HEDGING FUEL PRICES: USING POLITICS OR USING MARKETS?

Lynne Kiesling

On Monday Stumbling and Mumbling had a post on truckers in the UK complaining about high fuel prices. I really like his suggestion: instead of whingeing and bleating for a political solution, why does their trade association not offer price insurance?

The fact is, though, that high oil prices are a danger that is in principle easily insured against. That’s what oil futures markets are for.

Of course, it would be impractical for each individual road haulier to dabble in these markets. But it is perfectly feasible for the Raod Haulage Association to do so on their behalf, and to sell oil price insurance to its members.

There’s a lot of potential commercial and contractual innovation inherent in that suggestion, and the brilliant thing about having the trade association offer it is the reduction of transaction costs. He offers some hypotheses for why the trade association has not adopted such a potentially valuable innovation:

Could it be that their preference for demonstrating rather than managing risks themselves is a symbol of three aspects of our political culture?:

1. Infantilization. Rather than behave like adults, and look after their own affairs, road hauliers are screaming that someone else – the Chancellor tax-payer – should look after them.

2. A misunderstanding of markets. Non-economists regard these – wrongly – as places where risks are taken, rather than as places where risks are laid off.

3. The tyranny of politics. In a culture in which politicians are thought to have unbounded rationality (yup, it’s managerialism again) every problem is thought to have a political solution – notwithstanding a mountain of evidence suggesting otherwise. Sometimes, it just never occurs to people that they might be able to manage their own affairs better than politicians can.

Beautiful. Well said. And applicable in so many situations beyond fuel price hedging.

Another industry in which fuel hedging is actually common practice is the airlines. High fuel prices are playing a role in the current cycle of price increases and decreases and increases … as the airlines jockey to balance the very competitive environment with their rising fuel costs. A Miami Herald article from the AP summarizes it thusly:

Fasten your seat belts. Airlines moved closer to raising domestic fares on Tuesday after a frenzy of raising, cutting and re-raising prices.

If they stick, the latest increases would be the third in less than a month, for a cumulative jump of $30 or $40 on some domestic round trips. Carriers say they must charge more to cover the rising cost of jet fuel.

American Airlines’ chairman and chief executive, Gerard Arpey, said Tuesday that American expects to spend $1.4 billion more on fuel this year than last year – or about $5.4 billion, nearly double the carrier’s fuel bill of two years ago.

An NPR story this morning made a very interesting point about fuel price hedging in the context of passing prices on to air travelers: hedging requires some cash flow (ya gotta pay for it), and many of airlines have not been in a financial position for the past few years to be able to afford placing hedges for the kinds of prices we’re seeing now. But the financially healthy airlines, like Southwest, have been able to do so more than the others, and thus will be able to avoid some of the seesaw pricing changes of their competitors. This MSNBC discussion of Delta’s situation illustrates the point:

Every time jet fuel prices go up by a penny per gallon, it costs Delta an extra $25 million per year because the airline uses 2.5 billion gallons in a typical year.

All three major credit ratings agencies have Delta rated in the C range with negative or neutral outlooks, and Delta’s collective debt loads of $21 billion and cash reserves of only $1.8 billion (down from $2.7 billion a year ago) make it impossible for Delta to buy fuel hedging contracts.

Hedging contracts allow companies to buy fuel at a fixed price so costs remain steady if fuel prices spike. Delta settled its fuel hedging contracts last spring for a gain of $82 million when fuel was only $35 a barrel. That move ended up costing the airline $700 million in extra jet fuel expenses for the year.


7 thoughts on “HEDGING FUEL PRICES: USING POLITICS OR USING MARKETS?

  1. Yeah, my TB and comments are misbehaving. I think I have to uninstall and reinstall my MT-Blacklist software to get the problem solved. But I don’t like programming!

    I think if you just link to the permalink that’ll have to do for now.

    Thanks!

    LK

  2. It is hard enough to run a small business without adding extra costs for insurance. If ones goes round adding extra expense for risks that cut both ways, one will spend more than is necessary. Those large airlines that hedged their fuel costs before the latest spike were perhaps smart but absolutely lucky. If a business is able to keep its costs low and finances in order, it will be able to survive periods of high fuel costs and will not have paid extra money for insurance when fuel costs are lower than expected.

  3. Jack,

    I disagree. While luck certainly plays a role in outcomes, it’s important to recognize that there are two different types of risk: diversifiable and non-diversifiable. Hedging is a means, as S&M said, of laying off risk, with other people who face different risks or have different valuations of the risk or different risk preferences taking the other side of the transaction.

    One dimension in which we determine success of an enterprise ex post is by evaluating how much foresight they had, and how well they exercised that foresight. Opportunism and foresight are two of the traits that are most advantaged in the survival of the fittest and most adaptable institutions and organizations.

    Yes, insurance is another expense item to face. But you have to weigh its cost versus the cost of what you are insuring against. Having a political option for handling it affects how you weigh that tradeoff. We call that moral hazard.

  4. There is a second way for transportation companies to insulate themselves from fuel price fluctuations, investment in fuel efficiency technology. In the trucking industry this tends to be the more favorable avenue, although it involves more capital and a longer lead time to phase in high fuel efficiency vehicles into your fleet, there is less financial liability. Even if fuel prices fall the firm can still realize positive fuel savings from reduced fuel usage.

    Looking at the 10-K filing of a few of the largest publicly traded US trucking companies only one out of five have employed fuel hedges in the past 5 years (only Knight out of Swift, Heartland, JB Hunt, Werner and Knight). All five listed both fuel surcharges, a commonly accepted practice of passing fuel increases onto the customer, and investment in fuel efficient vehicles as methods used to address fuel risk. This seams to be due to the highly competitive nature of the trucking industry (far more than parcel, rail and even the airlines). Profit margins are painfully low and many firms already carry large liabilities on their balance sheet due to the ownership of large amounts of quickly depreciating assets (no infrastructure is owned as in other modes of transportation).

    Given the uncertainty of retaining business the risk of hedging fuel is not just a bet on future oil prices but also on highly unstable demand. Given the system of fuel surcharges currently in place a case could be made for large customers of transportation to hedge fuel since the ultimate cost is passed on to them in the current market as well as the relatively stable fuel consumption forecasts for an end consumer. The only problem is that the number of customers with enough consumption to make the economies of hedging fuel worthwhile.

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