Hedging shipping's fuel costs

CGES | DECEMBER 2009 | SOURCE: Global Oil Insight - Industry Watch

Since 1987 oil prices have been extremely volatile, ranging from lows of $11/bbl (for front month WTI) in December 1998 to a record high of $134/bbl in June 2008, followed by a precipitous decline to $42/bbl in January 2009 — a fall of $92/bbl (69%) in seven months — only to post a remarkable recovery to around $75/bbl these days.

Such volatility would obviously be a major concern for all businesses based on oil and worldwide shipping is one of the larger consumers of oil on a daily basis. A business can protect itself at various times against different forms of price volatility by hedging away these price risks.

Potential losses in shipping can come from different directions and ship owners have a number of ways in which they can shield themselves against them; for example, owners are able to hedge the interest rate and exchange rate risks while the ships that are on order are being built.

Hedging shipping's fuel costs

However, once a vessel has been delivered, the financial risks involved are concentrated in two main areas: on the revenue side the main risk concerns the freight rate, while the ever-changing price of fuel is the key risk on the cost side.

Shipping

A popular way of mitigating both the freight rate and the fuel risk in shipping is by time chartering, according to which the ship is rented out for an agreed period at a fixed daily charter rate.

Time charters are a good way of managing risk, especially if the owners are bearish about the freight market and believe freight rates are on a downward trend. By time-chartering the vessel the owners obtain a fixed income over the duration of the charter, subject of course to meeting certain performance criteria, while at the same time they do not have to worry about fuel costs, for these are covered by the charterers.

By contrast, should the ship's owners have a bullish view of the freight market they are most likely to operate the vessel on a spot basis, hoping to capture the short-term gains entailed in chartering out the vessel at successively higher single voyage rates.

Since ship owners have to cover the full cost of fuel in spot trading, which includes both the laden and ballast phase of the voyages, spot traders are exposed to the vagaries of the price of bunker fuel, hence their interest in fuel hedging instruments.

Hedging bunker fuel

Since no standardised, exchange-traded futures contract exists for fuel oil, it is not possible for a shipping company engaged in spot trading to offset completely the price risk associated with bunker fuel.

In the circumstances, it has essentially two choices: it can either use a widely traded oil futures contract — like, for example, NYMEX's West Texas Intermediate (WTI) crude oil contract — as a proxy to hedge away part, but never all, of bunker fuel's price risk, or it can exchange with a swaps provider (usually an investment bank or specialist derivatives trader) a pair of bespoke contracts, tailor-made to its specific needs.

According to one of the swapped contracts, the company agrees to purchase a specified amount of bunker fuel over a certain period from the swaps provider at a fixed price, while with the other contract the shipping firm agrees to sell back to the swaps provider the same amount of fuel at the market prices prevailing at specified intervals during the duration of the contract.

Since the swaps provider is now fully exposed to the price risk of bunker fuel he is highly likely to hedge this risk by buying crude oil futures on NYMEX. In this way, the desire of the shipping company to hedge its fuel risk results in the purchase of crude oil futures — either directly by the company, or indirectly by the swaps provider.

How can we judge whether a bunker fuel hedge is successful or not? Since tactical hedging entails entering and leaving the market at will, this type of hedging cannot be assessed on a consistent basis.

The efficacy of bunker fuel hedging can best be gauged by looking at a rolling hedge's profit and loss account over a long period. Our representative rolling hedge is based on a consumer of bunker fuel purchasing 3-month WTI oil futures and holding these futures contracts till expiry on a rolling monthly basis.

By comparing the average spot WTI price of a particular month with the price of the 3rd-month WTI futures contract three months earlier it is possible to obtain a measure of the success or otherwise of the hedge. Naturally, during periods when oil price is on a rising trend the rolling hedge would yield gains for the shipping company and vice versa during periods of declining oil prices

During the long oil price bull-run from March 2007 till early July 2008 the rolling hedge would have yielded handsome profits, but when oil price began to weaken thereafter, eventually crashing in the third quarter of 2008, the profits turned to losses, which eventually became onerous and would have led many ship owners to question the entire validity of hedging.

This is unfair, because hedging the price of bunker fuel is simply a device to fix in advance the shipping business' major variable cost. There are, nevertheless, a number of practical issues of particular relevance to the shipping industry that need to be touched upon and certain parameters need to be set before judgement can be passed on whether bunker fuel costs should be hedged routinely or not.

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