Begin Hedging Timeframe: not applicable

Once the requisite legal authorization, hedging policy, and brokerage or OTC counterparty agreements are in place, the transit agency can begin hedging following the strategy and process outlined in the hedging policy. Several other items that are needed prior to hedging are: a system of tracking profits and losses on hedge positions on a daily basis; a system for ensuring that the targets outlined in the hedging strategy are being met; a system for tracking the performance of the hedging strategy against the program’s goals and benchmarks (i.e., staying within the fuel budget for the year); a system for reporting hedging results to management and the board of directors on a periodic basis; and a system for reporting hedging activity and profits and losses in annual reports and financial statements. Samples of some of these reports and systems are included in the Appendix A: Case Studies.

59 A

Adverse Basis Risk In the context of a hedging strategy, this risk occurs when losses from an organization’s physical fuel/energy contract are not offset by profits from the organization’s hedging instruments. This problem can arise when the fuel contract is based on a price index that does not corre­ late perfectly with the price index referenced by the hedging product. Types of basis risk include locational basis risk, product/quality basis risk, and calendar (spread) basis risk.

At the Money A term used to describe an option that would be neither profitable nor unprofitable to exercise. Both call and put options are at the money when the strike price is exactly equal to the current spot price. C

Calendar (Spread) Basis Risk

A type of adverse basis risk caused by imperfect correlations that occur due to differences in the settlement dates of the organization’s physi­ cal fuel contract and settlement dates of the organization’s hedging instrument.

Call for Tenders Also known as a call for bids, a call for tenders is a competition strategy in which an organization invites qualified fuel/energy suppliers to bid for the organization’s fuel/energy supply contract.

Call Option An options contract that gives the buyer the right but not obligation to buy a commodity at a predetermined strike price. Typically the buyer must pay the seller of the call option an upfront premium. The seller of the call option must sell the commodity to the buyer at the pre­ determined strike price if the buyer chooses to exercise the option. Call options are typically settled financially.

Cap An options strategy that places a cap or ceiling on upward price move­ ments. A cap is created by purchasing an out­of­the­money call option. Cap-Price Instrument A physical contract, financial contract, or other instrument that

places a cap or ceiling on upward movements in the price of energy or fuel while allowing the buyer to fully or partially participate in downward price movements. Cap­price instruments often require the instrument’s buyer to pay an upfront premium to the instru­ ment’s seller.

Collar An options strategy that places a cap on upward price movements and a floor on downward price movements. Collars are created by pur­ chasing out­of­the­money call options and selling out­of­the­money put options. A premium is paid to purchase the call option and a pre­ mium is received from selling the put option.

Commodity Price Risk

A subset of energy price risk, commodity price risk refers to unexpected and unfavorable changes to energy prices caused by global or regional factors that are beyond the control of most market participants, such as crude oil prices and refinery outages.

Commodity Price Risk Management

Also called hedging, commodity price risk management refers to the use of physical contracts, financial contracts, or other instruments to reduce or eliminate commodity price risk.

Competition Strategies

Fuel or energy contracting strategies designed to increase competition for an organization’s fuel or energy supply contract.

Cooperative Buying Also known as pooling or demand aggregation, cooperative buying is market power strategy in which an organization increases its bargain­ ing position to obtain volume­discount pricing.

Counterparty Risk The risk that a counterparty in a hedging agreement will default on its obligations under the agreement

D

Delivery Price Risk A subset of energy price risk, delivery price risk refers to the unexpected and unfavorable changes to energy prices caused by local factors, such as the pricing practices of a local fuel distributor. These factors can often be influenced by individual market participants.

Delivery Price Risk Management

The use of procurement or contracting practices to reduce delivery price risk.

Derivative Any financial product that derives its value from value of an underlying asset or commodity. Futures, swaps, and options are derivatives. E

Energy Price Risk Unexpected and unfavorable changes in energy prices. Energy price risk can be divided into commodity price and delivery price, and tax risk segments.

Energy Price Risk Management (EPRM)

Sometimes called fuel price risk management, EPRM is the use of physical contracts, financial contracts, or other instruments to reduce or eliminate energy price risk. The goal of EPRM is to provide an organization with budget certainty. EPRM strategies can be catego­ rized into two groups: 1) strategies designed to manage commodity price risk, and 2) strategies designed to manage delivery price risk. Exchange An institution, organization, or association that hosts where stocks,

bonds, options, futures, and commodities are traded during specific hours on business days. Exchanges impose rules and regulations on the exchange participants and mitigates all counterparty/credit risk between buyers and sellers.

F

Firm, Fixed-Price Supply Contracts

A physical fuel or energy supply contract in which prices for future delivery are set in advance, usually for a fixed volume of fuel.

Fixed-Duration The process of hedging forward fuel or energy consumption within a fixed budget period (i.e., budget year).

Forward Contract A forward­price instrument that fixes the price of fuel or energy in the future. A forward contract can involve physical delivery of fuel or energy, but more often it is a paper contract that involves a financial, rather than physical, exchange at maturity.

Forward-Price Instrument

A physical contract, financial contract, or other instrument that con­ tractually or synthetically fixes the price of energy or fuel that will be consumed in the future.

Futures Contract A forward contract on an exchange. Several standardized futures contracts for energy products are traded on NYMEX.

H

Hedge Timing Hedge timing refers to how an organization times or schedules the entering and exiting of hedge positions (typically through the purchase and sale of hedging instruments).

Hedging See Commodity Price Risk Management.

Hedging Duration The length of time into the future over which an organization is hedged. Hedging Instrument The physical contract, financial contract, or other instrument that is

used to hedge energy prices.

Hedging Level The percentage of the organization’s fuel or energy that is hedged. Hedging Policy A document that outlines an organization’s strategy for managing

fuel price risk in broad terms. The document identifies the hedging instruments that the strategy will employ, the maximum hedge level, the maximum hedge duration, and the strategy for timing purchases. Often, the hedging policy will also outline the process for authoriza­ tion and approval of all hedging transactions and for monitoring the performance of the hedging program.

Hybrid Timing Strategy

A timing strategy that utilizes components of both managed and rule­ based timing strategies.

I

In-the-Money A term used to describe an option that would be profitable to exercise. A call option is in­the­money when the strike price is lower than the spot price of the underlying commodity. A put option is in­the­money when the strike price is higher than the underlying commodity’s spot price. L

Locational Basis Risk A type of adverse basis risk caused by imperfect correlations that occur due to differences in the delivery point of an organization’s physical fuel contract and the delivery point of the price index referenced by the organization’s hedging instrument.

Long Position If an organization is long an asset, it gains money when asset prices increase and loses money when asset prices decrease.

Long-Term, Fixed-Margin Contracting

Entering into a physical fuel supply contract over a long­term period (>1 year) with a fixed delivery margin. Pricing typically follows a rack plus margin method.

M

Managed Timing Strategy

Sometimes known as a dynamic, situational hedging, managed tim­ ing is a timing strategy that seeks to reduce the average fuel price under a hedging program by adjusting elements of the hedging strat­ egy (i.e., instrument, level, duration) in response to changes in the market environment or outlook.

Margin Account Also known as a performance bond, this account acts as collateral for outstanding futures contracts on NYMEX. Buyers and sellers of futures must fund and maintain margin accounts until their positions have matured. The value of these positions are marked­to­market every day and sometimes more than once in the same day. This means that as the price of a futures contract changes, money is either credited or debited to the margin accounts of buyers and sellers.

Margin Call On NYMEX, if the margin posted in the margin account falls below the minimum margin requirement, NYMEX issues a margin call which requires the owner of the account to either replenish the margin account with additional funds or close out his position.

Market Power Strategies

Fuel purchasing strategies designed to lower fuel prices by increasing an organization’s market power during negotiations.

Mark-to-Market In the context of forward contracts, mark­to­market accounting refers to accounting for the fair value of the forward contract based on the current price of forward contract.

N

New York Mercantile Exchange (NYMEX)

The world’s largest physical commodity futures exchange. Several standardized futures and options contracts for energy products are traded on NYMEX.

No Cost Collar A collar that has no upfront cost because the premium paid for the purchased call option is offset by the premium received from the sold put option.

O

Options Contracts Often compared to insurance, options contracts give the buyer the right but not obligation to purchase or sell fuel at a specific price (the strike price) over a specified period of time. Options contracts often involve an upfront premium payment from the buyer to the seller at initiation. As with other financial instruments, contracts are typically settled financially at maturity based on the difference between the strike price and the current spot price. Physical exchange of fuel rarely takes place. There are two types of options contracts: calls and puts.

Options Premium A payment, typically made upfront, that compensates the seller of an options contract for providing cap­price or floor price protection. OTC Swaps Several consecutive forward contracts that are traded over the counter. Out-of-the-Money A term used to describe an option that would be unprofitable to exer­ cise. A call option is out­of­the­money when the strike price is higher than the spot price of the underlying commodity. A put option is out­ of­the­money when the strike price is lower than the underlying com­ modity’s spot price.

Over-the-Counter (OTC)

Trading of financial instruments directly between two parties rather than through an exchange. OTC transactions allow customized instruments to be traded, thus reducing or eliminating basis risk. Unlike exchange­ traded transactions, OTC transactions have counterparty or credit risk. P

Participating Cap An options strategy that places a cap on upward price movements and allows unlimited but partial participation in downward price move­ ments. Participating caps are created by purchasing an out­of­the­money call option and selling an at­the­money put option. The quantity of the underlying commodity covered by the sold put option is less than the quantity covered by the purchased call option. If the premiums received on the sold put options fully offset the premiums paid on the purchased call options, the strategy is called a No Cost Participating Cap.

Performance Bond See Margin Account.

Price Corridor An options strategy that caps upward price movements but only up to a certain point. A price corridor is created by purchasing an out­of­ the­money call option and selling an even further out­of­the­money call option. The premium received from the sold call option offsets some but not all the premium paid on the purchased call option. Thus this strategy reduces but does not eliminate upfront costs.

Product/Quality Basis Risk

A type of adverse basis risk caused by imperfect correlations that occur due to differences between the type of fuel purchased under the orga­ nization’s physical fuel contract and the type of fuel of the price index referenced by the organization’s hedging instrument.

Put Option An options contract that gives the buyer the right but not obligation to sell a commodity at a predetermined strike price. Typically the buyer must pay the seller of the put option an upfront premium. The seller of the put option must buy the commodity from the buyer at the pre determined strike price if the buyer chooses to exercise the option. Put options are typically settled financially.

R

Rack Plus Margin (or Rack Minus Margin)

A pricing methodology where the price that the buyer pays for fuel or energy is equal to the price of fuel at a fixed delivery point or market hub plus or minus a fixed differential. The rack price is obtained by an independent third­party price reporting service, such as OPIS or Platts, and floats (i.e., is not fixed).

Reference Price The specific price index referenced by a hedging instrument for calcu­ lating payouts. Price indices typically track a particular fuel or energy product in a particular geographic location (i.e., heating oil in New York Harbor).

Reverse Auction A competition strategy in which an organization holds an auction where the roles of buyers and sellers are reversed. Multiple sellers (fuel/ energy suppliers) compete to supply a good or service to a single buyer by bidding successively lower prices. The seller that bids the lowest price during the auction period is awarded the supply contract.

Rolling-Duration The process of hedging forward fuel or energy consumption on a rolling basis (i.e., always 12 months forward).

Rule-Based Timing Strategy

Sometimes known as a schedule­based hedging, rule­based timing is a timing strategy that seeks to mitigate the risk of hedging at too high a price by entering hedge positions at preset intervals, levels, and durations. S

Short Position If an organization is short an asset, it loses money when asset prices increase and gains money when asset prices decrease.

Spot Price The current price of a particular fuel or energy product in a particular market.

Strike Price Determined at initiation, the strike price is the fixed price at which the owner of an options contract can purchase or sell the underlying commodity regardless of the spot price at the time of purchase or sale. T

Tax Risk In an energy price context, tax risk refers to the unexpected and unfavorable changes to energy prices caused by increases in federal, state, or local taxes on energy products.

Time to Reconcile The time intervals between when hedging contracts are settled (i.e., daily, weekly, monthly).

W

Web-Based Price Protection Program

An online fuel hedging service, such as Pricelock, Fuel Bank, and MoreGallons, that provides cap­price protection.

65

$/g dollars per gallon

ASP active server pages

c/g cents per gallon

DEPO Demand Pooling Global Services

EIA Energy Information Administration

EPRM energy price risk management

FFP firmed, fixed-price

GASB General Accounting Standards Board

NYMEX New York Mercantile Exchange

NYH New York Harbor

OPIS Oil Price Information Service

OMB Office of Management and Budget

OTC over-the-counter

RBOB reformulated blendstock for oxygenate blending

RFP request for proposal

SAIC Science Applications International Corporation st. dev. standard deviation

ULSD ultra low sulfur diesel

66

In document TCRP REPORT 156. Guidebook for Evaluating Fuel Purchasing Strategies for Public Transit Agencies TRANSIT COOPERATIVE RESEARCH PROGRAM (Page 68-76)