Energy Surge: How Do Companies Cope With Rising Oil Prices?

Businesses have a range of options to deal with rising oil prices, from doing nothing to getting into the oil business themselves.

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Companies have a seemingly endless assortment of gambits for coping with volatility in energy prices.

The simplest is to do nothing. American Airlines stopped hedging fuel prices after its merger with US Airways in 2013, in the belief that the economy provides a natural hedge since fuel prices usually fall when the economy weakens and ticket revenues rise when the economy is strong. For the same reason, United Airlines and Delta Air Lines stopped hedging in 2016.

Delta, however, has taken measures that fall at the opposite end of the spectrum. It purchased its own oil refinery in 2012 to protect against a surge in refining margins, known as the crack spread. The Trainer Refinery, about 15 miles southwest of Philadelphia, is owned by Delta subsidiary Monroe Energy. It reduced the airline’s fuel costs by $45 million in the second quarter of this year.

In between these extremes lies traditional hedging, which consists of locking in future fuel prices. But even this approach involves trade-offs.

“I like to use the analogy of a mortgage,” says Bryant Lee, a director on the commodity risk management team at Chatham Financial. “A floating-rate mortgage is always cheaper. You pay more for a fixed-rate mortgage to get price certainty.”

Corporate-risk managers use swaps, options and other instruments to guard against the unknown factors that could derail a company’s financials from quarter to quarter. “A number of our clients look at it as insurance,” Lee says. “They buy enough options to cushion the blow of a price rise long enough to adjust their business model.”

Not every business feels the impact of rising energy prices. Trex Company, a maker of decking and railing, makes its decking products out of recycled polyethylene from used grocery or shopping bags and from stretch, overwrap and agricultural film. “The recycled content is over 95% for our decking products,” says James Cline, the CEO. “It makes our products cheaper to manufacture compared to all competitors.” When oil prices are high, recycled pellets give Trex a pricing advantage over competitors using virgin polyethylene.

Hedging can certainly backfire. In the US, shale oil producers did not foresee oil’s latest rise, and hedged second-quarter production at around $55 per barrel. As oil prices rose above $70, they lost millions in income, and their share prices took a hit. Whiting Petroleum Corp, to cite just one example, said its crude oil hedges delivered a net negative of nearly $6.92 per barrel. Its stock fell 7.6% the next day. Some executives defended the hedging despite the losses, citing a business’s need for consistency and predictability with respect to capital.

Among the harder hit are those that use energy products as raw materials, including power generators, oil refiners and chemical manufacturers. Many rely on long-term contracts or insurance to provide a degree of certainty in their energy bills. Trucking, railroad and other ground-transport operators are raising prices to cover higher fuel costs.

Beyond fuel, petroleum is a ubiquitous raw material; it’s in plastics, ink, paint, candy, crayons, candles, tires, nylons and the coatings on paper cups, to name a few things. Plastic-packaging costs are rising. Food producers, distributors and retailers will pass along higher costs and freight charges to consumers.

A corporate hedging program should have clear objectives that encompass all stakeholders, Lee adds. “If you don’t have the wherewithal or cash reserves to get through an extreme market disruption, you should have a plan, such as hedging a certain percentage of your exposure. It depends how far out on the runway you want to hedge.”

When oil prices spiked to over $100 a barrel in 2008, Southwest had the bulk of its annual fuel consumption hedged at close to $50 a barrel, enabling the airline to remain profitable when other carriers were reporting big losses. As with any other form of insurance, “you have to consider the cost,” Derek Kerr, CFO of American Airlines, said in a recent podcast to employees. “It’s just been too costly to insure fuel for us.”

Boosting fuel efficiency is a long-term solution. Delta placed orders in December 2017 for more than 100 new aircraft to replace aging, fuel-guzzling planes. The planes will be delivered beginning in 2020. Deutsche Lufthansa and other major carriers have lowered their fuel consumption by increasing the efficiency of their fleets.

With jet fuel prices up 50% in the year to June, however, many airlines are raising fares or imposing fuel surcharges. Since it takes six months or longer for airlines to recoup higher fuel charges through fare increases, hedging can help to stabilizeearnings in the interim.