How to Manage Oil Price Risks

There are a number of ways to manage oil price risks.

For many industries, much of the cost of producing their product or service goes to the purchase of fuel, which is commonly used to power machines that make and transport these goods. As the price of oil rises and drives up fuel costs, some companies will often pay far more to produce the same product or service, dramatically reducing their profits. To protect themselves against unexpected spikes in the price of oil, some companies will attempt to manage these risks through a number of special measures.

Instructions

Managing Fuel Costs

1. Identify your needs. Before attempting to manage risks, a company should first identify how much fuel it will need to sustain the business in the immediate future. Due to the fluctuating nature of fuel prices, many companies that require large amounts of fuel, such as airlines, make yearly or semi-annual fuel consumption estimates. Companies that attempt to plan further ahead often lose money based on dramatic shifts in the price of fuel.

2. Study the market. Companies should attempt to make predictions about where the price of fuel is headed in the near term. This can be done by analyzing data related to the movement of the fuel price in the past and matching it against current factors that influence the price's direction, such as the current level of demand, the direction of the economy and certain political events.

3. Purchase derivatives. Once companies have made a guess as to where the price of fuel is going, they may choose to buy derivatives that given them the right to buy a certain commodity at a set time, price and location. This means that if prices rise, the company will not have to pay the inflated cost because they have already locked in their fuel a lower price. For a fee, companies can either buy oil outright or they can purchase an option--the right, but not the obligation, to purchase the commodity at a future date and price. This may be a preferable option if companies are unsure whether the price will go up or down.

4. Convert to an alternative source. In addition to hedging oil price risks through derivatives, companies can sometimes adapt their equipment to use other types of fuels. For example, a company that has a fleet of gasoline-powered cars might consider converting to flexible fuel vehicles, which take both gasoline and ethanol. This would allow them to purchase the corn-based alternative fuel if oil prices go too high.

References

• Telegraph.co.uk: British Airways fare rises 'absolutely inevitable' as fuel prices increase
• "Managing commodity price risk in developing countries"; World Bank; 1993
• IQPC: Oil & Energy Price Risk Management
• U.S. Energy Information Administration: Derivatives and Risk Management
• Chevron: Chevron Risk Management