Understanding fuel hedging contracts

In this article, Daniella Keet, head of commercial structured finance solutions advisory at FNB, explains the basics of hedging, and more specifically, how this financial instrument can be used to safeguard a farming business against large, unexpected increases in the fuel price.

Understanding fuel hedging contracts
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Most farmers would be surprised to know that the term ‘hedge’, now synonymous with investment banks and financial markets, has its origins in the 14th century and was used to describe a fence made from a row of bushes.

Therefore, to hedge a piece of land was to limit it in terms of size and create a protective barrier. Today, financial hedges are used in a similar way by protecting and limiting against the potential risks that accompany unexpected changes in prices of shares and a
range of commodities, including gold, oil, maize and fuel.

A hedge acts like a form of insurance in that, for a small cost, it protects against large and unexpected movements in price. As the price of the underlying item changes, the hedge is affected in the opposite way, thereby eliminating the risk of price movements.

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Basics of a hedging contract
In its simplest form, a hedge is a financial contract entered into by two parties in which they agree to fix a price for delivery in the future with the intention of minimising unexpected market risk.

In this way, you can protect yourself as the purchaser against increases in the purchase price, as you have already agreed to a price upfront. The contract locks you into a palatable price, for a specific quantity over a period. The value of this financial contract will be the difference between the actual price of the underlying item at a future point and the price you agreed upfront.

If the price of the underlying item has gone up and you are benefitting, you would be described as being ‘in the money’; if the price has gone down and the other party is
benefitting, you would be ‘out of the money’.

The mechanics of entering into a hedge are straightforward. You sign a contract agreeing to a future price for a specific quantity of the commodity, let’s say fuel, over a period. The price multiplied by the quantity (litres, for example, is known as the notional value of the contract.

Depending on whom you hedge through, you will generally be required to pay a deposit
(traditionally around 10%) of the notional value of the contract.

This is known as an ‘initial margin’ and is used to ensure that you will have enough
money to settle the contract. Your bank or broker will calculate the value of the hedge daily, based on that day’s fuel price.

The initial margin will be compared against this value, and if it is lower than the 10% of the notional contract value, you may be requested to top up your deposit with additional cash. At the end of the contract, the existing price of the underlying item, less the future price, will determine the profit or loss due to or payable by you, and this will be offset against your initial margin.

Throughout this time, you will have been purchasing fuel from the pump at that day’s current price, but the hedge contract results in the net effect of the price you paid being the palatable price you agreed to upfront.

More on fuel hedging
Fuel hedging, more specifically, is managing the risk of unpredictable movements in the fuel price. The latter is highly volatile, which means that the price frequently moves up
and down by large amounts. The volatility of the price paid at the pump is primarily due to the crude oil price being quoted in US dollars and the dollar/rand exchange rate.

A fuel hedge is a separate financial instrument and is a contract entered into with a third
party such as a bank or a broker. It does not affect your operations or replace the process
of purchasing fuel, but will afford you certainty with your cash flow, and you will be able to make key decisions more accurately.

This is particularly important if you have long lag times between diesel use and when your revenue is generated, or if you hedge the value of your harvest (revenue line).

It is recommended that you hedge a relatively small portion (20% to 30%) of your fuel spend until you are comfortable with the process.

An obvious risk to hedging is that the price may move down instead of up. But while you would not benefit from a reduced price, you would not be worse off than if the price did not move and you had not entered the hedge. This risk can also be mitigated by not hedging your full spend.

The objective of hedging is not to try to predict a future price or to make profits by picking the tops and bottoms, but rather to reduce the risk of unexpected price moves and thereby create cash flow certainty. This is best achieved by averaging out prices over a series of hedges.

Hedging options
Certain banks offer fuel hedging for clients with a large fuel spend. They typically have experts available who can tailor short-term and long-term risk management hedging strategies that take into account current market conditions.

The FNB product, for example, is aimed at a larger fuel user with a minimum of 100 000ℓ per trade, of which a maximum of 70% will be hedged.

Banks can also put in place a credit line (subject to credit approval) to manage the market movements of the fuel hedge. This means that a client will not need to pay any initial or variation margin (as explained earlier) to the bank when taking out a hedge.

The futures contracts through SAFEX provides a hedge for a portion of the local diesel price. The minimum quantity for a contract on SAFEX is 5 000ℓ, which caters to the needs of smaller farmers.

Email Daniella Keet at [email protected]. Further details can also be found on SAFEX’s website at sashares.co.za/safex.

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