Thriving in the new normal

By and |  December 10, 2013

Purchasing strategies for a volatile fuel price market.

Fuel costs can make or break the bottom line. Fleet operators sometimes build fuel cost assumptions into their budgets, making it difficult to adjust to increasing or decreasing fuel costs. Effective fuel cost management is a critical success factor.

Starting in 2004, a “new normal” asserted itself within U.S. fuel markets. Day-to-day price swings of 3 cents or more – swings that previously occurred only 6 percent of the time – now happen almost half the time. Swings of 5 cents or more went from happening 1.6 percent of the time to happening 25 percent of the time. This volatility is now embedded within wholesale fuel markets, and it shows no signs of abating.

Unfortunately, some fuel-purchasing managers use pre-2004 buying strategies that do not sufficiently address daily fluctuations in fuel prices. Many use spreadsheets and heuristics to time the market, or they lack diversification in their fuel portfolio. They believe they have adequate, contracted supply options. Some assume price swings eventually even out, or there is too much risk in adjusting to short-term market movements.

Others believe they need energy-trading capabilities, or they require hedging expertise to protect against price volatility. But these views are not consistent with industry best practices achieved in today’s fuel market.

Contracting 100 percent of supply means purchasing managers cannot take advantage of spot market opportunities in a volatile fuel market. Although fully contracting supply ensures access to fuel, it also raises total costs. For instance, it precludes managers from taking advantage of periodic fire sale prices when suppliers are long due to a pipeline movement.

A good rule of thumb is to contract about 80 percent of expected usage. In larger markets, where there are many spot suppliers, the contract percentage can be lower. In smaller markets, where there are fewer spot opportunities, contract at a higher percentage.

In either case, have multiple spot supplier relationships because prices will vary among them depending on their position and other market variables. Carefully monitor results using spot versus contract suppliers. If spot suppliers provided net savings over the full-contract term, lower the contract-to-spot ratio for the next round.

Fuel managers must make purchase decisions daily based on spot price availability – not just once a year at contract renewal time. An automated best-buy decision process must be inserted between the daily inventory management and dispatch processes. Adding this step before dispatching, which is already under time pressure, can be a business process challenge. But it’s well worth the effort.

Obtain supply options across regions
Some fuel purchasing managers will simply pick the closest terminal to their site location and get a supply contract out of that terminal. This underlying assumption is that freight will be the lowest at the closest terminal. So this will yield the lowest overall cost. This is not always the case, resulting in a much higher overall price than what might be available at a terminal that’s farther away or just across a state or regional boundary.

Consider this example from southern Michigan: If purchasing fuel for Detroit or its suburbs, there are several supply terminals in the area. Prices at these terminals tend to track pretty closely. But the supply manager who has a Toledo option right across the Ohio state line will be extremely happy several times a year.

While generally prices track closely between Detroit and Toledo, they sometimes don’t. For example, from Jan. 8-21, 2013, diesel prices in Toledo ranged from 21 to 41 cents less than in Detroit. So consider contract and spot supply options at adjacent terminals and regions, because using a more distant terminal and supplier may actually be the best primary contract option.

Another consideration is to actively solicit contract bids from suppliers in adjacent states. Even if the primary contract is local, find a spot supplier in an adjacent state.

Sometimes, the remote spot supplier’s price reacts differently to volatility and can provide great prices when the local market tightens. There may also be favorable excise tax differences for fuel sourced from an adjacent state or local jurisdiction.

Take advantage of short-term price movements
By taking a position on fuel prices next month or next year, a professional energy trader can use hedging strategies to mitigate the risks of price volatility. Most fuel users or resellers don’t have this kind of expertise in house. But by only using generally available information, it is possible to make an accurate precision on the direction of tomorrow’s fuel prices.

If prices are likely to go down, look for sites and tanks that can wait another day before they’re going to run out. By simply pushing the delivery out a day, the amount of the price move becomes savings. For example, if an average load is 7,500 gallons, pushing that delivery a day when the price is moving down by 3 cents will save $225. By shifting a load forward or backward like this just once a week, $11,700 is saved over a year for each site.

Making this kind of directional price estimate is not as hard as you might think. Savvy fuel purchasers monitor regional futures markets (i.e., NYMEX) to see the daily trend. Generally, a futures move of 2 cents or more indicates action should be taken based on this expected price move.

Experienced purchasing managers should be able to make an accurate, directional call 75 to 80 percent of the time using this model. Experience shows that with recent price volatility, a reasonable expectation is that 10 to 20 percent of loads can be confidently shifted to take advantage of expected price moves.

It’s often not necessary to push or pull a full day in order to take advantage of an expected move in the market. Some suppliers make price changes at noon, others at 6 p.m. and others at midnight. By working closely with a fuel carrier, it is possible to take advantage of price moves by adjusting lift times relative to price change times.

For example, if the price is expected to go up at midnight, perhaps the carrier can lift at 11:30 p.m. and deliver early the next morning. This might save considerably over lifting early in the morning and delivering later in the day.

In order to adjust delivery times to take advantage of short-term volatility, it is important to maximize carrier flexibility. Some fuel carriers are not interested in making these kinds of delivery adjustments – especially if it means leaving a truck idle. Sometimes, a carrier simply doesn’t have a truck available when it’s needed to pick up an extra load in order to stock up on a good price. Consider one of these strategies when working with carriers:

■ Make flexibility to load shifting a clear requirement in carrier negotiations. When deciding on a carrier, make sure they are willing to make delivery time adjustments as needed. This flexibility can even be worth paying a higher freight rate.

■ Arrange multiple carrier options for each site. If the primary carrier has no trucks available, the ability to utilize a secondary option may allow the capture of a significant price move.

■ Use guaranteed volume agreements to get higher priority and/or flexibility. Carriers need to plan based on the assurance that their trucks will be nearly fully utilized. Providing that assurance may gain flexibility or a priority position when truck availability is tight.

■ Allow deliveries at off-peak hours in order to facilitate higher truck utilization and delivery flexibility. By allowing deliveries late in the evening or early morning, carriers can keep an otherwise idle truck on the road. This improves their margins and makes them more likely to be flexible to delivery time adjustments.

Consolidate daily supply options
To leverage fuel price volatility, supply decisions must be made on a daily basis. In order to fit into an already tight daily inventory planning and dispatch process, supply adjustments need to be made quickly with the best information available.

This means purchasers need full access to all contract and spot prices for all products and terminals, contract ratability requirements, freight options for each site and terminal combination, and estimated retain and run-out delivery windows for each tank.

If some prices are coming in via email, some calculated in spreadsheets and others require a webpage lookup, purchasers cannot sufficiently evaluate all options and react quickly enough to get orders dispatched in time. This kind of analysis and real-time decision-making is impossible to accomplish using a spreadsheet-based process.

Fuel-purchasing software can consolidate and normalize pricing formats across suppliers, price change times, sites and freight options. The software can maintain current run-out windows for each tank based on the latest inventory and project usage information to assist in load-shifting decisions.

By automating daily best-buy decisions, not only is the lowest price option for each proposed order available, but purchasers can easily manage tradeoffs between spot purchases and contract ratability. For example, if the decision is made to take a great spot price today, will there be enough estimated volume through the end of the month to meet contract ratability requirements?

By automating the strategic sourcing process, each decision can be evaluated to both maximize tactical savings and minimize the opportunity costs of volume contracts. For example, suppose that analysis of the last three months of daily supply decisions shows that often the lowest spot price was not chosen simply to ensure contract ratability. This may indicate that contract volumes should be lowered in the next round in order to provide more spot purchase flexibility.

Fuel purchasers who choose to use supplier-based inventory management functions lose the ability to leverage spot prices and load-shifting optimizations. In fact, suppliers may choose to optimize on other factors – like their truck utilization or even their own margins.

Suppose prices are trending down. The tank could take a load either today or tomorrow. Will the inventory management supplier hold off until tomorrow to get a lower price? Or choose to put their truck on the road today? Outsourcing these kinds of decisions has a cost in today’s volatile market.

Measure purchasing effectiveness
Measurement is critical to improve fuel-purchasing effectiveness. Of course, fuel purchasing can’t be measured like other goods and services. But savings of even a few cents per gallon can have a significant impact on margins. Still, measurement in this environment is challenging, and it’s the reason why many purchasing managers just don’t do it.

There are two approaches that are typically used to measure fuel-purchasing effectiveness. Ideally, both should be used, although the second approach is more difficult to accomplish and requires more data.

■ Contract relative analysis. Measure the price actually paid relative to the primary supplier’s contract price on the planned delivery date. Using contract pricing for both fuel and freight as the baseline, the purchaser can measure their decision to use a spot supplier or adjust delivery timing to take advantage of price volatility. If the price paid is lower than the contract pricing, the decision resulted in savings. If the price paid is higher, then there was a loss relative to the contract.

■ Market relative analysis. Measure the price actually paid relative to a dynamic industry benchmark, such as the OPIS average. Be sure the index choice is local to where the fuel is purchased. If fuel is purchased from five different terminals, then a price index with daily prices for all five terminals is required. Note that in this case, it doesn’t matter what index is used to determine the price paid. A single index should be used as a consistent benchmark. This analysis provides an understanding of price paid versus market competition and helps measure the effectiveness of fuel contracting.

Measurement can be difficult, but the best fuel purchasers are doing it because it’s the only way to know that purchasing decisions are having the desired effect.

Factors affecting fuel
Ryan Mossman, vice president and general manager of the fuel center at FuelQuest, a software and services company for the downstream energy industry, weighs in on fuel price volatility in an interview with PP&E:

PP&E: How important is it, considering price swings, to have someone dedicated to the task of purchasing fuel?

RM: The challenge a lot of companies face, especially buying for commercial uses, is that most companies don’t have experts in the fuel markets. In the last seven years, volatility has increased dramatically and a lot of strategies and techniques that were best in class seven years ago are now completely outdated. Generally, people are a little bit behind because of the intensity of what the markets are doing globally.

PP&E: What are the biggest factors energy users should be aware of that are influencing these price swings?

RM: There are 1,000 little variables that add up. To me, one of the biggest forces that shape [the market] is increasing globalization. About 70 percent of gasoline and diesel is based on the price of crude oil. People all over the world are participating in this market. The U.S. proportion relative to that has been shrinking. You have economies like China that have started taking on a huge role in fuel consumption. What happens in China, for example, has a tremendous impact on the world.

Another key impact is the geopolitical area. [The U.S.] has gotten a lot of press because we’re finally able to produce many of our energy needs domestically, but world consumption has been driven by [many] countries that are politically unstable – whether it’s Nigeria and the unrest there that affects the amount of oil hitting the market. That affects gas and diesel.

Some of the volatility is also driven by currency – the strength of the U.S. dollar for example. Governments and central banks are a lot more active in their monetary policy. They’re intentionally manipulating the value of the currency. For example, in the U.S., we have quantitative uneasiness that’s keeping the dollar cheap. If you’re buying oil and dollars and you’re keeping it cheap, you’re propping up the price of oil. Again, on a daily basis you have things that are affecting the currency.

Gary Davis is a product marketing manager at FuelQuest Inc.

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