A variable fuel price hedge is a contractual tool used by companies that consume large volumes of fuel, such as airlines, shipping, and road transport, to mitigate the negative consequences of volatile, potentially rising fuel prices.
A fuel hedge contract is a futures contract that allows a fuel-consuming company to set a fixed or limited cost through a commodity swap or option. Companies enter hedging contracts to reduce exposure to future fuel prices that may be higher than current prices and/or to establish a known fuel cost for budgeting purposes.
How does it work?
By purchasing futures contracts, companies are protected from the risk of a possible increase in oil prices. A fuel hedge contract is a futures contract.
A futures contract is a customizable agreement in which two parties agree to buy or sell a specified quantity of an asset (mostly commodities) at a specified price at a future date.
Essentially, by entering into a futures contract, both parties make the decision to give up potential profits in exchange for certainty. It is also worth noting that there is always a “winner” and a “loser” when the futures contract reaches maturity.
A futures contract allows a high fuel-consuming company to set a fixed or limited cost through a commodity swap or option. Companies enter into hedging contracts to reduce potential losses in future fuel prices that may be higher than current prices and/or to establish a compliant fuel cost for budgeting purposes.
Background of the Subject
The cost of hedging depends on the estimated future price of the fuel. Companies form their hedging strategies based on anticipated future fuel prices or future crude oil prices.
Since crude oil is the source of all fossil fuels, crude oil and fuel prices are normally closely related. However, other cost factors, such as challenges with the refining process, can cause unusual differences in crude oil and fuel trends. If a company buys a fuel swap under a contract and the price of fuel drops, the company will actually have to pay an above-market rate for the fuel.
If the company buys a fuel call option and the fuel price goes up, the company will receive a return on the possibility of recoupling the actual cost of fuel.
If the company purchases a fuel call option that requires an upfront premium cost, such as insurance, and the fuel price drops, the company will not receive a return on the option but will have the advantage of purchasing fuel at a lower cost.
Fuel hedging providers
This service is mainly provided by specialized institutions and teams within fuel management companies, large oil companies, and financial services institutions.