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    What does it all mean and why do I care?

    Some firms have traditionally hedged with "NYMEX" by which they mean futures that trade on the New York Mercantile Exchange, generally either RBOB (Reformulated Blendstock for Oxygenate Blending) or HO (Heating Oil). These firms often do not realize that a better alternative is available.
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    As well as deciding which hedge strategy to employ, a firm also has to decide which reference price to use. The first thing to consider in selecting the reference price is the correlation between it and what you pay for fuel. A high correlation between the price you pay at the pump and your chosen reference price is important because it means that the hedge will perform as expected.
    • If the price you pay at the pump goes up by 50 cents, your hedge should go up by 50 cents. If it goes up by more or less than that, you may find yourself over or under hedged.
    • If a firm wishes to use the special hedge accounting treatment, as defined in ASC 815 (formerly FAS 133), a high correlation is essential not just highly desirable.
    • If a hedge does not include all of the factors that impact retail prices then changes in those factors will not be reflected in the reference price. For example, if fuel taxes are not included in the reference price, any changes in fuel taxes will cause the correlation to decline.
    Firms looking to hedge may choose from among the following reference prices:
    DOE Diesel
    • The national average retail price for diesel, as calculated by the Department of Energy based on a survey of gas stations around the country.
    • The futures contract based on the wholesale price of diesel, specifically No. 2 Heating Oil, delivered in New York Harbor.
    DOE Regular Gasoline
    • The national average retail price of regular unleaded gasoline, as calculated by the Department of Energy based on a survey of gas stations around the country.
    New York Harbor RBOB
    • The futures contract based on Reformulated Gasoline Blendstock for Oxygenate Blending, a wholesale grade of gasoline.
    Heating Oil and RBOB capture the most volatile components of fuel prices, namely the cost of crude oil and its refining. The two DOE national averages capture in addition federal, state, and local taxes; distribution and marketing costs; and gas station profit margins.
    For firms that purchase their fuel at retail pumps, the definitions would lead one to expect that the DOE national averages will always offer better correlation than Heating Oil (for diesel) or RBOB (for gasoline).
    A Case Study - How one firm protected its business
    In 2008, a large fleet based primarily in the Midwest and Southeast consumed approximately 3 million gallons of diesel. The chart below shows the average price the firm paid for diesel during the year compared to both HO and DOE diesel.
    Both DOE Diesel and Heating Oil were closely correlated with the firm's price. A simple regression showed that Heating Oil price changes explained 93% of the price changes faced by the client while DOE Diesel explained 97%. The difference seems negligible but it masks an important phenomenon. When wholesale prices rise, retail prices rise along with them. But when wholesale prices fall, retail prices do not fall as rapidly. A firm that pays retail prices but hedges with wholesale prices, such as HO, will be left uncovered.1

    Suppose the firm had hedged its 2008 consumption at the end of 2007 assuming that the spread between its average pump price and the hedge price stayed the same as it was in December 2007. The effectiveness of each hedge can be measured by looking at whether the hedge reference price for each month moved by the same amount as the pump price.
    December 07 to July 08
    The heating oil future hedge performed adequately when prices were going up. The pump price rose by $1.35 between December 2007 and its peak in July 2008. HO rose by only $1.20 so it didn't cover 15c (approx. 11%) of the increase. The firm consumes 250,000 gallons per month so, in July alone, the hedge would not have covered 250,000 * $0.15 = $37,500 of the increase.
    July to December
    The hedge performed terribly when prices fell. While the firm was still paying $3.78 in October (38c more than in December), Heating Oil was valued at $2.24 (23c less than in December). Compared to a hedge that was perfectly correlated, the firm would have lost 250,000 * $0.61 = $152,500 in October alone. Pump prices did catch up a little towards the end of the year. Whereas Heating Oil fell by a further $0.82 by December, pump prices fell by $1.55.
    The hedge was out by an average of $0.17 per gallon or $510,000 over the year.
    DOE Diesel
    December 07 to July 08
    A hedge based on the national average retail price performed very well throughout the year. Between December and July, the firm's price rose by $1.35 and the DOE average rose by $1.36. A hedge would actually have gone up by $0.01 per gallon or $2500 more than it should have.
    July to December
    When prices fell dramatically in October 2008, the firm's average pump price tracked the national average but with some noise because its purchases are confined to one part of the country. In October and November, the firm paid 21 cents and 10 cents respectively more than the national average. But in September and December, it paid 16 and 23 cents respectively less than the national average.
    Overall, the gains and losses balanced out and the net ineffectiveness was only $0.02 per gallon or $50,000.
    Over time, both DOE gasoline and diesel explain pump price changes better than HO and RBOB do.
    The DOE diesel or gasoline is a better hedge both in theory and in actual practice.
    • DOE diesel and gasoline are better correlated to pump prices then HO or RBOB.
    • In our experience, firms that use DOE Diesel or Gasoline as their reference price can usually qualify for hedge accounting whereas firms that use RBOB and Heating Oil typically cannot.
    • One further benefit of using the DOE reference prices is that standard hedge contracts for DOE gasoline and diesel include protection against increases in state fuel taxes. Standard hedge contracts based on RBOB and HO do not.
    1See http://www.slate.com/id/2196273/ for more on the stickiness of retail prices on the way down.

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