#1: Swaps

A swap is a financial instrument that allows the buyer to hedge his bunker exposure by fixing the price he pay for fuel at a predefined level, over a predefined time period.

Execution:

• Select the most relevant contract (e.g. US Gulf Coast No.6 Fuel Oil 3%)
• Select volume of fuel to hedge
• Select time period

(This example uses Monte Carlo simulated data assuming 30% volatility and a Fuel Oil index starting at an execution price of 100.)

Scenario 1:  Fuel price moves below swap execution price (red zone).  The buyer makes a cash payment to his trading counterparty but this is offset by lower physical fuel prices in the market.

Scenario 2:  Fuel price moves above swap execution price (green zone).  The buyer receives cash from his trading counterparty to offset the higher physical fuel prices you must pay in the market.

By using a Fuel Oil Swap, the commercial hedger has ‘locked in’ the price he will pay for bunkers over the time period he selected.  This provides cash-flow certainty, allows executives to more easily manage their budgets and removes exposure to fuel price spike that can have a significant impact on the company’s ability to generate profits.

There are a number of reasons to hedge and a variety of different strategies.  These vary depending on the business risks a company faces within its particular industry sub-sector, as well as on a management team’s attitude to risks and their business objectives.

Ultimately, risk management is about allowing executives to focus on their core competences.  They are not experts in oil markets, able to forecast prices, predict events and envisage technological developments.  They are experts in the business of transportation and logistics.  Hedging exposure to fuel prices allows them to focus their time on what they do best, running their company and securing its competitive edge.

Over the coming weeks I will highlight the principal reasons for hedging and provide a broad outline of the available solutions.

#1: Increase cash-flow certainty

#2: Eliminate risk of financial distress

We will address these two reasons together, as there are inextricably linked.  Uncertainty surrounding a company’s cash-flow causes numerous problems for its management team.  It makes budgeting, planning and (for publically traded companies) producing earnings guidance, tremendously difficult.  Consider a company in need of making a large capital expenditure to upgrade or purchase new equipment.  Wild swings in global oil markets and thus fuel prices can cause significant volatility in a company’s cash-flow and profitability.  It is difficult for executives to know when and if, they can afford to purchase the new equipment.  It also challenging to accurately calculate the likely return on investment, related to this capital expenditure.  This in turn can lead to further difficulties when planning future hiring or training programs.

The elimination of financial distress is the logical extension of cash-flow certainty.  By hedging exposure to extremely high fuel prices (that may remain elevated for an extended period of time), executives are able to eradicate a scenario that could significantly damage a company’s ability to effectively operate and to generate profits, putting at risk its long term viability.