Opinion: Managing Hidden Fuel Surcharge Costs

By Jonathan Leak
Senior Vice President
Price Risk Management Programs
World Fuel Services Corp.

This Opinion piece appears in the Dec. 21 & 28 print edition of Transport Topics. Click here to subscribe today.

One silver lining in the financial storm of the past year or so had been a steep decline in the price of oil generally and diesel fuel in particular. The decline in retail diesel fuel prices and subsequent easing of freight fuel surcharges helped, at least for a time, to offset at least a portion of the distress caused by the recession.

Recently, however, petroleum prices have been climbing once more because of the weak U.S. dollar (which encourages investments in “hard” commodities), rising equity prices and encouraging signs that the economy may be rebounding. As such, it’s likely that the issue of freight fuel surcharges will be a hot topic in 2010 and beyond for those with indirect exposure to the diesel market.

To the extent that common carriers are able to include a fuel surcharge provision in their freight agreements with customers, they will do so, of course, in order to offset the provider’s direct exposure to volatility in diesel fuel prices. For the shipper, however, fuel surcharges represent a significant, volatile but often overlooked component of their cost structure.

To keep a lid on potentially unacceptable exposure to fuel prices, shippers have two possible strategies to consider:

• They can hedge themselves by taking a financial position in the diesel index that drives most fuel surcharge calculations.

• They can partner with their freight provider so as to “lock in” the surcharge provisions.

Strategy number one — hedging — acknowledges that fuel surcharge calculations reference a fuel price index, typically the weekly Energy Information Administration U.S. average retail diesel price. Changes in the EIA index, whether up or down, will determine the appropriate rate of surcharge to add to the freight invoice.

Shippers can protect themselves from adverse movements in the index by executing a financial contract known as a swap (or option) on this particular index. In this way, if diesel prices continue to rise, the settlement value on the swap also rises. This strategy can be likened to a surcharge insurance policy that will provide a financial reimbursement to the shipper for any increases in fuel surcharges from the carrier. The amount of fuel surcharge volume to be locked in can be calculated by considering the base level of expected freight spending and the tiers of the fuel surcharge table in effect.

Alternatively, many shippers are adopting strategy number two and finding ways to work with their carriers to avoid fuel surcharge adjustments in the first place. By doing so, the shippers are pushing the risk of volatility in diesel prices back onto the carriers, with the expectation that the carriers will take the necessary financial steps to protect themselves.

Fortunately, carriers can put their own price protection in place easily enough by taking a similar position on the diesel fuel index.

Perhaps more important for the carrier, the ability to insulate the carrier from rising diesel prices can enable the carrier to offer an important competitive differentiator, i.e., no fuel surcharge adjustment at all.

In an environment where too little freight is chasing too much hauling capacity, this offering should have broad appeal and generate more activity for carriers that are able to embrace the idea. In this case, everybody wins in a relationship that is transforming the landscape, where carriers are now looking to provide shippers with feasible solutions while protecting themselves from the continued volatility of the diesel markets.

To recap:

• Fuel surcharge provisions in manufacturers’ freight agreements create a hidden and potentially unacceptable exposure to fuel prices.

• Manufacturing executives should seek — and are seeking — to protect themselves from a worst-case scenario in which their freight fuel surcharge expenses rise faster than the recovery in the general business.

• Fortunately, the underlying price index related to many surcharge programs is a tradable index, and a variety of fuel surcharge management (i.e. “hedging”) strategies are available for consideration.

• Shippers are seeking help from their carrier partners in mitigating fuel surcharge exposure, and, in some cases, they are looking for their carrier to provide for a fixed price surcharge rate.

• Where carriers can offer proven risk management techniques commonly used in other fuel-hedging situations, manufacturing executives can effectively mitigate this risk and help stabilize their shipping costs.

World Fuel Services Corp., Miami, is an independent marketer of marine, aviation and ground fuels that also offers price risk-management services to its customers.