Is there value creation from hedging as a means to remove the risk of freight cost fluctuation?
Fuel hedging can protect companies whose fuel costs make up a large portion of their operational costs from unexpected price changes that could hurt their budgets and profit margins. By fixing your fuel costs, you can avoid budget overruns caused by a volatile oil market.
In this case study, we uncovered an opportunity to use fuel hedging as a source of value for our clients whose fuel costs make up a significant portion of their operational costs. We found this tool that hedge variance for them as it protects our clients’ budget and profit margins from unexpected price changes. With fuel derivatives offering market participants a variety of ways to hedge fuel price volatility, our team at Credo CFO has a strategic way of mitigating market volatility that reduces the risk of fuel budget that is spiraling out of control, improving cash flow, and stabilizing prices.
We use the best proxy for gas prices available: the United States Gasoline Fund with ticker symbol NYSEARCA: UGA. Issued by the United States Commodity Funds (USCF) Investments, UGA is the gasoline ETF product that moves higher and lower with NYMEX gasoline futures prices. This is a product that you can place money in that will generate a positive or negative variance for you based on fuel cost. Working in an inverse to gasoline costs, this investment returns approximately 60% on investment.
Historically, the only financial instruments tied to the price of gasoline were futures, which were largely inaccessible or impractical for the average investor. However, with the proliferation of commodity-based ETFs has come the US Gasoline Fund (UGA), which tracks the futures market for gasoline and provides a relatively simple way for retail investors to hedge gasoline exposure. This provides us with a relatively simple method for hedging gasoline exposure that retail investors can use.
UGA is one of the commodities exchange-traded funds (ETFs) with the best one-year trailing total returns. UGA is structured similarly to a commodity pool. It is intended to track changes in gasoline prices. By investing in futures contracts on reformulated gasoline blendstock for oxygen blending (RBOB) and other gasoline-related futures, the ETF allows investors to bet on a rise in gasoline prices. The fund may also make forward and swap contracts investments. It allows investors to implement a short-term tactical tilt toward a specific segment of the energy market, but it is unlikely to appeal to those looking to build a long-term, buy-and-hold portfolio.
Although some of our clients are small businesses who don’t do this habitually, it is not at all unusual for a CFO to use idle cash and financial products to generate desired effects on a company’s P&L – both for profitability and for risk management (e.g. earnings surprises). So, in that sense, this is not a “creative solution”, it is more of a fundamental solution that any trained CFO would naturally implement.
Using Credo’s strategy, we agree that absorbing freight cost in our financial model at a rate of ~ 0.6% of revenues is our ultimate goal.
There are two important premises that must be in place to make this work:
- You have enough capital to work with to generate the volume of dollars you need to completely offset your freight cost variances.
- Fuel costs of your vendors are being passed to you in the cost of freight they charge. You can rely on them to charge you more when fuel costs increase, and you can rely on them to charge you less when fuel costs decrease (or at least confront them on it and successfully negotiate them down.
Looking at UGA’s performance in the past 12 months, we can see that it has returned about 60%. We would merely take the inverse of this return to determine the amount of idle cash needed to be placed with this tool.
The next step is look at the figures of your company at a 12 month period and estimate the freight cost to see how much would be the negative variance if nothing is done.
Using Credo’s strategy, we are able to…
- Generate a positive variance in freight costs in order to offset your negative variance
- Add back a substantial amount of net income by adding a certain amount into the hedging tool depending on the pattern that you are currently operating under
- Maintain your net profit margins regardless of how freight costs fluctuate
How Credo Can Help
What we are accomplishing here is removing the risk of freight cost fluctuations due to unpredictable and uncontrollable fuel costs. This hedging tool works on a sliding scale on an inverse relationship with the freight costs.
Despite the unpredictability of fuel prices, you can remain confident due to the assurance that comes with using hedging as a risk management tool. And with ETF offering investors an equity exposure to gasoline prices, we have to take advantage of products like UGA as a useful hedge against inflation (not to mention how that can also help in diversifying investment portfolios beyond more traditional stocks and bonds). Because the fundamentals of the gasoline market do not support very high prices, and with political uncertainties increasing risk premiums, it is best to use a finance strategy like the one we advise at Credo to make sure you are profiting from outstanding opportunities in the energy sector. Our goal is to help you navigate any climate as we anticipate your company’s changing needs through an evaluation of your situation as new hedging opportunities arise.
- Understanding the Impact of Gross Margin on Profitability - February 21, 2024
- How Can Companies Grow Revenue with Credo? - February 19, 2024
- EBITDA: A CFO’s Perspective on Operational Performance and Financial Health - February 14, 2024