Fuel Management: Survival of the Smartest
 |
|
A casual observer scanning crude oil’s spectacular breakout more than US $100/bbl this past spring might be excused for thinking the most important news stories for airlines, trucking firms, railroads and other major fuel users had something to do with fuel prices – that is the easy answer.
No, the most important story detailed a Stanford University study indicating the total population of humans might have collapsed to as few as 2,000 about 70,000 years ago. The human race came close to extinction and survived only by using superior intelligence, organizational skills and teamwork to adapt to a stressful new environment.
The story was similar in a macroeconomic sense during the first oil shock of the 1970s: while the United States chose to duck the issue with myriad price controls and supply allocation schemes, all of which proved counterproductive, Japan chose to face higher fuel prices head-on. It organized its society to minimize energy use and in a phrase that makes even the most tendentious management consultants grit their teeth by now, they decided to work smarter, not harder. The results were so impressive that by the late 1980s, Japan was the envy of the industrial world.
Comparative Airline Fuel Hedge Efficiency (Graphic courtesy of Merrill Lynch)
The good news
We see the same survival mechanism operating today in the most pressured transportation industry, the airlines. We know of the recent bankruptcies, such as Aloha and ATA airlines, and the pending mergers such as Delta and Northwest airlines. All airlines, however, are not created equal with respect to their ability to manage and pass on their rising fuel costs.
If we use Merrill Lynch’s projections of crude oil price changes on earnings for selected airlines and then normalize these changes in net income against fiscal year 2007 earnings before interest, taxes, depreciation and amortization, one firm, Southwest Airlines, stands out as a winner in the highest oil price scenario.
Fuel price risk management matters, not only for the airlines, but also for all transportation firms. We can repeat the exercise for railroad stocks, where we find Union Pacific and CSX able to ride out the rising cost of diesel fuel while Burlington Northern Santa Fe and Norfolk Southern take a hit.
In the trucking industry, Landstar and J.B. Hunt have been able to pass rising fuel costs on to their customers and achieve positive relative performance in the face of rising diesel fuel performance. In the package delivery business, UPS has done slightly better than FedEx, although both firms’ stocks have been pressured.
The question often arises whether a price has risen to a level so high that further capping is counterproductive. The answer is simple: a buyer is always at risk to higher prices. This natural risk profile is independent of the price level as well as a company’s forecast. Hedgers in both directions in all commodities have found out the hard way that markets move much further and faster than expected. What was once “too high” or “too low” now sits in the rearview mirror.
The hedge challenge
Rising absolute price is not the only problem for fuel price hedging. The influx of speculative money into commodity futures has distorted basis relationships between local markets and exchange-traded futures. The differential between diesel fuel at the U.S. Gulf Coast and New York Mercantile Exchange heating oil used to spike to the downside; it now spikes to the upside. Moreover, the absolute magnitude of basis differentials has expanded as well. This affects the pricing of capping swaps and average-price or Asian options.
All distillate-based fuels – diesel, jet kerosene or marine diesel – are forced into the same seasonality as space heating fuels such as natural gas. The cost of all capping trades will rise – and their efficacy will decline – as the implied volatility of heating oil futures spikes with the seasons. Unexpected weather will affect hedging costs.
Command and control
Pressure on operating margins from an increasingly volatile input cannot be wished away, and no industry can pass through all its increased costs to its customers, especially if economic activity slows. No fuel buyer should expect to trade its way out of the predicament. If the world’s most sophisticated hedge funds implode with regularity in the energy markets, particularly those natural gas markets whose movements affect heating oil and therefore distillate-based fuels at the margin, how can airlines, railroads and trucking firms expect to make this their long-term business model?
The answer is not so much in absolute success in price risk management as in relative success. If one firm in an industry enjoys a cost advantage over its competitors, it can expand operating margins and become a more aggressive bidder for new business. Relative price risk management success, just like evolutionary success, derives from superior intelligence and teamwork.
A single software solution, such as SolArc’s RightAngle, provides fuel buyers with a management tool to help realize this competitive advantage and adhere to a growing set of best practices in the business. The software provides for physical and financial deal capture, for the scheduling and logistics of shipments, for position management linked to external price reporting services, accounting and settlement, and for risk analytics. This last feature cannot be overemphasized in a world increasingly intolerant of any management failure to stay on top of price risk, mark-to-market financial reporting and budgetary impact of variance. This tool can forecast the hedged cost of fuel by combining the financial deals with physical deals in the “FuelCenter” budgeting module. “What if” price scenarios analysis can be run on these forecasts to generate multiple budgets with different forward price curves. After a final budget is adopted, actuals can be compared with the forecast to identify differences in items like price, volume and foreign exchange rates.
Airlines in particular have been able to optimize fuel consumption and increase revenue ton-miles per gal of fuel by managing all discretionary weight on the plane and flight-path management. This software allows for the capture of each aspect of a flight’s fuel efficiency, including the scheduled routes and aircraft types selected and crew’s discretionary decisions, for subsequent analysis. Each fuel purchase at each location can be accounted for in terms of proper quantity and in manageable financial terms such as taxes, duties and fees against a fuel efficiency benchmark. No one can improve fuel management performance unless they know whether their actions taken to-date have improved performance.
The fuel management business is complex in its physical logistics – storage, variable lifting schedules, delivery locations, terminal operations – and pricing formulas. The software recognizes these deal terms and requirements and generates contracts seamlessly. The deals and hedges are handled as a package for accounting, with FAS 133 hedge accounting and a range of taxes and fees built into the system for integrated financial control. SolArc’s LogisticsCenter provides the management tools to track thousands of daily fuel uplifts and account for fuel consumption by aircraft.
The natural seasonality of fuels and observed deviations of the forward curves from backwardation to the upward sloping forward curve and back in relatively short periods of time makes the software’s ability to generate basis and underlying price forward curves invaluable; it is hard to see how any manager can manage a book of swaps and both vanilla and exotic options without such a capability.
The combination of superior intelligence and superior tools has worked before in human history. In fact, that is why we have human history: someone in our distant past looked at a bad situation and said, “I’m going to make this work.”
About the author: Howard Simons has been researching market trends, designing trading systems and risk management programs and generally educating market professionals since 1978.
