Diesel Fuel Hedging: A Competitive Analysis

One of the most common questions we receive from prospective clients is, "What's the best fuel hedging strategy?"  The short answer is that the best strategy(s) depends on the specific company as well as numerous, other variables.  

Imagine today that ABC Industries, a large industrial company which consumes, on average, a million of gallons of diesel fuel per month, decides, based on analysis performed by their CFO, that forward prices for heating oil futures, the benchmark for diesel fuel, are "cheap" relative to where they anticipate spot heating oil prices to trade over the course of the next two years.  As such, ABC, at the suggestion of their NYMEX broker, decides to "hedge" their exposure to potentially rising fuel prices by purchasing twenty heating oil contracts per month, for the two year time frame.

If ABC's analysis proves to be correct and heating oil prices do indeed increase over the next two years, they will, as hoped, be the recipient of large "hedging" gains.  In this scenario, all else being equal, ABC should experience lower costs of goods sold and higher profits margins as a result of the anticipated "hedging profits".  On the other hand, should heating oil prices decline over the course of the next two years, ABC will be at a competitive disadvantage, vs. their competitors that didn't employ a similar "hedging" strategy, as they will experience both higher costs of goods sold and lower profit margins.  Or worse, if the ABC's losses are large enough, they may simply join the list of companies that have gone belly up thanks to large, speculative, trading losses, masked as hedges.

On the other hand, suppose that ZYZ Industries, also a large industrial company with an average monthly fuel consumption of a million gallons, has the goal of becoming the most cost efficient company in its industry, at least in part, by better managing the company's fuel costs.  In addition, XYZ has, with the assistance of an outside firm with extensive experience in fuel hedging, developed a formal, fuel hedging policy, including hedging strategies which have been pre-approved by their management team, which addresses XYZ's tolerance for risk, based on an extensive analysis of the potential impact of both higher and lower fuel prices, on the company's costs of goods sold, profit margins and revenues.

Furthermore, XYZ and their energy risk management consultants have concluded that the company will be able to meet its financial goals, regardless of whether fuel prices increase or decrease over the next two years, by hedging 65% of its projected fuel requirements, via a combination of average price call options on heating oil and Gulf Coast diesel fuel basis swaps.  XYZ chooses to hedge with call options and basis swaps, rather than heating oil futures, as their analysis concludes that the combination of these instruments will provide them with a hedge that best reflects their actual exposure as well as their tolerance for risk.  As such, XYZ moves forward accordingly and hedges 65% of their anticipated fuel consumption, as dictated by their hedging policy and pre-approved hedging strategies.

XYZ's approach provides a sound "system" which will ensure that their fuel hedging strategies have a very strong probability of producing the desired results.  ABC's approach is, arguably, little more than an educated, speculative bet on heating oil futures. 

In summary, the best fuel hedging strategy is most often the result of having the "best game plan".  Does your company have a formal fuel hedging policy or are you simply a speculator dressed as a hedger?