As crude oil and refined products prices once again seem to be on an upward trend, we've received several requests for more information on the basics of international fuel hedging, across a wide range of industries (air, heavy industry, marine, road, etc.).

As this post will be the first of several in a series, we'll going to begin with fixed price swaps (also known as fixed-for-floating swaps), which are one of the most commonly used hedging instruments in the global fuel markets.  In subsequent posts, we'll also cover additional types of swaps, as well as options and other hedging strategies, which are based on more complex structures.

Given that the focus of this post is international fuel hedging, it's going to focus on hedging with gasoil swaps, based on gasoil futures, the international benchmark for distillate fuels, as traded on the Intercontinental Exchange (ICE) in London.

A gasoil swap is an agreement whereby one market participant, say an airline, exchanges their exposure to floating (or market) gasoil prices for a fixed gasoil price, over a specified period(s) of time.  Swaps are called such as the buyers and sellers of swaps are “swapping” cash flows.

Fuel consumers, such as airlines, utilize gasoil swaps in order to fix or lock in their fuel costs, while refiners and fuel marketers utilize swaps in order to lock in or fix their margins, revenues and/or cash flow.  Foreign exchange, interest rate and agricultural and other energy, commodity risks can be similarly hedged with swaps.

As an example of how an airline can utilize a gasoil swap to hedge their jet fuel price risk, let's assume that you're an airline who primarily flies in Western Europe and needs to "lock in" a portion of your jet fuel costs for a specific month.  For sake of this example, let's also assume that you are looking to hedge 5,000 MT (metric tons) of your anticipated June fuel consumption.   In order to do accomplish this, you could purchase a June gasoil swap from your bank’s fuel trading group.  If you had purchased this based on the price as of the close of business on Friday, the price would have been (approximately) $1,035/MT.

Next, let's look at how the swap would perform if gasoil prices in June average both above and below your price of $1,035/MT

In the first scenario, let's assume that gasoil prices increase and that the average price for ICE gasoil futures for each business day in June is $1,050/MT.  In this scenario, your hedge would result in a "gain" of $15/MT ($1,050 - $1,035 = $15) or $75,000 (5,000 MT X $15).  As a result, you would receive a payment of $75,000 from your bank, which would offset the increase in your actual jet fuel costs by $15/MT. 

In the second scenario, let's assume that gasoil prices decrease and that the average price for ICE gasoil futures for each business day in June is $1,000/MT.  In this scenario, your hedge would result in a “loss” of $35/MT ($1,035 – $1,000 = $35) or $175,000.   As a result, you would have to make a payment of $175,000 to your bank, which would offset the decrease in your actual jet fuel costs by $35/MT. 

As this example shows, purchasing a gasoil swap allows airlines to hedge their exposure to volatile jet fuel prices, an expense which often accounts for somewhere between 25-50% of an airlines total operating expenses.  If the price of gasoil (and in turn, jet fuel) increases, the gain on the swap offsets the increase in the actual "into-plane" jet fuel cost.  On the other hand, if the price of gasoil (and in turn, jet fuel) decreases, the loss on the swap offsets the decrease in the actual "into-plane" jet fuel cost.

While this example addressed how airlines can utilize gasoil swaps to hedge their jet fuel price risk, the same methodology can also be used to hedge exposure to other distillate fuels (i.e. diesel fuel) as well.  In addition, as previously mentioned, refiners and fuel marketers can also utilize gasoil swaps to hedge their fuel margins, revenues and/or cash flows.  

As is always the case with fuel hedging, the devil is in the details.  Furthermore, there is clearly a risk to hedging with fixed price swaps, as swaps result in a "loss" if the price of the underlying instrument settles below the price of the swap.

As many of you may already know, hedging jet fuel with gasoil swaps (as well as gasoil futures and options), subjects airlines to basis risk, a topic beyond the scope of this post.  However,  we will provide it the attention it deserves it in a future post.

If you would like to learn more about how you can hedge your exposure to volatile jet fuel prices with gasoil swaps or any other hedging strategies, please contact us, we would be glad to assist you.