A trader’s guide to hedging renewable diesel fuel

How to avoid erosion of profits through periods of renewable diesel price volatility

The complaints about higher fuel prices have reached the highest levels of office in the United States. On May 30, 2022, President Biden released an opinion piece in the Wall Street Journal called “My Plan for Fighting Inflation.” President Biden addressed elevated fuel costs and said, “the pump price is largely elevated because Russian oil, gas, and refining capacity are off the market.”

Gasoline and diesel prices were elevated before Russia attacked Ukraine. These prices started to skyrocket following the invasion, primarily driven by crude oil prices.

Another factor behind the lack of gasoline and diesel fuel is the absence of local refining capacity. In the United States, distillate stocks (inventory levels), a broad category that includes diesel fuel and heating oil, are at their lowest levels in the past 5 years. Distillate stocks are closing in on a 20-year low, which followed a severe decline in jet fuel use in the wake of the 911 attacks.

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Why are refinery inventories so low?

Crude oil production has rebounded following a falloff at the pandemic’s beginning. Unfortunately, there is little desire by oil producers or refiners to make future investments in these petroleum products. The upshot is that the demand for a carbon-friendly fuel source has reduced the appetite for future investment in petroleum production. Private investors are less willing to deploy capital to the petroleum industry as the demand for electric vehicles accelerates.

Buy protection when you can, not when you need to

Many traders were caught off guard as fuel surcharges eroded their profits. Unfortunately, there is no short-term solution to elevated gasoline, renewable diesel, and diesel prices. The issue’s core is that there is little private investment in the oil refining business. Capital is looking for lower carbon-intensive energy sources like electricity or biofuels. The lack of refining capacity is helping to drive up prices. More crude oil might help over an extended period, but it’s unlikely to assist in the short term.

Traders should consider hedging their forward fuel costs even at these elevated levels. There is a relatively straightforward way to hedge Renewable Diesel and gasoline exposure. If you are willing to take a basis risk, you can purchase a heating oil or gasoline futures contract on the New York Mercantile Exchange.

These futures contracts are obligated to purchase heating oil (diesel fuel and renewable diesel fuel) or gasoline in New York Harbor. Alternatively, you might consider purchasing a call option on Heating Oil or Gasoline. A call option is a right but not the obligation to buy an underlying product (heating oil or gasoline) at a specific price on or before a certain date.

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The graph above shows a payout of a Low Sulfur Heating Oil (Diesel) option contract (the price of renewable diesel moves in lockstep with diesel fuel given the exact location). The cost of an option that expires on 10/28/22, with a strike price of $4.00 per gallon, is about $0.45. You would start to break even on this call option when the cost of Diesel reaches $4.45. The most you can lose on the hedge is $0.45.

There is an additional benefit of purchasing a call option instead of a futures contract. If the diesel price declines back to levels seen in January 2022 near $2.35 per gallon, you will only forego the $0.45 you paid for the call option. If diesel prices rise above $4.45, you will benefit and offset your fuel surcharges.

Summary

The bottom line is that renewable diesel prices are likely to remain volatile. To avoid further erosion of profits from diesel surcharges, traders might consider hedging. There are several ways to hedge your diesel exposure. One of the most effective is through a call option.

If you are interested in a detailed explanation of how to hedge your renewable diesel exposure, contact our risk solutions team.

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