13 Jan 2020

Derivatives .... shedding the risk

Itumeleng Merafe & Quentin Allison

Investec Specialist Bank

The latest round of load-shedding has focused attention on the cost of running generators during power outages, in particular mitigating the effects of volatile diesel prices. 

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Mention fuel prices and most of us think only in terms of what it costs us every time we fill our tanks at the garage. However, the reality is that changes in fuel prices affect us in other ways too. Fuel prices affect the cost of transporting goods to retailers, costs that are either passed on to consumers or absorbed by the retailer.

 

Now with load-shedding a reality for South Africans, fuel costs are having another impact on the cost of doing business, in the form of running generators to ensure business continuity.

 

In today’s “always-on” business environment, sitting out outages and waiting until the power comes back on is not an option. For shopping malls, hospitals, office blocks and other key services, lengthy power outages mean a breakdown in services to clients, loss of income (and sometimes jobs) or even a health risk.


Many businesses and other organisations have had to invest in generators and have found themselves having to cover a new cost, the cost of diesel. 

Volatility and business planning

The cost of diesel would be enough of a challenge for businesses if it were steady and predictable. Unfortunately, diesel prices are highly volatile, which makes planning and costing difficult.

 

The price of diesel is set by government, as part of what is known as the basic fuel price. A number of factors go into the setting of the basic fuel price (such as fuel levies) but the two key variables are the US dollar price of oil and the rand / US dollar exchange rate, both of which are usually volatile. Much of that volatility stems from factors outside of the control of South Africans, such as global confidence in emerging markets and global oil supply dynamics.

 

Combined, these two variables (exchange rate and oil price) make up 65% of what determines the basic fuel price. However, they account for 98% of the changes in the basic fuel price – which accounts for the volatility of the basic fuel price.

In short, businesses have to deal with an important and volatile cost item on their income statements. They can absorb the cost of rising rand diesel prices (which affects cash flows and profitability) or pass it on to customers and clients (again affecting profitability and cash flow if customers withdraw their business). 
Mitigating costs by using derivatives

Fortunately, businesses need not be at the mercy of global exchange rates and oil prices. Thanks to a liquid and well-traded market in oil and currency derivatives, there are a number of hedging structures available to minimise risk and help you to manage your costs and cash flows.

 

A hedge can be constructed by using over the counter (OTC) or exchange-traded derivatives. There are a number of strategies that can be structured to mitigate your diesel price risks using rand / dollar derivatives and gasoil futures.

 

(Gasoil is a broad term used to describe a range of petroleum products, including diesel, marine diesel, and heating oil. The gasoil futures contract is one of the most actively traded oil contracts on the International Petroleum Exchange and has been shown to have a 95% correlation with the basic fuel price.)

 

So how would the hedge work in practice?

 

There are two basic techniques you can use, one that locks in a price using a swap and another that uses call options:

 

  • With a swap strategy, you get a fixed rand price per litre on a specified volume over a predetermined period by buying a swap. The advantage of this mechanism is that it locks in a fixed price for a certain time period and protects you from any price increase above the swap price.
 
  • With a call option strategy, you create a ceiling price in exchange for an upfront premium, which reflects the likelihood that the option will be exercised. The farther the strike price is from spot price (it’s less likely to be called), the lower the amount of premium paid upfront. 

 

The main advantage of using call options is that you participate fully in downside price movements while protecting against price increases above the call level. Although there is an upfront cost associated with this strategy, it may prove to be more cost-effective than locking in a fixed price should prices retrace dramatically.

 

Strategies will differ according to your business’s needs. In the current environment of volatile global currency and energy markets and electricity constraints, it’s worth having a conversation about managing your diesel price risks.

 

Written by ​Itumeleng Merafe, Head of Interest Rate Structuring, Investec Specialist Bank and Quentin Allison Head of Commodities Trading & Structuring, Investec Specialist Bank.