Introduction to hedging tools (4)
Following on from our initial three installment series on the principal reasons to hedge fuel price risk, we are going to explore the basic tools available to companies who wish to implement a bunker risk management strategy.
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.
- 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.