By Ryan Azbell, MS, Director – Commodities Risk Management, Huntington Capital Markets

Financial tools such as fixed-price swaps and costless collars can provide greater predictability when diesel prices become difficult to budget

For businesses that rely heavily on diesel fuel, swings in pump prices can quickly affect operating costs and profit margins. Mulch and soil producers, distributors, landscapers, trucking operations, and other businesses with substantial fuel consumption may have limited ability to pass those increases along to customers, particularly when prices are locked into contracts or budgets months in advance.

One strategy for managing that exposure is diesel fuel hedging. Rather than attempting to predict where diesel prices will go, a hedge can be structured to provide greater certainty around future fuel costs.

According to Huntington Capital Markets’ Commodities Risk Management group, commodity hedging strategies can be used to help companies lock in margins versus a budget, establish fixed-price programs for customers, develop sales strategies around known costs, and secure longer-term pricing. The bank offers several over-the-counter commodity products, including fixed-price swaps, caps and floors, and consumer and producer collars. Diesel is among the refined products covered by its commodities program.

How a diesel hedge works

Diesel hedging generally involves using a financial contract tied to a recognized market index while the company continues purchasing its physical fuel from its normal supplier.

For example, a company may purchase diesel at the prevailing price from its fuel supplier throughout the year. At the same time, it enters into a financial hedge based on the NYMEX Heating Oil, or HO, contract, which is used as the reference index for ultra-low-sulfur diesel.

The financial settlement offsets some or all of the change in the market price. The company therefore continues buying the physical fuel it needs while using the hedge to provide greater predictability in its overall fuel cost.

This distinction is important: the hedge does not replace the company's physical diesel purchases. Instead, the financial transaction is designed to offset changes in the underlying market.

Hedging can be particularly useful for businesses that know approximately how much fuel they will consume during a future period. A company with predictable monthly diesel requirements can establish a hedge for a specified number of gallons and a specified period.

Fixed-price swaps

One of the most straightforward structures is a fixed-price swap.

For example, a construction company wants to hedge 25,000 gallons of diesel per month from August through December 2026. The company enters into an average-rate fixed swap at $4.25 per gallon based on the NYMEX HO diesel index.

Under the arrangement, the customer agrees to pay Huntington the fixed $4.25 rate for the hedged volume. Huntington, in turn, pays the customer the market price based on the average daily NYMEX HO price for the applicable month.

The company still purchases its physical diesel from its normal supplier at the market price. The financial settlement between the company and Huntington is what creates the effective fixed-price result.

The mechanics become clearer when looking at the monthly settlements. In Huntington's example, the fixed price is $4.25 per gallon. If the average monthly market price rises above $4.25, Huntington pays the customer the difference. If the market price falls below $4.25, the customer pays Huntington the difference.

For example, if the monthly average is $4.40, the $0.15-per-gallon difference produces a $3,750 payment to the customer on 25,000 gallons. If the average is $4.20, the customer owes $0.05 per gallon, or $1,250.

The result is that the financial settlement moves in the opposite direction of the physical fuel price, helping bring the company's effective cost back toward the fixed hedge price.

For a business trying to establish a reliable operating budget, that predictability can be more important than attempting to capture every possible decline in diesel prices.

Costless collars provide a price range

A second strategy is a costless collar. Rather than establishing one fixed price, a collar establishes both a ceiling and a floor.

For example, a distribution company wants to hedge 100,000 gallons per month from January through June. It establishes a collar with a $2.60-per-gallon ceiling and a $2.25-per-gallon floor, based on the NYMEX Heating Oil index.

The structure provides protection if diesel prices rise above the $2.60 ceiling while allowing the company to participate in lower prices within the established range. The collar requires no upfront option premium in the example.

If the average monthly diesel price remains between $2.25 and $2.60, there is no settlement with the bank.

If the average price rises above $2.60, Huntington pays the company the difference above the ceiling. If the average price falls below $2.25, the company pays Huntington the difference below the floor while simultaneously benefiting from purchasing physical diesel at the lower market price.

The result is a defined range of potential effective fuel costs rather than a single fixed price.

In this settlement example, the January average price is $2.20, below the $2.25 floor, resulting in a $0.05-per-gallon payment by the company. In April, the average reaches $2.65, above the $2.60 ceiling, resulting in a $0.05-per-gallon payment to the company. May's $2.75 average produces a $0.15-per-gallon payment.

What does hedging accomplish?

For a fuel-intensive business, the primary benefit of hedging is cost predictability.

Consider a mulch producer that knows it will consume roughly 30,000 gallons of diesel each month during its peak production and delivery season. A sharp increase in diesel prices can affect harvesting, grinding, loading, trucking, and delivery costs simultaneously.

If the company has quoted prices to customers based on a particular fuel-cost assumption, an unexpected increase can squeeze margins.

A hedge can help the company establish a more predictable fuel-cost component when setting those prices.

Hedging can also support longer-term customer contracts. If a company can better estimate its future fuel costs, it may be more comfortable offering customers pricing for a defined period rather than relying on fuel-price assumptions that could quickly become outdated.

Huntington identifies several potential uses for commodity hedging, including locking in margins against a budget, creating fixed-price programs for customers, developing growth and sales strategies around known costs and securing strategic long-term pricing.

Hedging isn't a bet on fuel prices

The objective of a properly structured hedge is not necessarily to achieve the lowest possible fuel price.

That distinction is important.

If diesel prices decline after a company locks in a fixed-price hedge, the company may effectively pay more than it would have without the hedge. Conversely, if prices rise substantially, the hedge can offset some of the increase.

The trade-off is therefore price certainty versus the ability to fully benefit from favorable price movements.

A fixed-price swap provides the greatest degree of certainty but limits the benefit from falling prices. A collar provides a range: the company receives protection above the ceiling but accepts exposure below the floor.

For companies considering hedging, the starting point should therefore be the business's fuel-consumption profile, budgeting requirements and tolerance for price fluctuations—not a prediction about whether diesel prices will rise or fall.

Understanding the basis risk

Another consideration is that a financial hedge based on NYMEX HO does not necessarily move in perfect lockstep with the price a company pays its local fuel supplier.

The NYMEX HO contract serves as the reference price in the examples presented by Huntington. The actual price paid for physical diesel can also reflect transportation costs, regional supply conditions, supplier margins and other factors.

As a result, companies should understand how closely their actual fuel costs track the index being used for the hedge and how the hedge volume corresponds with their expected consumption.

The objective is to construct a hedge that reasonably matches the company's actual exposure.

A tool for managing margins

For mulch, soil, and compost businesses, diesel is often a significant operating expense that touches multiple parts of the supply chain. Production equipment, loaders, grinders, trucks, and delivery fleets can all contribute to fuel consumption.

That makes fuel-price volatility more than a line item on the income statement. It can influence product pricing, customer contracts, production decisions, and ultimately margins.

Diesel hedging offers one way to bring greater certainty to that exposure.

The key is to view the hedge as a risk-management tool rather than a trading strategy. Companies need to determine how much diesel they are likely to consume, over what period, and what level of price certainty they need. They also need to understand the financial obligations and potential costs associated with the selected hedge structure.

The examples provided are for informational or illustrative purposes and commodity rates and products are subject to change. Companies should consult their own accounting, legal, and tax advisers regarding those matters.

For businesses whose profitability can be materially affected by diesel prices, however, understanding the mechanics of hedging can be an important step toward managing one of the industry's most unpredictable operating costs.

For additional updates on commodities strategies and market analysis, be sure to subscribe the Huntington Business Insights at: https://www.huntington.com/learn/business-resources

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