Each week, I get calls and emails from customers inquiring about the right time to lock in fuel prices for the upcoming year. All too often, I hear comments like “Last year we didn’t time the market quite right and lost” or “Two years ago when we locked, we were up big and it really paid off. We want to do that again. Can you tell us when to lock?”
Whenever I get an opportunity to speak with consumers about price risk management, I like to ask about their method of forecasting diesel prices and how they relate that process to their budgeting process. Every company puts fuel budgets in place (if you don’t, we need to talk). From Procurement Managers to Supply Chain Managers, straight up to the CEO, budgets are crucial; however, as you’re probably well aware, they are not an exact science. At best, a fuel budget is informed by a combination of historical data and price forecasts, molded together to develop a budgeting plan for each fiscal year.
Price Risk Management Rule: Disregard Price Forecasts.
Price Forecasts are necessary when determining a budget but not when implementing a hedge program. As American economist Edgar Fiedler aptly put it, “Forecasters tend to learn less and less about more and more and in the end, they know nothing about everything.” In truth, nobody in the world knows with certainty where fuel prices are going, but it’s safe to say they’ll go somewhere. Once a budget has been developed, your company must understand the dynamics of the fuel market and as Alan Apthorp has recently discussed in his article, “Predicting the Future? Oil Market Futures Fundamentals,” the fuel price forward curve, where one can lock in fuel prices in the future, is a crucial element.
The EIA and economists develop price forecasts by analyzing fundamentals such as supply, demand and inventory. These sources are valuable when budgeting, but when executing a hedge program all that matters is the price you can lock in for the future, right now. A successful fuel price risk manager checks their emotions at the door and implements a program put in writing and followed by the company’s risk management team. This may incorporate a specific time for locking in prices (budget season), a layered approach (locking in prices over time) or even allowing for flexibility to lock in at predetermined levels.
To be clear, I don’t mean to suggest risk managers should completely ignore market prices and go in with blinders when locking in fuel prices. One must completely understand price risk and use tools such as historical data and probability (ex. how high or how low prices are likely to move over time) when determining their company’s fuel price risk.
It is difficult to control our emotions and train our minds to overcome psychological biases such as the gambler’s bias I hear so often when speaking to clients about “winning” on their price locks. But successfully managing fuel price risk requires discipline, focus and a solid fuel price risk management program.