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The fundamentals of diesel hedging, Part 2

Wednesday, March 31, 2010

In Part 1 of this article, we gave you a short overview of the functioning and dynamics of commodity markets. Now we look how the prices breathe.

Prices on the commodity markets never “sleep”. Changes in the spot market price for oil, in particular, can be triggered by a variety of factors:

• Supply and demand. In Q3 – Q4 2008, the oil price fell from USD 149 to USD 32/barrel due to a pronounced weakening of demand.
• Political risks. The Middle East conflict is often cited as an example here.
• Weather. Hurricanes in the Gulf of Mexico push prices higher due to short-term stoppages in oil production.
• Inventories. Inventory build-ups in Cushing, Oklahoma (site of one of the largest oil depots in the US) led to sharp declines in the price for West Texas Intermediate (WTI) grade oil in Q1 2009.
• Economic output. Expectations of weaker or stronger demand have an effect on the oil price over the medium term.
• Other factors. Freight, production costs, substitution, technological advancement, investment in new sources.

Whether SMEs and municipal enterprises must necessarily formulate their own firm opinions about price movements is a question that must be critically examined. Having an opinion is certainly not a disadvantage. But the sheer volume of different factors that affect the spot price overwhelm even some commodity experts. Oftentimes, price expectations relate to the coming few months. But those seeking medium-term planning reliability cannot afford to juggle with short-term price forecasts. A look at the long end of the commodity price curve can make more sense in such cases, as many of the above-mentioned short-term price factors have less of an effect here, giving way instead to fundamental factors such as production costs.

The arguments in favour of this method for increased planning reliability are strengthened further when looking at the prevailing price forecasts. The graphic below illustrates the oil price forecasts by various research firms published in January 2009 (source: Reuters poll). A gap between the forecasts of USD 60/barrel on average proves that even the professionals have no crystal ball with which to foresee the future. The median forecast indicates an oil price correction to the level of marginal production costs (see Part 1 of this article) in the medium term.

The underlying parameters are given in the table below:
The transaction to be hedged is a regular diesel purchase order for 100 metric tonnes occurring on the 27th of each month.

The screenshot below depicts the hedged transaction in sals.a (USD/mt) as well as the approximate future pump prices (EUR/litre including tax at a constant rate).

The approximate future pump prices fluctuate when the market prices and/or exchange rate for EUR/USD change. Moreover, rates of fuel tax, VAT and the contribution margin do not remain stable over time (see www.mwv.de). Thus, the gross price only remains constant if unchanging fuel tax rates, VAT and contribution margins are entered.

Fig. 3: Correlation Brent crude vs. ICE Gasoil

Oil, however, is not a single product, but rather a family of products with numerous types and grades. The same can be said for distillates such as diesel or light heating oil. There is no instrument available for precise hedging of pump prices. In order to hedge an underlying transaction (e.g. diesel purchase), a reference price index must first be calculated, which tracks as closely as possible the price fluctuations of the underlying transaction. Reference prices for diesel are 10 ppm ULSD (source: Platts) and/or ICE Gasoil (source: Intercontinental Exchange - ICE). In our example, we use ICE Gasoil, as it exhibits a closer correlation to pump prices, and because the prices, unlike Platts, are transparently available to the public on the market’s website.

On the world market, diesel (= gasoil) is traded in USD per metric tonne (mt). 1 metric tonne = 1183 litres (a density of 0.850 kg/litre is generally assumed - so that 1mt = 1176 litres). In order to calculate an approximate EUR pump price, the EUR/USD exchange rate must also be taken into account.
A commodity swap can be described as follows:

• A purely monetary transaction in which the amount paid is set off against the amount payable in the contract currency (“netting”)
• The nominal amount is expressed in units of volume (metric tonnes) and forms the basis of calculation for settlement
• A symmetrical transaction with respect to its risk/return profile
• Monthly settlement of the fixed-price is based on the market price applicable at the time of payment (generally the closing price). The market price is calculated as the average daily price in the relevant month (monthly average settlement price – MASP)
• The swap may have either a positive or a negative market value between the settlement date and maturity, depending on the movement of the reference price on the world market.
• The example does not take into account any markups by the banks.

After conclusion of the commodity swap, no significant changes take place in the financial management process. The purchasing department continues to take care of physical procurement under the best terms from different wholesalers (generally based on daily prices). The finance department concludes a (monetary) commodity swap with the bank upon consultation with the purchasing department. The swap volume is based on the volume prescribed by the purchasing department. Thus, planning reliability is achieved with a high degree of flexibility in the underlying transaction.

As a rule, banks are willing to enter into a swap starting with a minimum volume of 60mt/month. For smaller monthly volumes, pooling is an option. More information on such a solution is best obtained directly from the bank.                      

1. ^{Distillates are oil products obtained through the refining of crude oil. No. 2 distillates include heating oil, kerosene and diesel fuel.}

• The fundamentals of diesel hedging, Pt.1
• Cross Currency Swaps, Pt.1