This post is the second of several in a series covering the most common energy hedging strategies. You can access the first post, which covered energy futures, via this link. In subsequent posts we will also be exploring the basics of energy commodity options as well as more "complex" hedging structures such as basis swaps, collars and option spreads.
A swap is an agreement whereby a floating (or market) price is exchanged for a fixed price, over a specified period(s) of time. In addition to energy commodities, swaps can also be used to exchange a fixed price for a floating (or market) price. Swaps are referred to as such because the buyers and sellers of swaps are “swapping” cash flows.
Energy consumers utilize swaps in order to fix or lock in their energy costs, while energy producers utilize swaps in order to lock in or fix their revenues and/or cash flow. Likewise, energy professors, refiners, traders and marketers often use swaps to hedge their profit margins and inventories (stocks). Similarly, swaps are also utilized by companies seeking to hedge their exposure to foreign exchange, interest rate and agricultural commodity risks as well.
As an example of how one can utilize an energy swap, let's assume that you're a large fuel consuming company in Houston, who wants to fix or lock in the price of your anticipated ultra-low sulfur diesel fuel (ULSD) cost for a specific month. For sake of simplicity, let's assume that you are looking to hedge 80% of your anticipated, October fuel consumption, which equates to 100,000 gallons. In order to do accomplish this you could purchase an October Platts’ Gulf Coast ULSD swap from one of your counterparties, often a financial institution or commodity trading firm. If you had purchased this swap yesterday at the prevailing market price, the price would have been (approximately) $1.3166/gallon ($55.30/BBL).
Now let’s examine the results of this swap if Gulf Coast ULSD prices settle both higher and lower than your price of $1.3166/gallon.
In the first case, let's assume that fuel prices increase and that the average price for Gulf Coast ULSD, (as published in Platts’ US Marketscan) for each business day in October, is $1.50/gallon. In this case, the swap would result in a hedging gain of $0.1834/gallon ($1.50 - $1.3166 = $0.1834) or $18,340. As a result, you would receive a payment of $18,340 from counterparty, which would offset the increase in your actual fuel cost of $1.50/gallon by the amount of your gain, $0.1834/gallon.
In the second case, let's assume that fuel prices decrease and that the average price for Gulf Coast ULSD, for each business day in October, is $1.20/gallon. In this case, the swap would result in a hedging loss of $0.1166/gallon ($1.3166 - $1.20 = $0.1166) or $11,660. In this case, you would have to pay your counterparty $11,660.
As the results of both outcomes indicate, by purchasing a ULSD swap for $1.3166/gallon, your net fuel cost will be $1.3166 regardless of whether ULSD prices settle higher or lower than $1.3166. If ULSD prices settle higher than $1.3166 you will have a gain on the swap which offsets the increase in your physical fuel price. On the other hand, if ULSD prices settle lower than $1.3166, you will have a loss on the swap which offsets the decreases in your physical fuel price.
While this example examined how swaps can be used to hedge diesel fuel price risk, the same methodology can also be used to hedge exposure to various energy commodities such as electricity, gasoline, jet fuel, natural gas, propane, etc. In addition, as previously mentioned, energy producers, refiners, traders and marketers can also utilize swaps to hedge their energy price risk. For example, if you are a crude oil producer looking to hedge your oil production, you could do so by selling crude oil swaps.
If you would like to discuss how your can hedge your exposure to volatile energy prices with swaps or any other strategy, please feel free to contact us.
UPDATE: This post is the first in an introductory series on energy hedging. The additional posts in the series can be accessed via the following links:
Editor's Note: This post was first published in March 2011 and has recently been updated to reflect current market conditions.