World Bunkering >Articles > Risk management > Risk management is more important now than ever

Jonathan Leak

In the past year or so, global commerce has been rocked to its very foundation by a tectonic shift, a rolling earthquake of events that has created the worst financial crisis in recent history and plunged the world’s economies into deep recession. The collapse of the US housing bubble led to toxic assets, which nearly caused a systemic failure of the banking system, requiring government and central bank intervention. We now find ourselves “here” – trying to reassess, refit and reorder our businesses in the post-crisis environment. In this situation, risk management is more important now than ever.

For owners and operators in the marine shipping industry, this means restructuring their business model for a dramatic drop in demand for waterborne cargo and bulk commodities. One silver lining in the financial storm, however, has been a steep decline in the price of oil generally, and bunker fuel in particular. Because bunker fuel is a major expense component for the shipping industry, in fact the largest operating expense for many shipping sectors, the decline in fuel prices has helped to offset at least a portion of falling revenue. The key question is can we expect this “natural revenue hedge” to persist? Or should shipping executives be seeking to protect themselves from a worst case scenario in which the fuel expense line rises counter-directionally or faster than the revenue line?

Oil price drivers

In order to fully grasp the history and outlook for petroleum prices, it is important to acknowledge that long before crude oil prices hit the all-time record high last summer, “oil” had developed into an investment asset class. As such, crude oil and the slate of refined products trade, not merely on the supply and demand fundamentals of that particular market, but also on the trading whims of a large swathe of “non-commercial” investors, including hedge funds, mutual funds, speculators as well as legitimate hedgers. For several years, a pattern of robust economic growth (primarily in developing Asia) constrained supply capacity (especially refinery capacity) and the weak US dollar contributed to a tight physical oil market and a market bias that encouraged investment in the “long” side of the paper oil market. Consequently, in mid-July 2008, NYMEX crude oil breached $147 per barrel and MOPS 380 cSt fuel oil touched $760 per metric tonne.

Then, oil prices stalled as demand expectations fell, as a result of the worsening financial crisis and imminent recession. Perpetuated by a broad liquidation of long positions by organisations in the oil markets in order to meet collateral calls and to try to avoid financial ruin (unsuccessfully in many cases), spot fuel oil prices plummeted along with crude oil and other refined products. By New Year’s Eve 2008, MOPS 380 cSt had fallen an amazing 74% to $198 per metric tonne and NYMEX crude oil was trading at $45 per barrel – more than $100 lower than the peak just six months before.

Recovery

Since the beginning of this year, however, petroleum prices have been on an upward trajectory again. This has confounded many bearish prognosticators in the industry press who predicted much lower prices on the basis that a deep global economic recession would reduce the demand for oil and send prices to levels not seen since the Asian financial crisis of the late 1990s. This has not happened. Instead, fuel oil prices have more than doubled since the New Year’s Eve low while crude oil prices have risen by 56% as of the time of writing. Production cuts by OPEC and reduced refinery utilisation have largely offset the lower consumption rates while a persistently weak US dollar and stronger equity prices have encouraged investment flows back into commodities.

The outlook for oil prices is of course very unclear and subject to a multitude of variables – none of which can be predicted with any reliability. The bearish forecasters continue to bemoan that prices are disconnected from supply/demand fundamentals and prices should be much lower. This was a common complaint throughout most of the past several years while petroleum prices rose to all-time record high levels. On the other hand, the bullish forecasters cite OPEC output discipline, deteriorating oil industry infrastructure suffering from lack of investment and the inevitable recovery of world economies. In fact, several banks have raised their 2010 forecast for WTI crude oil to be as much as $100 per barrel – a 40% increase from current levels. In any event, the key point is that bunker prices can be expected to remain volatile, unpredictable (counter-intuitive at times) and with an apparent bias to the upside.

Accordingly, shipping executives should be seeking to protect themselves from a worst case scenario in which their bunker fuel expenses rise counter-directionally or faster than the recovery in shipping rates. To achieve this broad objective, a variety of bunker price risk management (ie “hedging”) strategies are available to fuel oil consumers.

As with any financial strategy, however, it is critically important that hedgers understand the implications of their programmes under a full range of market conditions and to adhere to a common set of industry best practices that are designed to ensure that risk management programmes are effective and well-governed. These general best practices guidelines include:

Perform Purchase Stream Analysis

Before an organisation can begin to develop its hedging programme, it must clearly understand how it actually procures its fuel supply, including delivery points, methods of price discovery, historical volume patterns and any forward-looking operational plans. The hedging organisation should be able to model the effects of changing fuel prices on the organisation’s overall financial performance.

Develop Clear & Achievable Hedge Objectives

Prudent price risk management is a risk mitigation tool and not a means to speculate on the future price behaviour. Hedgers should set forth clear objectives such as: i) disaster insurance, ii) budget protection, or iii) price volatility management. Fuel hedge programmes should never be considered to be a profit centre. As such, the performance measure of the programme should never be the “gains” or “losses” on a transaction but rather whether the stated hedge objectives were achieved.

Develop Objective-Driven Strategies

It is no overstatement to say that there are a vast number of different hedging strategies available to organisations, ranging from the simple fixed price supply contract to complex and exotic derivative structures. For most fuel consuming organisations, the financial exposure to be hedged is fairly straightforward – they are “short” fuel and therefore adversely impacted as prices rise. Likewise, the hedge strategy need not be overly complex. A good guideline is that if a hedge strategy can’t be easily explained in common terms to senior management in a minute or less, then it is probably not an effective strategy.

In some cases, a shipping firm may have the ability to pass along fuel price increases to its customer through a bunker escalation clause in its contract of affreightment. Theoretically, this is a fuel hedge of sorts; however, there are often practical reasons that reduce the effectiveness of this provision. The time lag and nuances of how the calculations work mean that the coverage afforded under the clause is an imperfect fit with the price exposure. Further, in a market characterised by excess shipping capacity, operators may be reluctant to try to impose bunker escalation clauses for competitive reasons.

For many buyers of bunker fuel, price assurance is the primary goal. When possible, they can buy fixed price bunkers from their supplier and therefore create a perfectly effective hedge. Alternately, they may consider “over the counter” derivative strategies such as fixed price swaps, caps or collar instruments – each with different payout profiles and characteristics. Hedgers should set their goals first and then ensure that the resulting strategy will achieve those objectives.

As a side note, it should be acknowledged that the business term “derivative” has got two black eyes in the post-crash environment. Billionaire investor Warren Buffett once described financial derivatives as “financial weapons of mass destruction” and a specific type of financial derivative, credit default swaps, is attributed to the downfall of insurance giant AIG.

In fact, most practitioners recognise that derivatives are neither intrinsically good nor evil, moral nor immoral, but rather tools to be employed. Much like a kitchen knife, a baseball bat or automobile, the tool can be used for its good and intended purpose or can be misused with catastrophic consequences. At the core of the matter, financial derivatives are legal contracts that exchange risk from one party that wants to shed a specific risk to another party that wants the risk.

Despite the bad press, the use of derivatives to manage various types of risks continues to be robust. According to the Bank for International Settlements, as of December 2008, total outstanding notional value of OTC derivatives was $592 billion – down only 13% from pre-crisis levels but roughly equal to December 2007 levels. Seventy-one percent of these outstanding positions were interest rate swaps while only 7% were credit default swaps. When used prudently and with reputable, credit-worthy counterparties, derivatives should continue to play an active role in risk management decision-making.

Execute Programmatically

Many successful hedging programmes employ a scale-in approach in which a series of smaller transactions are taken over time instead of large, infrequent transactions. This method reduces the chance that “too much” fuel is hedged at “too high” a price and provides a dollar cost averaging approach to building a consolidated hedge position.

Establish Sound Governance & Corporate Controls

Lastly, but certainly not least important, any fuel hedge programme should be designed to ensure that it will operate in a disciplined, non-speculative way. The programme should be subject to direct oversight by the organisation’s senior management, have appropriate separation of duties and be conducive to routine audit to ensure compliance with all rules, parameters and guidelines. The status and current mark to market value of all hedge positions should be updated frequently and reported to senior management. All policies and procedures should be codified in a manual that will serve as the philosophical centrepiece of the programme as well as the operational parameters, limits and guidelines of permissible activity.

In conclusion, players in the global shipping industry are grappling with ways to retool their business in a weak demand, weak revenue environment. For a while, the lower revenue was partially offset by lower bunker prices; however, fuel prices are headed back up and are expected to be volatile, and could be poised to move even higher. Accordingly, bunker price risk management is more important than ever in order to protect against rising bunker prices while we eagerly await a sustained recovery in shipping demand.

“If a hedge strategy can’t be explained in a minute or less, it is probably not effective”