to lock-in low fuel prices for years to come. 6.3 Hedge Timing Timing is one of the most significant determinants of the outcome of a hedging strategy. Hedging, if done properly, will often achieve its primary goal: budget certainty. However, budget certainty is not the only goal sought by transit agencies. Typically, transit agencies also seek to hedge at a price that will be lower than the market price or at least to avoid hedging at price that will be significantly above the market price. When and how agencies enter hedging positions will have an effect on whether the hedged price will be favorable or unfavorable to the market price. Timing issues are particularly important for forward-price contracts because they lock-in a price, thus preventing the agency from benefiting from price declines. For instance, amid runaway fuel prices in the first half of 2008, several transit agencies rushed to hedge their fuel price exposure, fearing that prices would continue to rise or stay high for the foreseeable future. However, prices peaked in summer 2008 and then precipitously declined as the economy entered a deep recession. Many of the agencies that had locked-in prices with forward-price instruments in early 2008 ended up paying record fuel prices in 2009 despite a crash in spot market fuel prices. Of course, avoiding such an outcome would have required that the transit agencies (or their fuel consultants) have the ability to predict when and how future fuel prices would peak and crash. Figure 6.3 plots No. 2 fuel oil spot prices (the thickest line) against the 18-month forward futures price curve at three-month Figure 6.2. Hedge duration with a tapered approach. Source: SAIC 0% 20% 40% 60% 80% 100% 10 11 12 13 14 15 16 17 18 19 20 1 2 3 4 5 6 7 8 9 21 22 23 24 Months

Hedging Level, Duration, and timing 43 intervals from 2005 through 2010. The futures curves are indicated by the thin lines extend- ing from the spot price series. Figure 6.3 illustrates the importance of timing. Hedging with an 18-month strip in June 2007 at roughly $2.00 to $2.10 per gallon would have avoided the extreme run-up in spot prices over the second half of 2007 and into 2008. Hedging with an 18-month strip a year later in June 2008 would have had the opposite effect of locking-in prices at roughly $3.80 to $4.00 per gallon and tremendously overpaying for fuel versus the market price over the second half of 2008 and through 2009. Clearly, both timing and the amount of fuel hedged at any particular point are important considerations. Three strategies for hedge timing and amount are discussed below. Single-point decisions haves the highest risk of hedging at too high of a price. The other two strategies, managed timing and rule-based, seek to mitigate the risk of hedging at too high a price. 6.3.1 Single-Point Decisions A single-point decision is when an agency hedges its entire fuel consumption (or its target hedge level) for a long duration at a single point in time. While single-point decisions are used for firm, fixed price (FFP) contracts, they generally are not used with other forms of hedging. The risk with hedging using single-point decisions is that the resulting hedge (or FFP contract) may be extremely favorable or extremely unfavorable compared with how market prices actually develop. This risk has become increasingly acute in recent years as volatility in energy markets has increased. Reduc- ing energy price risk below that of FFP contracts is often a goal, and single-point decisions are not likely to achieve this. Managed timing and rule-based hedging strategies generally have greater potential to reduce energy price risk. Source: SAIC, CME Group $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 $4.00 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 N o. 2 F ue l O il Pr ic e ($ pe r g all on ) Spot Price 18-mo. Futures Curves Figure 6.3. No. 2 fuel oil spot prices and NYMEX futures curves (2005–2010).

44 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies 6.3.2 Managed Timing Strategy A managed strategy—sometimes known as a dynamic, situational strategy—is a timing strat- egy that seeks to reduce the average fuel price by adjusting elements of the hedging strategy (instrument, level, duration, etc.) in response to changes in the market environment and price outlook. Managed strategies require the transit agency to hire a full-time, in-house energy market expert or to hire a consultant with the relevant expertise to operate the hedging program. Man- aged strategies involve constantly watching developments in energy markets and taking a view on where prices are headed. Depending on the market outlook, the hedging program manager might choose to adjust components of the agency’s hedging strategy. For instance, if the manager sees a bubble developing in energy prices and expects an imminent collapse, the manager might suggest locking-in prices for only a short period (i.e., three months) rather than hedging further out. Alternatively, the manager might suggest hedging with a cap-price instrument (such as a cap or a collar) instead of a hedging with forward-price instrument if cap premiums are favorable. In a period of record low fuel prices, the expert might suggest hedging out as far as possible. Dur- ing some periods, such as rapidly falling prices, the expert may suggest remaining unhedged and waiting for prices to stabilize before hedging again. The underlying assumption with managed timing strategies is that it is possible to beat the market through market intelligence and savvy use of hedging instruments. This strategy does not require managers to predict the direction of the market at every juncture. Instead, the manager must be able to understand market environment and assess the risks and opportunities of hedging at different points in time. This strategy is underpinned by the belief that making adjustments in response to changing market outlooks will result in better performance than single-point decision strategies that are not based on expert market analysis. The value of managed strategies versus single-point decisions cannot be easily evaluated as the philosophy and quality of managed strat- egies will differ from program to program. Regardless of the value of these programs, managed hedging strategies typically require higher fees (if managed by an outside hedging consultant) or greater time and investment devoted to maintaining an in-house hedging program. The potential value of a managed hedging program must be weighed against the extra costs and the track record of the program manager. 6.3.3 Rule-Based Timing Strategy Rule-based timing strategies—sometimes known as schedule-based or continuous hedging strategies—seek to mitigate the risk of hedging at too high of a price by entering hedge positions at preset intervals, levels, and durations. Rather than adjusting the strategy in response to chang- ing market outlooks, a rule-based timing strategy uses a single strategy that is designed to mitigate the risk of hedging too high regardless of the market environment. Rule-based strategies involve splitting hedging purchases into multiple transactions that are spaced over time so that no single transaction is driving the hedged price. This is sometimes called a dollar-cost averaging strategy and can be achieved by entering hedge positions at regular intervals to cover a small share of the next year’s fuel purchase. For example, a rule-based strategy might call for hedging 100% of the next forward six months of fuel consumption using 12 separate No. 2 fuel oil futures contracts with progressively fewer contracts covering 7 to 17 months forward (11 contracts covering the seventh forward month, 10 contracts covering the eighth forward month, etc.). Figure 6.4 shows the coverage profile of this hypothetical strategy. As the current month’s contract matures, a new contract is purchased for each forward month in order to maintain the coverage profile. Figure 6.5 backcasts the performance of this type of rule-based strategy against actual spot fuel prices from June 2006 through June 2011. The resulting fuel price is a 12-month moving average of the current month’s future price with a 6-month time lag.

Hedging Level, Duration, and timing 45 Source: SAIC, NYMEX 1.00 1.50 2.00 2.50 3.00 3.50 4.00 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 $ p er ga llo n Hedge Average Price (Variance = 17%) Spot Price (Variance = 28%) Figure 6.5. Average prices from rule-based hedging strategy backcast against actual spot No. 2 fuel oil prices. Figure 6.4. Coverage profile of rule-based timing strategy. Source: SAIC 100% 92% 83% 75% 67% 58% 50% 42% 33% 25% 17% 8% 0% M+1 M+2 M+3 M+4 M+5 M+6 M+7 M+8 M+9 M+10 M+11 M+12 M+13 M+14 M+15 M+16 M+17 M+18 Composed of 12 separate contracts Months

46 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies Figure 6.5 shows that this strategy does not lock-in a fixed price level for the long term as with single-point hedging decisions. Overall, between June 2006 and December 2010, the hedged and spot price series have roughly the same mean at $2.15 per gallon. In other words, the rule-based hedging strategy does not fare any better or worse on average than purchasing fuel at the spot price. However, the rule-based hedge strategy price series has a variance of 17%, which is sig- nificantly less than the spot price variance of 28%. Furthermore, under the rule-based hedging strategy the price for any given month is fully established six months in advance and is between 50% and 92% established from 12 to 7 months in advance. Overall this equates to roughly 85% of the agency’s price being established over the next 12 months at any given point in time. Of course, this is only one example of rule-based strategies. Other strategies might use different parameters and would fare differently under the same circumstances. One noticeable disadvantage to the rule-based (continuous) hedging strategy is that it is more effective for organizations with larger fuel consumption. This is because each futures contract covers 42,000 gallons. This means that an organization that consumes 504,000 gallons per month (around six million gallons per year) can average each month’s prices with 12 contracts. How- ever, smaller organizations would use fewer contracts to cover each month, thus reducing the averaging effect and increasing the risk of overpaying for fuel versus the spot price by hedging at the wrong time. For instance, an organization consuming 168,000 gallons per month (around two million gallons per year) would need to hedge each month with four contracts, perhaps spacing these purchases three months apart. Because the intervals are greater, the averaging effect would be less effective. 6.3.4 Hybrid Strategies Managed and rule-based strategies are not necessarily mutually exclusive and a transit agency might incorporate components of both into its overall strategy. For instance, even if an agency follows a rule-based approach, it may have some leeway to make decisions on when hedging positions are entered within each interval, even if each hedging interval is predetermined by a schedule. For example, if an agency’s strategy calls for a new contract for December 2011 to be purchased in June 2011, the agency has a one-month period (about 20 trading days) in which to lock-in a price. Given the volatility of energy markets in recent years, prices can fluctuate significantly from day to day or even hour to hour within a trading day. Thus, keeping a watch on energy markets and managing the timing aspect of purchases will be involved to some degree in any rule-based strategy even if the strategy restricts hedging decisions to a particular time window. Conversely, a managed hedging strategy may at times call for the agency to adopt a rule- based approach under certain market environments. For instance, a hedging manager might choose to employ a rule-based strategy for several months in a low-volatility market that exhibits no clear upward or downward price trend.