Pandemic-Fueled Hedging Innovation On Diesel May Be A Keeper

Hedging of exposure to the shifts in the price of fuel has been a rarely sighted activity in the trucking market for a variety of reasons: Fuel surcharges allow pass-throughs to customers, it ties up capital, and hedging losses can be painful blots on earnings reports for public or private companies.

But the volatility of the diesel market through the pandemic opened up an opportunity for K-Ratio, the Chicago-based risk management firm that offers a variety of services to the freight industry. And with the first anniversary later this month of its unique hedging tool, Kyle Lintner, the principal and managing director at K Ratio, never thought the program would get this far. 

"I didn't think the program would make it beyond the end of the year, and now it's turned into a permanent offering," he told FreightWaves.

The method that the trucking industry has long used to deal with fuel price volatility is the fuel surcharge. Outside of the West Coast, it is almost always based on the changes in the Department of Energy/Energy Information Administration weekly retail diesel price. (West Coast markets often use the California price from the DOE, given the higher level of diesel prices in the Golden State.)

But about a year ago as oil markets plummeted, K-Ratio was contacted by numerous existing and potential clients who wanted some way to lock in those low diesel fuel prices, Lintner says. The DOE price opened the year at $3.079 a gallon, dropped to $2.548 by the first week of April and then slumped to a springtime low of $2.386 in mid-May. The bottom of the market was $2.372 in early November.

K-Ratio had spoken to clients about the possibility of hedging diesel futures but often didn't get very far. "They never thought about it until the coronavirus hit and diesel sold off so hard that those same people called us back and said, ‘Do you guys offer diesel hedging?'" he said. 

Lintner knew the traditional hedging tools would probably not work. They involve buying or selling ultra low sulfur diesel futures or ULSD options on the CME commodity exchange.  Both of those approaches can be expensive. They can also leave a company looking at a significant loss, albeit a loss that would only occur if the diesel market moved down to benefit both carrier and shipper. 

Instead, Lintner said, what carriers were interested in was "locking up the price when it was pennies on the dollar." He added that companies wanted a way to take advantage of those low prices for an extended period of time without exposing themselves to the losses that always loom in a traditional hedging program.

"The sentiment was that if the hedge lost money, then they lost money," Lintner said. "They were forgetting that it is a zero-sum game."

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The solution amounts to a program that is more like insurance than a pure hedge. While it is open to carriers and shippers alike, Lintner said the bulk of the business has been done with carriers.

A carrier decides on an amount of diesel it wishes to hedge into the program. A strike price is set based on the current market. If the carrier wants to hedge, the price of ULSD on the CME out along the forward curve is used as the basis for the hedge. 

Lintner said the price the hedger pays to K Ratio for its risk management services fluctuates, but not widely. It's usually about 7 cents per gallon. A hedge of 100,000 gallons per month would cost a hedger $7,000 upfront if that price was 7 cents.

The determination of whether the hedge will pay out to the company doing the hedging is then established on the basis of the price of ULSD on CME four trading days before the end of the month, which is the day that options trading for that month comes to a close. 

If the market rises 2 cents per gallon above the price set in the original hedge, it means K Ratio needs to make a payout, because the hedge is designed to protect against rising prices. A hedge of 100,000 gallons would result in a payment of $2,000: 2 cents per gallon for 100,000 gallons.

K Ratio makes its money by taking 7% from each distribution, so that payout would be reduced by 7%. If there is no payout because of the way the market moves, then there is no distribution and K Ratio does not collect anything.

But if the price drops 2 cents less than the strike price, nothing happens. There is no payment from K Ratio to the hedger, because there was no need to protect against rising prices; they fell instead. And that, Lintner said, has been a key to the program's success, because companies have avoided hedging under more traditional methods in the past because they didn't want to see money going out the door. 

"They aren't obligated to us if the market goes down," he said.

But if trucking companies use a fuel surcharge, why do they need to hedge? Lintner said there are two key reasons: Empty miles don't carry a surcharge, and neither does a spot market linehaul, where the rate per mile is contracted on an all-in basis. 

"Ours is just a cap that allows them to budget properly," Lintner said.

What he said has surprised him is that even as the price of diesel has risen, with the DOE/EIA price tacking on more than 80 cents in a 20-week, record-breaking run of increases, interest in the program has not faded. 

"I thought that once we got up here, we would stop acquiring customers," Lintner said. "I thought the well would dry up because diesel is no longer a cheap play."

But that hasn't happened. Lintner attributes that to the fact that the program has no downside — the possibility of a big hedging loss — and as a result, "we are getting customers faster than we were earlier."

Although the program comes with the certainty of laying out that 7-cents-per-gallon upfront charge, the reality as Lintner sees it is that if the price of diesel rises, there will be a distribution from K Ratio to the hedger. And if the retail price of diesel falls, the upfront payment is gone, but the company that did the hedging is benefiting from lower prices at the pump.

Lintner said most of K Ratio's clients in the program are carriers. He was somewhat surprised that more shippers weren't in the program because while a fuel surcharge is supposed to protect carriers, its goal is pretty much to dump the impact of higher diesel costs onto the shipping community. 

He added, though, that he also is running into some shippers that are hedged through traditional means, and they are out through 2021 on their hedges.

The program has been successful enough that Lintner put some metrics on it. From a standing start less than a year ago, the volume of ULSD trade on the CME that can be attributed to the program is about 1% of all open interest in the producer/merchant/processor/user category and about 2.5% in the swap dealer category, which describes K-Ratio. 

Those numbers seem small but could be seen as impressive given that the program didn't exist a year ago, and is being marketed into a sector that previously tended to avoid hedging.

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