Locking in Today's Fuel Prices for Tomorrow: Is it Worth the Risk

Posted on June 4, 2009 by Alex Roman, Managing Editor

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[IMAGE]iS-6076485L.jpg[/IMAGE]When fuel prices escalated last summer it severely impacted many transit agencies who suddenly found themselves paying double the amount written into their budgets. The effects of those escalating fuel prices caused many agencies to scramble to find ways to offset the increased expenditures, which often included cutting services or raising fares, all while ridership was climbing toward record numbers.

Because of the instability in fuel pricing, many transit agencies began to look into the practice of Energy Price Risk Management (EPRM), - commonly referred to as fuel hedging - which is a tool used to stabilize fuel costs, involving a contractual commitment by a transit agency to pay a pre-determined price for future fuel purchases, thus eliminating market uncertainty.

"The main problem for public transit agencies is that fuel is a major input to their business. In many cases, it is the second-largest expense after labor, but labor is a known cost. What agencies don't know is what fuel is going to cost," explains Jeff LeMunyon, principal for Linwood Capital LLC, a commodity trading advisory firm based in Minneapolis.

LeMunyon adds that because fuel is extremely variable in price, as has been evident over the past few years, it becomes a problem for transit agencies because it creates a level of financial uncertainty. He believes, therefore, that the solution is for transit agencies to create some kind of fuel cost certainty, which can possibly be accomplished through an effective EPRM program.

A lesson

Explaining the way EPRM works is often difficult, but it helps if you have an understanding of how commodities are traded, bought and sold. For transit agencies using diesel fuel, the commodity market is heating oil futures:  heating oil prices are used as a proxy for diesel prices as both are distillates and the prices are highly correlated. Two important factors in commodity trading are the spot price (current market cost), and the futures price, which is forecasted weeks to years in advance. Depending on the current inventory of oil and levels of demand, spot prices can be higher or lower than future prices.

As a general rule, if forward prices are higher than spot prices, inventories are large relative to demand. If forward prices are lower than spot prices, it indicates tight supplies and low inventories relative to demand. When forward prices are lower than spot prices, a transit agency can "lock in" a price for its future fuel needs at prices lower than spot prices.  This, however, often occurs as nominal prices are relatively high.

"If markets are going up, you probably want to hedge more because you're managing risk. And if markets become relatively low, then you'll want to lock in those things and take advantage of that low price opportunity," explains LeMunyon.

The trick for agencies entering into an EPRM agreement, therefore, is figuring out when to purchase on the spot market and when to lock in a contract for the future, while finding an acceptable average that fits within your agencies' budget.

What are the benefits?

Simply put, entering into an EPRM agreement creates budget certainty. Meaning if an agency eliminates the inherent price volatility of fuel, it can create a budget knowing what its fuel costs for the year will actually be.

"The idea of being able to promote the value of this type of contract was sort of handed to us on a silver platter, because within the same fiscal year we've gone from paying $4.17 a gallon in July to $1.18 a month ago," says Ed Pullan, procurement officer for the Charlotte (N.C.) Area Transit System (CATS).

Like many in the transit industry, escalating fuel prices last summer propelled CATS into EPRM, which they began to institute last January. Previously, CATS solicited price quotes from area suppliers and placed orders, daily, from the lowest bidder. Although they received competitive price quotes, CATS was paying a high price for fuel and faced with a severe over expenditure, since it had only budgeted $2.40 a gallon.

"We realized we had to think a little bit more innovatively about how we were going to control this in the future," explains Pullan, who adds that CATS has budgeted $2.45 a gallon for Fiscal Year 2010, and can currently lock in prices at about $1.75 for any portion of its estimated 3.5 million gallons the system will use.

"The three key goals of what we're doing right now are price protection, unlimited supply and budget stability," says Jean Leier, manager, public and community relations, for CATS. 

Obviously, building that certainty into your budget can save hundreds of thousands of dollars.

The Greater Cleveland Regional Transit Authority (GCRTA) had budgeted $18.8 million for its 2010 fuel before entering into a contract in January of this year. Having now purchased 80 percent of its fuel, GCRTA projects that its fuel costs for 2010 will now be lowered to $9.8 million.

"We are quite pleased," says Gale Fisk, executive director, office of management and budget for GCRTA. "Timing is everything, and we have been very opportunistic."

Because of EPRM, Michigan-based Ann Arbor Transportation Authority (AATA) saved $563,000 in fuel costs for Fiscal Year 2008, paying $1.78 a gallon when prices had hit the $4 mark. Phil Webb, controller for AATA, says that the agency, which has practiced EPRM since around 2004, enjoyed significant peace of mind when fuel prices escalated, as well as yearly when it's time to create a budget. 

"When we go through our budgeting process, we could pretty much know within so much certainty what our fuel is going to cost," he says. "Last summer, some transit agencies had to make other arrangements, whether it was cutting services or elsewhere, because fuel prices were much higher than expected. We didn't have to do that."

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