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

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47 Delivery Price Risk Management Delivery price risk management is the practice of employing competition and contracting strategies to lower the level and volatility of fuel prices. The delivery price, which is often known as the supplier’s margin, is the cost of distributing and marketing fuel from the rack facility at the refinery or pipeline terminal to the transit agency’s fueling station plus the supplier’s profit. In retail markets, the supplier’s margin is the difference between the retail fuel price and the supplier’s fuel acquisition cost (the wholesale price). The national average retail supplier margin for ULSD was approximately 23 cents per gallon from January 2007 through December 2010. The coefficient of variance around the mean value was roughly 32% with a low of 13 cents per gallon and a high of 47 cents per gallon. The high value, which was nearly double the average for the period, was reported in October 2008 when supply shortages occurred in several states after Hurricane Ike disrupted refinery production and pipeline infrastructure in the Gulf Coast, causing a ripple effect throughout the eastern United States. There are three strategies that transit agencies can use to manage delivery price risk: long- term, fixed-margin contracting; competition strategies; and market power strategies. These strategies can be used in combination with one another to reduce the supplier’s margin and manage delivery price risk from extreme market events such as the one that followed Hurricane Ike. These strategies and their impacts are discussed in the subsections below. 7.1 Long-Term, Fixed-Margin Contracting The simplest way to manage the fluctuations in the retail fuel supplier margin over the course of a year is to avoid buying fuel at the retail price and instead buy fuel under a long-term contract (one year or longer) with a fixed margin. Long-term contracting is advantageous for two reasons. First, it allows the transit agency to negotiate a fixed margin, which reduces one source of vari- ability in the agency’s fuel costs over the contract term and helps to prevent temporary spikes in the supplier’s margin such as the one that occurred following Hurricane Ike. Second, long-term contracting increases the volume and thus the monetary value of the transit agency’s supply con- tract, making it more attractive for individual fuel suppliers. This improves the transit agency’s bargaining position and makes competition strategies easier to implement (see Section 7.2). Long-term contracting has the potential to lower some of the transit agency’s fuel price vola- tility. Figure 7.1 compares the national average retail diesel margin with the national average margin for commercial buyers with long-term contracts by month from 2007 through 2010. Figure 7.1 also presents the standard deviation—the absolute value of the average deviation from the mean—for each margin. This figure shows that not only was the margin for long-term contracts significantly lower—an average of 12 cents versus 23 cents per gallon—but contract margins were also much more stable. Of course it is important to note that long-term bulk S e c t i o n 7

48 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies contracts typically involve the delivery of fuel to a fueling station that is owned and operated by the transit agency. The cost per gallon of operating this station has not been added to the long-term contract margin and will vary from agency to agency based on a number of factors. Nevertheless, having a long-term contract with a fixed margin would have protected the transit agency from the blow out in the retail margin that occurred in the second half of 2008. Long-term, fixed-margin contracting is particularly effective at managing fuel price risk when combined with the hedging of commodity price risk. This combination leads to a situation where the delivery price (supplier’s margin) is fixed via contract and the floating rack price is synthetically fixed using hedging instruments. This combination produces a fully fixed price. Long-term, fixed-margin contracting protects the transit agency from price spikes caused by local supply and demand characteristics while hedging protects the agency from spikes in the commodity price of the fuel caused by global forces. 7.2 Competition Strategies Competition strategies are designed to increase competition among fuel suppliers in order to lower the supplier’s margin and achieve lower overall fuel prices. There are two major types of competition strategies: calls for tenders and reverse auctions. Competition strategies typically work well with long-term, fixed-margin contracts because they allow suppliers to compete to provide services at the lowest margin. Before we discuss competition strategies, however, it is important to explain the two main components of the supplier’s margin: the supplier’s cost structure and the supplier’s profit. Differences in these components will cause margins to vary from supplier to supplier. Typically, the supplier’s profit is the only component of the supplier’s margin that is negotiable. Differing cost structures are the primary reason for differences in fuel suppliers’ margins. Given equal profit margins, a more efficient cost structure will lead to a lower supplier’s margin. For instance, a supplier that delivers fuel to a transit agency over a shorter distance will have a more efficient cost structure than a supplier shipping fuel from farther away and will thus be able to supply fuel to the transit agency at lower cost. Larger fuel suppliers are also more likely to have 0.00 Ja n-2 00 7 Ma r-2 00 7 Ma y-2 00 7 Ju l-2 00 7 Se p-2 00 7 No v-2 00 7 Ja n-2 00 8 Ma r-2 00 8 Ma y-2 00 8 Ju l-2 00 8 Se p-2 00 8 No v-2 00 8 Ja n-2 00 9 Ma r-2 00 9 Ma y-2 00 9 Ju l-2 00 9 Se p-2 00 9 No v-2 00 9 Ja n-2 01 0 Ma r-2 01 0 Ma y-2 01 0 Ju l-2 01 0 Se p-2 01 0 No v-2 01 0 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50 M ar gi n ($ pe r g all on ) Retail Margin (mean = 0.23, st. dev = 0.07) Contract Margin (mean = 0.12, st. dev = 0.02) Source: SAIC, Energy Information Administration: http://www.eia.doe.gov/dnav/pet/pet_pri_dist_dcu_nus_m.htm Figure 7.1. US average ULSD supplier margins by type, 2007 to 2010.

Delivery Price Risk Management 49 more efficient cost structures because they are able to leverage economies of scale to provide lower per-unit distribution costs. Suppliers’ margins may also be lower in areas that do not require diesel fuel to be blended with biodiesel. Fuel distribution is more expensive when biodiesel blending is required because fuel distributors must make two stops—one at the petroleum product rack and one at the biodiesel rack. Biodiesel cannot be blended in pipelines or in bulk storage tanks due to its corrosive effect on those infrastructures, so before delivery of the finished, blended product to the transit agency, the biodiesel is typically splash blended in the fuel supplier’s delivery trucks while en route to its destination. Identifying fuel suppliers with the lowest cost structures will often lead to lower suppliers’ margins. The profit margin is a smaller component of the supplier’s overall (cost plus profit) margin, but has a higher potential for negotiation. Competition strategies—those strategies that seek to increase competition to lower prices—are likely to be more successful for large transit agencies that operate in markets with multiple fuel suppliers. These strategies are likely to be less effec- tive for smaller transit agencies with little market power, particularly if the agency is located in a market dominated by one or two fuel distributors. In these areas, market power strategies— strategies that seek to lower prices by increasing the transit agency’s bargaining power—are more likely to be effective (see Section 7.3). 7.2.1 Call for Tenders A call for tenders (or call for bids) is a contracting practice in which a transit agency invites qualified fuel suppliers to bid for the transit agency’s fuel supply contract. The call for tenders may be an open tender, which is open to all fuel suppliers that can guarantee performance under the contract, or a restricted tender, whereby the tender is preceded by a pre-qualification question- naire in which the transit agency assesses the ability of the fuel supplier to supply the requested quality and volume of fuel and assess the financial stability and overall counterparty risk of the supplier. Public transit agencies are familiar with employing calls for tenders (open or restricted) as it is a common requirement for government entities and entities that receive direct state or local government funding. 7.2.2 Reverse Auctions Another innovative competition strategy is to hold a reverse auction. Reverse auctions are known by many different names, including: service auction, procurement auction, sourcing event, and e-sourcing. At the federal level, this purchase method has been promoted in several memoranda issued by the Office of Management and Budget (OMB).13,14 The roles of buyers and sellers are reversed in a reverse auction. In a normal auction, buyers bid to purchase a good or service. Competition among buyers drives the price up and the buyer with the highest bid at the end of the auction purchases the item at the highest bid price. In a reverse auction, multiple sellers compete to sell a good or service to a single buyer by bidding successively lower prices. The seller that bids the lowest price must provide the service at that price. In the context of fuel procurement, a transit agency would hold a reverse auction for its fuel supply contract. Among other terms, the contract would specify the type of fuel, the volume 13Office of Federal Procurement Policy, Office of Management and Budget, May 12, 2004. “Utilization of Commercially Available Online Procurement Services.” As viewed at: http://www.whitehouse.gov/sites/default/files/omb/assets/omb/procurement/ publications/online_procurement_051204.pdf 14Office of Federal Procurement Policy, Office of Management and Budget, July 18, 2008. “Effective Practices for Enhancing Com- petition.” As viewed at: http://www.whitehouse.gov/sites/default/files/omb/procurement/memo/enhancing_competition_ 071808.pdf

50 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies of fuel, and the timing and location of fuel deliveries required by the agency. The fuel supplier that can guarantee performance of the contract at the lowest bid wins. In terms of a fuel supply contract that follows index plus margin pricing, fuel suppliers compete to bid the lowest margin. Because fuel suppliers can bid multiple times and because the bids of other suppliers are known, a reverse auction has the ability to achieve a lower supplier’s margin than a call for tenders. Typi- cally the winner of the auction will be the fuel supplier that has the lowest combination of cost structure and profit margin. According to a recent study, firms that employ reverse auctions as a strategic management technique increased bids by 20 to 30 times the normal number of bids and consistently received price reductions of 12% to 24%.15 For fuel procurement, this would equate to a 12% to 24% reduction in the supplier’s margin, not a reduction in the overall fuel price (index plus margin). Thus, a public transit agency that pays a fixed supplier’s margin of 12 cents per gallon might expect to reduce the supplier’s margin by 1.5 cents to 3 cents by holding a reverse auction. Recent reverse auction success stories include: • In 2004, the Baltimore Regional Council Purchasing Committee (BRCPC) achieved a 42% sav- ings in the transportation of 4.9 million gallons of heating oil to nine school districts, reducing transportation costs from 10 cents per gallon to 5.9 cents per gallon.16 • In 2007, the state of Connecticut achieved a savings of more than $20 million for 570 million kWh of electricity for the 2009 fiscal year, a savings of roughly 3.5 cents per kWh hour.17 • FedBid, the company that manages reverse auctions for federal procurement, says its systems can produce savings of up to 15% on commodities.18 There are several types of reverse auction models that a transit agency can employ: out- sourced, consultative, software, and active server pages (ASP). An outsourced model is a fully managed model in which an outside company runs the reverse auction. The company provides this service free to the buyer, but requires suppliers to pay fees of 1% to 2% of the contract price. Presumably, suppliers will pass some this cost to the transit agency in the form of slightly higher bids. A consultative model involves hiring a consultant to set up an in-house system for perform- ing reverse auctions. Consultants charge a fee for this service and will often take a percentage of the buyer’s savings. Other approaches include installing special reverse auction software or using a web-hosted ASP application. The outsourced and consultative models are typically only appropri- ate for high-value contracts ($50,000 to more than $1 million) whereas software and ASP models typically have no limit on contract size. Because the value of annual fuel contracts for public transit agencies is typically large, all models are able to provide effective solutions. Figure 7.2 from sorcity.com compares and contrasts the characteristics, fees, purchases, and total time to establish each of available reverse-auction models. One potential disadvantage of reverse auctions (or any competition strategy where the sole consideration is price) is that the winning bidder may have been able to bid the low- est price because it reduces its cost structure in ways that may be dangerous or detrimental to the supply operation. For instance, a low-cost bidder may reduce its cost structure by failing to adequately maintain its fuel delivery vehicles or storage tanks, potentially leading 15Farris, Ted, et al. “Reverse Auction Case Studies Effectively & Ethically Lowering Supply Chain Costs.” Institute on Supply Management. http://www.ism.ws/files/Pubs/Proceedings/JFGuillemaudFarrisRoth.pdf (April 14, 2011). 16“eSchoolMall Helps Maryland Schools Save Money: Reverse Auction Provides Significant Reduction in Energy Costs.” Eschoolmall.com. July 26, 2004. http://www.eschoolmall.com/customer_feature.asp?pdate=7/26/2004 (April 14, 2011). 17“Reverse Auction Yields Savings of $20M.” The State of Energy. CT Office of Policy and Management. Jan/Feb. 2008. http:// www.ct.gov/opm/lib/opm/pdpd_energy/the_state_of_energy_jan-feb08.pdf (April 14, 2011). 18“FedBid Inc. has been awarded a five-year contract to provide online reverse auction services for federal agencies.” AllBusiness. com. January 13, 2006. http://www.allbusiness.com/technology/technology-services/857536-1.html (April 14, 2011).

Delivery Price Risk Management 51 to off-spec fuel. For this reason, a transit agency may need to subject fuel distributors to a very thorough prequalification process before allowing them to participate in the reverse auction. Alternatively, the transit agency might evaluate the winning bidder after the reverse auction. If the bidder fails to meet the transit agency’s requirements, the contract can be awarded to the second-lowest bidder (contingent on this bidder also meeting the agency’s qualifications). Reverse auctions have the potential to significantly reduce the supplier’s margin, but this strat- egy may only be effective in large markets with multiple, qualified fuel suppliers. For instance, a reverse auction with only one bidder would be ineffective. At a minimum, two qualified bidders are needed in order to realize savings from reverse auctions. As a result, competition strategies are often more difficult to employ for electricity and natural gas procurements because these services are frequently provided by local monopolies. 7.3 Market Power Strategies Market power strategies are designed to increase a transit agency’s bargaining power, typi- cally by combining its fuel consumption with other consumers. By itself, a small transit agency with relatively low fuel consumption may not have significant market power and would be a price taker in supplier negotiations. Furthermore, a small transit agency might not have its own onsite fueling station and would have to rely on retail fueling stations. Because the agency lacks bargaining power, it may have to pay the retail price for fuel or receive only a small discount from the retail supplier. By practicing pooling, cooperative buying, or demand aggregation with other consumers, the transit agency and its partners can increase their bar- gaining power and obtain volume discount pricing. Prime candidates for pooling are other government agencies in the transit agency’s jurisdiction (police, fire, schools, etc.) or other transit agencies in nearby cities or counties that have similar requirements with respect to the types of fuels consumed. Despite their attractiveness as a tool for increasing market power, fuel purchasing coop- e ratives can be difficult to form. They require not only identifying partners with similar Source: sorcity.com Figure 7.2. Reverse-auction models available online (from sorcity.com).

52 Guidebook for evaluating Fuel Purchasing Strategies for Public transit Agencies consumption needs but also convincing each partner to give up some degree of indepen- dence in order to realize price savings as an combined entity. Creating a cooperative may be very difficult if each partner is already locked into a firm-volume (guaranteed purchase) contract. Even once a cooperative has been legally formed, bargaining can be difficult if one or more of the cooperative’s partners has a low credit rating. Although the fuel supplier may sign only one contract, it must assess the risks of default for each of the cooperative’s part- ners. The credit risk of each partner may be a particular issue if the cooperative is seeking a fixed-price contract (one in which the fuel supplier hedges fuel volumes for the cooperative) because it may be tempting for one of the cooperative’s partners to default on the contract if the retail price falls below the fixed price. Some of the complications of forming a fuel pur- chasing cooperative can be alleviated by using a demand pooling company. Demand Pooling Global Services (DEPO), a Dallas-based firm, runs an online platform that allows users to enter their specifications to form a cooperative. DEPO clients are primarily state and local governments. 7.4 Effectiveness of Delivery Price Risk Management Strategies Long-term contracting, competition strategies, and market power strategies can each be used independently or in combination to minimize the supplier’s margin and achieve a lower overall fuel price. The effectiveness of any one strategy is difficult to assess because of differences between transit agencies and the markets in which they operate. On average, a transit agency would have saved roughly 11 cents per gallon if it used long-term contracting instead of retail purchasing of ULSD from 2007 through 2010, although this figure does not take into account the cost of operating a transit agency-owned fueling station. Nevertheless, long-term contracting is likely to reduce prices overall and also protect the transit agency from extreme spikes in the supplier’s retail margin. Source: SAIC, Energy Information Administration: http://www.eia.doe.gov/dnav/pet/pet_pri_dist_dcu_nus_m.htm 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 $ p er g al lo n Contract Price (average = 2.42, st. dev = 0.6) Retail Price (average = 2.53, st.dev = 0.62) Rack Price (average = 2.3, st. dev = 0.61) De c-2 00 6 Ma r-2 00 7 Ju n-2 00 7 Se p-2 00 7 De c-2 00 7 Ma r-2 00 8 Ju n-2 00 8 Se p-2 00 8 De c-2 00 8 Ma r-2 00 9 Ju n-2 00 9 Se p-2 00 9 De c-2 00 9 Ma r-2 01 0 Ju n-2 01 0 Se p-2 01 0 De c-2 01 0 Figure 7.3. Historical comparison of US average ULSD contract, retail, and rack prices, 2007 to 2010.

Delivery Price Risk Management 53 Competition strategies such as calls for tenders and reverse auctions can also achieve greater savings on the supplier’s margin. From 2007 to 2010, the ULSD price savings from reverse auc- tions were in the range of 1.5 cents to 3 cents per gallon. It is difficult to measure the savings from forming a fuel purchasing cooperative, but it is likely to be considerable for smaller-volume transit agencies. Delivery price risk management strategies are effective at lowering a transit agencies overall fuel costs. However, these strategies do little to impact fuel price volatility. In other words, these strategies will lower the overall cost compared to doing nothing, but they do little to increase budget certainty, which is the primary goal of energy price risk management. Figure 7.3 shows the performance of long-term ULSD contract prices for commercial buyers, ULSD retail prices, and ULSD wholesale rack prices from January 2007 through December 2010. Contract prices were significantly lower by roughly 11 cents for contract prices versus retail prices, but contract prices had only a slightly smaller standard deviation (60 cents versus 62 cents). Commodity price risk management is a more effective strategy for mitigating fuel price volatility and ensuring budget certainty.