The fundamentals of diesel hedging, Part 1

“Commodities markets are taking a breather” – this is the best way to describe the current development of the oil price. Finance departments, however, cannot afford to take a break, because now is the time to actively consider commodities price management.

Commodity price management is often mentioned in the same breath as "intelligent" procurement. And, indeed, securing a supply of materials or fuels is crucial for ensuring problem-free production and logistics processes. Operational measures, however, have their limits:

1. “Intelligent” procurement can only achieve limited cost savings, as it is impossible to underbid the market
2. Such measures have only a short-term effect, and offer no protection against long-term price trends
3. Fixed-price contracts are inflexible and have a short time horizon of 9-12 months

To supplement activities aimed at ensuring favourable procurement conditions, financial instruments linked to the crude oil or diesel markets can be used. This involves cooperation between the purchasing and finance departments, since commodities derivatives function in the same way as traditional forward currency transactions or interest rate swaps.

Commodity price risk management is based on

1. an understanding of how commodities markets function,
2. determination of the right hedging period and
3. setting the minimum benchmark price. 

It must be emphasized that a long-term commodity price hedge via the financial markets is by no means solely the prerogative of large companies. The transactions have come down so much in size that even family businesses and public-sector enterprises can take advantage of these instruments.

Figure 1: Diesel price curve ICE Gasoil 0.1% in USD per metric tonne (12 December 2008)

The Diesel price curve shows the prices that can be realized in the market for various maturities (Dec. 2008-2011). The graphic depicts prices for the diesel grade ICE Gasoil 0.1%. [1] These are called “forward commodity prices” – but should not be confused with a forecast. In general, an upward sloping curve (“contango”) indicates lower demand for diesel, while a falling curve (“backwardation”) is a signal of short supply. The short end of the curve is considerably more volatile than the segments four years out and beyond. Political factors and speculation-related skewing of the supply/demand relationship at the long end of the curve play a minor role. Figure 2 illustrates the spread between the spot price (1 month) and the four-year forward rate for crude over the past 12 months. The red circles represent the current prices.

Figure 2: Change in the price of BRENT crude (1-month vs. 4-year forward price)

The long end of the crude oil curve, and the diesel curve derived from it, approximate the “marginal costs of production” [2] for oil extraction and refining (not taking into account the differences in quality between Brent and WTI or DUBAI oil). Currently, the marginal costs of production are estimated to be between USD 60-80 per barrel. The high price reflects that, in addition to the traditional, low-cost extraction methods used by OPEC and the CIS countries, a majority of the higher global demand for crude oil must be satisfied using new sources and more sophisticated production methods. Higher material and labour costs also play a role. A marked decline in demand and persistent levels of production by OPEC and CIS countries, however, could cause a decline at the long end of the curve.

For the hedging of diesel transactions, the maturity of the transaction should be set in such a way as to offer the longest possible period of reliability for planning. Terms of 15-24 months should be selected for hedging the basic procurement needs of the business. Such a transaction aims at ensuring maximum procurement flexibility with medium-term planning reliability. Many hedging plans fail due to improper timing. Hopes for a better price often hold businesses back from hedging transactions. As a result, many self-described “conservative customers” remain in the highly speculative short-term arena (oil price volatility is currently around 80%). In most cases, the forward curve for crude oil and diesel slopes downward (future prices are lower than near-term prices). The historic gap between long-term swap prices (concluded for a longer period) and the short-term price is perceived as “moderately prohibitive”. Since commodities prices “breath”, however, systematic hedging is possible: starting small and increasing hedging volume in the event of a significant decline in the long-term price. The hedging period can also be gradually increased as necessary. Banks now also provide well-constructed “product kits”, which offer solutions customised to specific client needs.

A minimum diesel price (excl. fuel tax, taxes and EBV fees) serves as a good reference value for evaluation of hedge quality. Unlike world market prices (USD in metric tonnes), these are expressed in the more practical terms of EUR per litre. Example: a modern “40 tonne” tanker lorry consumes between 30-35 litres of diesel in 100 kilometres on a normal route. The average distance travelled by a lorry is roughly 10,000 kilometres per month.

How does a diesel price hedge work?

The table below shows the current world market prices for diesel in USD per metric tonnes and "net pump prices" in EUR per litre [3] (excl. taxes). Based on this, a tanker lorry consuming roughly 3,500 litres per month would currently (Dec. 08) have a monthly diesel bill of approx. EUR 1,015/vehicle (excluding taxes!). The forward prices for the period Dec. 2009 – Dec. 2010 provide the best estimate of possible diesel price developments. That is: the price levels at which market participants are willing to commit for a future delivery date.

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Footnotes

^{1. The diesel grade ULSD 10ppm is also traded in the market. There is a very high correlation between the prices for this type of diesel and ICE Gasoil. The price difference is roughly USD 15-20 per metric tonne. For our calculations, we use the ICE Gasoil price.}

^{2. Costs for profitable production of one additional litre of crude oil or diesel.}

^{3. Formula: EUR/L = [USD-price per MT / EUR-USD exchange rate]/1176}

• Currency management with financial instruments during the crisis
• The fundamentals of diesel hedging, Pt 2