Energy Hedging — Back to the Basics Part II — Swaps

This post is the second of several in a series covering the basics of energy hedging. You can access the first post, which covered energy futures, via this link. In subsequent posts we will also be exploring the basics of energy commodity options as well as more complex hedging structures such as basis swaps, collars and option spreads.

A swap is an agreement whereby a floating (or market) price is exchanged for a fixed price, over a specified period(s) of time. In addition to energy commodities, swaps can also be used to exchange a fixed price for a floating (or market) price. Swaps are called such as the buyers and sellers of swaps are “swapping” cash flows.

Energy consumers utilize swaps in order to fix or lock in their energy costs, while energy producers utilize swaps in order to lock in or fix their revenues and/or cash flow. Similarly, swaps are also utilized by companies seeking to hedge their exposure to foreign exchange, interest rate and agricultural commodity risks as well.

As an example of how one can utilize an energy swap, let’s assume that you’re a large fuel consuming company in New Orleans, who wants to fix or lock in the price of your anticipated ultra low sulfur diesel fuel cost for a specific month. For sake of simplicity, let’s assume that you are looking to hedge 100% of your anticipated, May 2011 fuel consumption, which equates to 100,000 gallons. In order to do accomplish this you could purchase a May 2011 Platts’ Gulf Coast ultra low sulfur diesel (ULSD) fuel swap from your bank’s commodity trading desk. If you had purchased this swap yesterday at the prevailing market price, the price would have been (approximately) $3.1012/gallon.

Now we will examine how the swap would perform if fuel prices both increase and decrease between now and the end of May.

In the first scenario, let’s assume that fuel prices increase and that the average price for Gulf Coast ULSD, (as published in Platts’ US Marketscan ) for each business day in May, was $3.50/gallon. In this scenario, your hedge would result in a gain of $0.3988/gallon ($3.50 – $3.1012 = $0.3988) or $39,880. As a result, you would receive a payment of $39,880 from your bank, which would offset the increase in your actual fuel expenses by $0.3988/gallon.

In the second scenario, let’s assume that fuel prices decrease and that the average price for Gulf Coast (pipeline) ULSD, (as published in Platts’ US Marketscan) for each business day in May, was $2.50/gallon. In this scenario, your hedge would result in a “loss” of $0.6012/gallon ($2.50 – $3.1012 = $0.6012) or $60,120. As a result, you would have to make a payment of $60,120 to your bank, which would offset the decrease in your actual fuel expenses by $0.6012/gallon.

As this example shows, purchasing a diesel fuel swap allows large fuel consuming companies to hedge their exposure to volatile fuel prices. If the price of fuel increases, the gain on the swap offsets the increase in actual fuel cost “at the pump”. On the other hand, if the price of fuel decreases, the loss on the swap offsets the decrease in the actual fuel cost “at the pump”. While this example examined how swaps can be used to hedge diesel fuel price risk, the same methodology can also be used to hedge exposure to various energy commodities such as electricity, gasoline, jet fuel, natural gas, propane, etc.

In addition, as previously mentioned, energy producers can also utilize swaps to hedge their revenues and/or cash flows. For example, if you are a crude oil producer looking to hedge your oil production revenues, you could do so by selling crude oil swaps.

While we’ve attempted to walk you through basic examples of how swaps can be used to hedge energy price risk, the devil is clearly in the details. If you would like to learn more about hedging your exposure to volatile energy prices with swaps as well as futures, options, etc. please feel free to contact us .

UPDATE: This article is one in a series of five on the basics of energy hedging. The subsequent three articles can be found via the following links:

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