#3: Collar

A collar (a combination of a call option and a put option) is a financial instrument designed to hedge a company’s fuel exposure by locking prices into a certain range.  These products are often traded at zero upfront cost.  However, depending upon the exact structure, a premium can be received.

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
• Select price cap level (or call strike price)
• Select price floor level (or put strike price)

(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 the price floor level (red zone).  The company makes a cash payment to its trading counterparty but this is offset by the lower physical fuel prices that it pays in the market.  The company will benefit from falling prices until the floor is passed.

Scenario 2:  Fuel prices remain between cap and floor levels (un-shaded zone).  There are no further cash payments or receipts.  Physical fuel is purchased in the market and the company is exposed to price fluctuations within the predefined range.

Scenario 3:  Fuel price rises above cap level (green zone).  The company receives cash from its trading counterparty to offset the higher physical fuel prices that it must pay in the market.  The company will be exposed to rising fuel prices until the cap is passed.

By using a collar (we will assume a zero cost for this example), the commercial hedger has defined a range of prices within which his bunker price will be constrained over a particular time period.  This structure is often used by companies who desire similar upside protection to a cap, but do not wish to pay a premium for this insurance against rising prices.  By adding a floor into the structure, they receive a premium that allows them to finance the cap.  While they retain some exposure to the benefits of falling prices, they forego the ability to take advantage a price drop beyond a certain level, in order to pay for their insurance against price spikes.

A collar is somewhat analogous with a bunker price adjustment clause in a COA or voyage charter-party.  If a pool operator was unable to include this clause in his contract, he may set up a collar to lock his bunker prices into a particular range and ensure the contract maintains the same financial performance as it would have if the clause had been included.

Certain market situations or attitudes to risk by company executives require instruments with more flexibility then a swap.  Rather than locking in a particular bunker price for a defined time period, a hedger may prefer to retain some exposure to fuel prices while setting an upper limit, beyond which he would be unwilling to pay.

#2: Cap

A cap (or call option) is a financial instrument which protects a business from rising fuel prices whilst allowing it the flexibility to take advantage of falling prices.  A simple way to view it would be as an insurance contract.  You pay a premium to the seller of the contract and he insures you against fuel prices that are above a predefined level.

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
• Select price cap level (or strike price)
• Pay premium

(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 remains below cap level (un-shaded zone).  There are no further cash payments or receipts.  Physical fuel is purchased in the market and the company is able to take advantage of falling prices.

Scenario 2:  Fuel price rises above cap level (green zone).  The company receives cash from its trading counterparty to offset the higher physical fuel prices that it must pay in the market.

By using a cap, the commercial hedger has set a maximum fuel price he will pay for bunkers over the time period he selected.  The cap level chosen may be the fuel price at which the company becomes unprofitable.  A different scenario may be the company effectively insuring themselves against financial distress.  The cap level selected would be protection against an extreme price spike that threatened the company’s ability to continue operations.  There are many ways to structure this type of hedge.  Different market conditions require different strategies, and different companies have different objectives they are trying to achieve.  The optionality provided by a cap allows executives additional flexibility relating to their budgetary and risk management decisions.

#5: Attract quality investors

Attracting quality investors is tremendously important, whether it is a long-term institutional asset manager or pension fund buying shares in a publicly-traded company, or a private equity firm or hedge fund taking a significant stake in a privately-held company.  These investors are not just looking for exposure to an industry that will help them meet their return targets; they are looking for a best-in-class management team or a company with operations they believe to be significantly better than those of others within that cohort.  Take for example the significant amount of private equity money that has been put to work in the shipping industry.  These P.E. funds believe vessel prices and day rates have been at the bottom of the cycle and both will see an upswing in coming years as economic activity improves.  Their return model is based on improving asset prices and stronger charter revenues.  They are not looking for commodity exposure that could potentially erode their return on investment.  Given the high percentage of costs accounted for by fuel expenditure, companies with unhedged fuel exposure can effectively act like an inverse proxy for global oil markets.  By having a plan in place to address these risks and remove some uncertainty from their business model, companies can position themselves as a more attractive investment option than their peers.

#6: Taxpayer protection

In recent years, with varying degrees of austerity sweeping through national and municipal level budgets alike, it has never been more important for government agencies to deliver services ‘on budget’.  Whether it be commuter ferry services, lifeline ferry services, or coastguard/naval departments, agencies at the local and federal level have significant fuel expenditures and are exposed to this price volatility in the same way as public or private companies.  Similar to corporate executives, the administrators and officers of these agencies are charged with effectively running their departments and delivering a quality public service while remaining within pre-defined spending limits.  Without a hedging strategy, these agencies retain significant cost uncertainty and needlessly expose taxpayers to volatile global oil markets.

#3: Secure Competitive Advantage

One of the most important reasons to manage price volatility in fuel markets is to secure a company’s competitive edge.  If you ask an executive why his company performs better than the competition, it is highly unlikely that he would cite the ability to purchase fuel at lower prices than his peer group.  He would list the quality of his management team, the additional services the company offers its customers, reliability and perhaps flexibility with regard to contractual terms.

The essence of bunker hedging is that it allows a company to remove the risk of price spikes from damaging profitability and focus on being a better operator and differentiating its services from the competition.  Let us look at two examples:

A)      A pool operator who has traditionally insisted on a fuel clause in charter contracts

The operator has traditionally included these contractual clauses to protect itself against sharp rises in bunker prices.  Given the current oversupply of vessels, many of its clients are refusing to accept this fuel price risk and there are other operators willing to charter vessels without this clause.  Therefore, to remain competitive, the company must decide whether to follow suit.

The fuel clause can be easily replicated with exchange-traded financial instruments; a company with a sophisticated hedging program would be able to price, retain on its books, and hedge this fuel risk.  This would allow the operator to offer more flexible contractual terms to its clients: one price where the operator passes on the fuel risk, and a different price where the operator retains and manages that risk.  Despite the different prices and terms, the hedging program would effectively render the financial performance of these contracts identical.

B)     A regional fuel supplier or bunker trading house offering new products

Many small- and medium-sized suppliers have traditionally only offered fuel either at i) spot prices or at ii) a price agreed today for delivery at an agreed date in the future (physical fixed price forward).  Although the fixed price forward is a useful hedging tool for some companies, it does little to help companies who may not know in advance how much fuel they require or those who wish to retain some ability to take advantage of potentially lower future prices.  There are a number of hedging instruments that provide attractive optionality for fuel buyers (caps, collars, barrier physical fixed price, as well as more highly customized solutions).  However, many of these solutions are only offered by a few large multi-national suppliers/traders.  A smaller business with a hedging program would be able to offer similar products to its customers and retain and manage that price risk.  Having a hedging program in place would allow the company to market a wider range of solutions and enable it to increase the volume of business it does with both existing and new customers.

#4: Improve Finance Terms

Bunker risk management can also play a significant role when negotiating terms with a financier.  A hedging program (or lack thereof) can affect the availability and size of credit facilities, loans and the interest rates payable on them.  Lenders will pay particular attention to the asset or trade that is being financed, but also to the credit risk posed by the company to whom they are lending.  If we take, as an example, a pool operator purchasing a new ship, an operator hedging their exposure to fuel prices may receive more preferential loan terms than one who doesn’t.  Given how low day rates have been in recent years, lenders are well aware of the impact a fuel price spike can have on an operator’s profitability.  Since the financial crisis, lenders in the maritime sector have had to deal with a significant number of non-performing loans.  Underwriting standards are tightening and companies that want increased access to credit, or better credit terms, need to be aware of the effect unhedged risks will have.