Vehicles

What Fuels You?

Howard A. Morin
Posted on July 1, 2008

During the last few months, we have learned about issues such as cash management and company benefits. Now we drill, no pun intended, into another topic that we deal with every day: fuel.

The cost of gas always seems as if it’s rising and recently hit a record high. Owners cannot afford to ignore this cost since it is a major expense in your transportation business as significant as insurance, rent, and vehicle payments. This issue causes operators of all sizes to question their ability to survive, especially with a looming nationwide economic slowdown.

So what really is the problem? Why don’t we just keep raising our prices or add escalating fuel surcharges? The rising cost of fuel is probably not something that can infinitely be passed on to clients. When times are good, people don’t seem to mind increasing costs. Now it’s hard to raise rates and surcharges, especially in a slowing economy. Variable and flat-fee surcharges are not only showing up on black car services and limousine rides, but also on airline tickets, shipping orders, and short-haul deliveries as well. And unlike surcharges based on an index which goes down when prices fall, flat fees tend to remain. Some clients don’t understand the connection between fuel charges and actual fuel costs and question it regularly.

Fuel management has major consequences. Many limousine business owners are asking whether they can afford to sustain these rising costs. Some people are looking at fleet management programs to leverage the economies of buying large quantities of fuel while others are looking at hybrid vehicles and fuel-cost hedging. The addition of hybrid vehicles to many fleets can serve more than one purpose. It allows a lower cost transportation option to the client who may be willing to surrender some legroom, comfort, and luxury. In addition, it presents a green, “eco-friendly” face on your business, and the wider industry overall.

What is Hedging?

For the purpose of this article, we will look at the business of fuel cost hedging. The term “hedging” is derived from the phrase “hedging your bets,” used in gambling games such as roulette. When you buy insurance for your vehicles, you are hedging. Doing so is one of the oldest means of hedging against risk. Insurance is bought to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life. Fuel cost hedging is the practice often used by airline companies to protect against the shock of anticipated rises in price.

In the financial world, a hedge is an investment taken out specifically to reduce or cancel out the risk in another investment. By definition, hedging is a strategy designed to minimize exposure to an unwanted business risk such as the skyrocketing cost of gasoline, while still allowing the business to profit from an investment activity.

Some form of risk taking is inherent to any business activity. Some risks are considered to be “natural” to specific businesses; the risk of fluctuating oil prices, for example, is natural to firms that drill for and refine oil. Other forms of risk are unwanted but cannot be avoided without hedging. Someone who has a luxury transportation business, for example, expects to face natural risks such as the risk of competition, poor service, and so on. The risk of the fleet being destroyed by fire or getting into accidents is unwanted, and can be hedged via insurance policies.

Why Do Transportation Firms Hedge?

Fuel costs have substantially risen over the past several years, pressuring businesses such as airlines, shippers, and ground transportation services to maintain positive cash flows. The airlines have been hedging their fuel costs since the 1980s. From day to day, we don’t know if gas is headed to $5 per gallon in Los Angeles or down to $3 per gallon in your city, so what are the implications of both?

Major weather events such as hurricanes and political instability in the Middle East could cause energy prices to rise dramatically without much warning. How would this affect your business in the upcoming month, quarter, or year? In the words of an ancient Chinese proverb:

         “Predicting is very difficult, especially as it concerns the future.”

What Are the Benefits of Hedging?

For starters, it allows businesses to generate more consistent and stable cash flows. Knowing when your Town Cars are busiest and how many teenagers fit in your Stretch H2 are easy and rather predictable. Fuel hedging also allows an operator to take advantage of investment opportunities in times of high gasoline prices. It is more likely that businesses will go bankrupt when fuel and other costs are high, and in such cases they are often forced to sell vehicles, office equipment, and other assets at below-market prices.

Some owners I talk to think they are too small, or a hedging strategy will not reap any reward or have an effect. One of the most frequent questions I get is, “What are the risks of not hedging?” By not hedging, limousine companies are taking on the risk of rising fuel prices into their business models. That may be fine if there are large cash reserves. Most operators are not in this position with the rising cost of insurance, regulation, and other daily operating expenses. When fuel prices rise dramatically, it is hard to pass all of the cost on to customers. At some point, raising prices, let’s say greater than 10%, will cause a 10% reduction in revenue.

There is a magic number in there that says at some point raising prices past this point will cause a significant drop in revenue. The success of such efforts over time is unpredictable. Are your clients willing to sustain yo-yo pricing from month-to-month or year-to-year based on changing costs? Luxury transportation providers — especially with large gas-guzzling fleets that want to manage risk, prevent huge swings in operating expenses, and enhance bottom line profitability — choose to insure themselves adequately and hedge fuel prices.

[SIDEBAR]

OTHER ALTERNATIVES ARE WORTH EXPLORING

Here are a few more fuel hedging strategies available to luxury transportation companies, ranging from simple to sophisticated:

COMMON STOCK

The common stocks of global oil companies are traded on major exchanges and can be bought and sold. This represents an equity ownership stake in the leading providers of oil and gas.

ETFs (EXCHANGE-TRADED FUNDS)

These are representative baskets of securities that trade like common stock. An index representing fuel prices or the cost of a barrel of oil can be bought or sold as easily as common stock.

EQUITY AND INDEX OPTIONS

A call option is the right to buy a particular asset at a predetermined fixed price (the strike) at a time up until the maturity date. These contracts in certain combinations can be used to protect or leverage virtually any outcome. There are options available on a multitude of underlying instruments such as gas company common stock, fuel and gas indexes, and ETFs.

FUTURES CONTRACTS

A futures contract is an agreement to buy or sell a specified quantity and quality of a commodity, such as gas or oil, for a certain price at a designated time in the future. The buyer has a long position, which means he or she agrees to make delivery of the commodity (i.e., purchase the commodity). The seller has a short position, which means he or she agrees to make delivery of the commodity (i.e., sell the commodity). Futures contracts are traded on an exchange, which specifies standard terms for the contracts (e.g., quantity, quality, delivery, etc.) and guarantees their performance (removing counterparty risk).

[END SIDEBAR]

GET MORE INFORMATION

Financial instruments such as stocks, options, and futures involve significant risks. You can find additional information on the investment vehicles described in this article by visiting the following websites:

 

• www.nyse.com The New York Stock Exchange

• www.cboe.com The Chicago Board Options Exchange

• www.nasdaq.com The NASDAQ Stock Market

• www.nymex.com The New York Mercantile Exchange

 

For more information about whether any of the strategies described to you in this article may be an appropriate solution for your business, contact your financial advisor or banker, and your legal and tax advisors. Meanwhile, stay safe and on time.

 

– HOWARD MORIN is a financial advisor with a leading global financial services firm and a consultant to the limousine Industry. To email Howard: [email protected].

Related Topics: fuel management, fuel prices

Comments ( 0 )
More Stories