Planning budgets for stable fuel prices

March 1, 2003
Setting a budget for fuel purchases requires an understanding of the physical costs of fuel production in conjunction with the paper costs as reflected

Setting a budget for fuel purchases requires an understanding of the physical costs of fuel production in conjunction with the paper costs as reflected on the New York Mercantile Exchange, J Scott Susich said. Understanding the market forces at work in determining prices is essential, he said, because fuel is the second largest expense item in any fleet operation.

Susich is a senior analyst with the Energy Management Institute in New York. He spoke to the 32nd annual Dairy Distribution and Fleet Management Conference in Savannah, Georgia, February 12 to 15, 2003.

Fuel pricing begins with crude oil, Susich said. Crude exists virtually everywhere, but getting to it is more difficult in some locations than others. In addition, the quality of crude varies from location to location. For instance, good quality crude can be found in South Dakota, but it is under 17,000 feet of solid rock. That makes crude oil in South Dakota a lot more expensive than crude that can be found under 2,000 to 3,000 feet of sand and soft sandstone in the Middle East. “The crude oil we use today comes from places where its recovery is most economical,” he said.

A great deal of the world crude oil supply comes from nations that belong to the Organization of Petroleum Exporting Countries, a cartel of 11 members. “Make no mistake,” Susich said. “OPEC does not care about the relationship between the price of crude oil and the economic condition of fleets that need fuel. OPEC members do not care if the price of fuel goes up. They care about the price of crude oil only in terms of their own gross national product.”

Oil price supports economy

The simple facts are that many oil-producing nations have a good supply of only two things — oil and sand, Susich said. “They don't have factories, not any industry at all to speak of,” he said. “Their entire economy is built around oil production. As a result, they price oil in a way that keeps money flowing into the national treasuries. If the demand for oil falls, they will lower the price in an attempt to raise demand so that prices will have to increase. The only equation some of those countries care about is demand times price.”

The technology of oil exploration has advanced significantly in the past two decades, Susich said. Exploration companies drill very few dry holes any more. If they start to drill, they are pretty sure that they will find oil. However, variables still exist. For instance, the oil may be there, but the exploration company has no idea of what the quality will be until they get a sample. At the same time, the cost associated with exploration has dropped. Some major oil companies spend only $2.50 per barrel in exploration costs for a product that sells for 10 times that much, he said.

Since the mid 1990s, the number of products distilled from a barrel of crude oil has risen dramatically. At one time, the oil industry dealt with only a few products — two grades of diesel, kerosene, and three grades of gasoline. Now, the industry produces low-sulfur and high sulfur diesel in two grades along with two more grades of fuel formulated to meet the standards in California. Add in products formulated for specific parts of the country, and the oil industry now refines about 16 different diesel fuels. The same product proliferation has happed in the gasoline market. The cost impact is that all this different fuel has to come from the same refineries that once produced only two types of diesel and three grades of gasoline. The impact becomes more severe as time goes on, because environmental regulations make it extremely difficult as well as expensive to build more refining capacity, Susich said.

Regional fuel pricing

Fuel pricing is determined in five regions of the country. Refiners trade product among themselves in these regions known as spot markets. Spot markets are physical locations where fuel is refined and stored. A spider web of pipelines is used to transport product from the major refining areas to marketing areas. For instance, gasoline or diesel can be moved by pipeline from Houston, Texas, to northern New Jersey, Susich said. “Curiously, products are not separated physically in a pipeline,” he said. “If diesel is pumped into the pipe behind an order of jet fuel, some mixing will take place at the ends of the load. However, it is so slight that a little diesel mixed with the jet fuel doesn't matter when it is stored in a million-gallon tank.”

Another little-understood factor in fuel pricing is that the label on it matters little. Different retailers sell fuel at different prices, but most of that fuel comes out of the same tank at a pipeline terminal, Susich said. The importance of this fact is that diesel fuel is a simple commodity, and buyers should attempt to treat it as such. “A certain amount of service from a local distributor who does a good job and who maintains a good supply of fuel can be important, but in the end, remember that diesel is just diesel,” he said.

Retailers usually generate a profit of 10 to 12 cents per gallon. Talk of price gouging by retailers usually is nonsense, Susich said. “In a volatile market such as we have now, retailers usually can't raise pump prices fast enough to keep up with rising wholesale prices,” he said. “When the price of oil jumps quickly, most retailers lose money. That's why retail prices do not drop as quickly as they climb, because the retailer has to try to recover some of the loss as prices fall.”

Taxes add to cost

Taxes make up a large percentage of the price of fuel. However, when retail prices are high, the percentage paid in tax is lower. At current pricing, tax comprises about 25% of the total price, but at lower retail prices, taxes can amount to as much as 50% of the total price, Susich said.

Beyond the physical aspects of fuel pricing, the futures market, as set by the New York Mercantile Exchange, plays an important role in determining prices. The futures market is nothing neither more nor less than a mechanism for buying and selling commodities, Susich said. “Those people yelling at one another on the Exchange trading floor have a real effect on business all over the country,” he said. “They tend only to know about trading commodities, but the activity on the trading floor finally comes to represent the sum total of all knowledge about the oil industry at any given moment.”

One of the seeming absurdities of the commodities business is that its practitioners can buy and sell things that they don't own, Susich said. Reality strikes when one trader has to buy a commodity in order to deliver on a previous sale. The market operates on a forward curve where traders want the current price to be higher than the projected price at some point in the future. “In the past year, the price of fuel has gone up 89%,” he said. “No one can predict things like that. Budgets are not written to reflect such changes.”

Futures predict pricing

However, managers can look for clues in the market to predict changes in fuel pricing. The most important clue — not even clue, more like inconvertible evidence — is activity on the New York Mercantile Exchange, Susich said. “Believe it; what happens on the NYMEX will eventually makes its way to a fleet's balance sheet,” he said. “The changes are not always exactly the same, particularly as pricing moves from producer through the chain to retail, but in most cases, changes will correlate with about 90% accuracy or better.”

The difference between the paper market and the physical market is a simple calculation called “basis,” Susich said. Basis is the difference between the physical price and the futures price. For instance, from January 1999 to June 2002, the average physical price in Denver was 85.25 cents per gallon, and the average futures price for the same period was 76.45 cents per gallon. Subtract the futures price from the physical price to arrive at a basis of 8.8 cents per gallon, he said. This calculation provides managers with a tool for projecting local prices based on average futures prices.

A good way to build a budget is look at the forward curve of futures pricing and add the local basis calculation to reach a rough approximation of future pricing, Susich said. Such a projection will be a lot more accurate than trying to look at average prices and add in a factor for things such as inflation. In building a projected budget, use actual price figures paid for fuel for at least two years. At the same time, research the futures prices from the NYMEX over the same period of time and calculate the difference between the two. The best way to handle this data is monthly. Futures contracts are sold by the month, so data is available allowing accurate projections for budgeting.

Data costs money

Historical data about NYMEX pricing must be paid for. Several companies make it available. Unfortunately, it is rather expensive, but that expense tends to pay for itself in better budgeting results, Susich said. Some suppliers will provide historical cost information. In addition, information about the forward curve of futures pricing can be mined from the NYMEX web site.

For the most accurate projections, do the calculations by product, amount, and location. The basis figure will provide a much better picture of what fuel for June 2003 will cost in Denver than simply adding a fudge factor based on the consumer price index to historical purchases from last year, Susich said. “Not only is this method accurate, it provides its own internal logic that can be used to explain the budgeting process to management,” he said.

However, projections do not represent a hard budget. Nobody can predict oil prices 12 to 16 months in advance. “If they could, they would be running Exxon,” Susich said. “Not even Exxon can project future oil prices that accurately.”

Leave room in budget projections for adjustment. The forward curve from the futures market is probably pretty accurate for three to four months. The farther into the future projections go, the more pessimistic the assumptions need to be. Present upper management with the worst-case scenario, Susich said.

If a firm budget must be presented, build a risk management plan to go with it to guard against extreme market changes. Buying futures contracts is one way to lock in fuel prices, Susich said. However, those contracts need to take the entire nature of the business into account. For instance, a trucking company might not feel comfortable hedging its fuel price projections by buying futures. If the market falls dramatically, paying more for fuel could place that trucking company at a competitive disadvantage. Other companies have more options. If fuel is a smaller part of the entire financial picture, a company might be able to survive while paying more than the current market price for fuel as long as the price is stable and predictable, he said.

“Such a plan might cost three cents per gallon more than the market price, but for the life of the contract, prices will remain stable,” Susich said. “This is much like buying insurance. The price may be higher, but it will never rise above the contract level.”

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