J & l railroad case study answers

Hedging Strategy for Commodity Risk (J&L Railroad (UVA-F-1053)) Study Questions:

1. Should J&L hedge all of its exposure to diesel fuel for the ensuing year? What percentage of the 210 million gallons would you hedge?
2. What are the pros and cons of using NYMEX contracts versus using the risk-management products offered by KCNB? Is the use of a monthly average price a net advantage or disadvantage to J&L? What about the bank?
3. Using the estimate of 17.5 million gallons per month, how would you construct a futures hedge for the next 12 months? How would you construct a commodity-swap hedge?
4. Should Matthews use a cap as a hedge? What strike price for the cap would you recommend she choose?
5. If Matthews wants to minimize the cost of hedging, should she use a collar? What cap and floor strike prices would you recommend using?

This disguised case was revised and updated by Rick Green based on an earlier version adapted from a Supervised

Business Study written by Jeannine Lehman under the direction of Professor Kenneth Eades. Funding was provided

by the L. White Matthews Fund for finance case writing. Copyright  1994 by the University of Virginia Darden

School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to

sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,

used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,

recording, or otherwise—without the permission of the Darden School Foundation. Rev. 8/09.

J&L RAILROAD

It was Saturday, April 25, 2009, and Jeannine Matthews, chief financial officer at J&L

Railroad (J&L), was in the middle of preparing her presentation for the upcoming board of

directors meeting on Tuesday. Matthews was responsible for developing alternative strategies to

hedge the company’s exposure to locomotive diesel-fuel prices for the next 12 months. In

addition to enumerating the pros and cons of alternative hedging strategies, the board had asked

for her recommendation for which strategy to follow.

Fuel prices had always played a significant role in J&L’s profits, but management had

not considered the risk important enough to merit action. During February as the board reviewed

the details of the company’s performance for 2008, they discovered that, despite an increase of

$154 million in rail revenues, operating margin had shrunk by $114 million, largely due to an

increase in fuel costs (Exhibits 1 and 2). Having operating profit fall by 11% in 2008 after it had

risen 9% in 2007 was considered unacceptable by the board, and it did not want a repeat in 2009.

Recently in a conversation with Matthews, the chairman of the board had expressed his

personal view of the problem:

Our business is running a railroad, not predicting the strength of an oil cartel or

whether one Middle East nation will invade another. We might have been lucky in

the past, but we cannot continue to subject our shareholders to unnecessary risk.

After all, if our shareholders want to speculate on diesel fuel prices, they can do

that on their own; but I believe fuel-price risk should not be present in our stock

price. On the other hand, if the recession continues and prices drop further, we

could increase our profit margins by not hedging.

Diesel-fuel prices had peaked in early July 2008 but then had trended downward as a

result of the worldwide recession and softening demand. By January 2009, diesel-fuel prices had

fallen to their lowest level since early 2005. At February’s meeting, the board had decided to

wait and see how the energy markets would continue to react to the recession and softening

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demand. By March, however, oil and diesel-fuel prices had begun to rebound, so the board

charged Matthews with the task of proposing a hedging policy at the meeting on April 28.

It was industry practice for railroads to enter into long-term contracts with their freight

customers, which had both good and bad effects. On the positive side, railroads could better

predict available resources by locking in revenues in advance. On the negative side, fixed-price

contracts limited railroads’ profit margins and exposed them to potentially large profit swings if

any of their costs changed. In this regard, diesel fuel was a particularly troublesome cost for

railroads, because it represented a large cost item that also was difficult to predict due to the

volatility of fuel prices.

An ideal solution to the fuel-price risk would be for railroads to enter into long-term

fixed-price contracts with their fuel suppliers. A fixed-price contract with suppliers when

combined with the fixed-price contracts with freight customers would serve to steady future

profits. Moreover, by contracting with fuel suppliers to deliver all of J&L’s fuel needs at a fixed

price, management could be assured of meeting its fuel budget numbers at year’s end. At times,

fuel suppliers had agreed to such contracts, but over the years, J&L had not been satisfied with

the results. The problem was that when fuel prices had risen substantially, many suppliers

walked away from their commitments leaving J&L with a list of three unattractive options:

1. Force compliance: J&L could take the supplier to court to enforce the contract; however, many suppliers were thinly capitalized, which meant that the legal action against them

could put them into bankruptcy. As a result, J&L might get little or nothing from the

supplier and yet would be saddled with significant legal fees.

2. Negotiate a new price: This usually meant that J&L would agree to pay at or near the current market price, which was equivalent to ignoring the original contract; plus it set a

bad precedent for future contracts.

3. Walk away and buy the fuel on the open market from another supplier: This choice avoided “rewarding” the supplier for defaulting on its contract but was functionally

equivalent to never having the contract in the first place.

Based on this history, J&L’s board decided to “assume the fuel suppliers are not the

answer to our fuel price problem.” The board then asked Matthews to explore other alternatives

to manage the fuel risk and preserve J&L’s relationships with the fuel suppliers.

Mathews had determined that, if J&L were to hedge, it could choose between two basic

strategies. The first was to do the hedging in-house by trading futures and options contracts on a

public exchange. This presented a number of tradeoffs, including the challenge of learning how

to trade correctly. The second was to use a bank’s risk management products and services. This

would cost more but would be easier to implement. For either alternative, she would need to

address a number of important details, including how much fuel to hedge and how much risk

should be eliminated with the hedge.

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Railroad Industry

Railroads hauled record amounts of freight in 2006 and 2007 and began to encounter

capacity constraints. In 2008, the industry hauled nearly 2-billion tons of freight, although rail

traffic declined due to weakness in the economy. The transportation of coal was by far the

number one commodity group carried. Other significant commodity groups were chemicals,

farm products, food, metallic ores, nonmetallic minerals, and lumber, pulp, and paper products.

Freight and unit trains had expanded the industry since deregulation in the 1980s. Rail

carriers served as long-distance haulers of intermodal freight, carrying the freight containers for

steamship lines, or trailers for the trucking industry. Unit train loads were used to move large

amounts of a single commodity (typically 50 or more cars) between two points using more

efficient locomotives. A unit train would be used, for example, to move coal between a coal

mine and an electric generating plant.

Several factors determined a railroad’s profitability: government regulation, oligopolistic

competition within the industry, and long-term contracts with shippers and suppliers. The

railroad industry had a long history of price regulation; the government had feared the

monopolistic pricing that had driven the industry to the brink of ruin in the 1970s. Finally

recognizing the intense competition among most rail traffic, Congress passed the Staggers Rail

Act of 1980, allowing railroads to manage their own assets, to price services based on market

demand, and earn adequate revenues to support their operations. America’s freight railroads paid

almost all of the costs of tracks, bridges, and tunnels themselves. In comparison, trucks and

barges used highways and waterways provided and maintained by the government.

After the Staggers Act was passed, railroad fuel efficiency rose 94%. By 2009, a freight

train could move a ton of freight 436 miles on a single gallon of locomotive diesel fuel,

approximately four times as far as it could by truck. The industry had spent considerable money

on the innovative technology that improved the power and efficiency of locomotives and

produced lighter train cars. Now, a long freight train could carry the same load as 280 trucks

while at the same time producing only one-third the greenhouse-gas emissions.1

Market share was frequently won or lost solely on the basis of the price charged by

competing railroads. Although rarely more than two or three railroads competed for a particular

client’s business, price competition was often fierce enough to prohibit railroads from increasing

freight prices because of fuel-price increases. But, as fuel prices during 2008 climbed higher and

faster than they had ever done before, there was some discussion in the railroad industry

regarding the imposition of fuel surcharges when contracts came up for renewal. So far,

however, none of the major carriers had followed up the talk with action.

1 Association of American Railroads, http://www.freightrailworks.org.

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J&L Railroad

J&L Railroad was founded in 1928 when the Jackson and Lawrence rail lines combined

to form one of the largest railroads in the country. Considered a Class I railroad, J&L operated

approximately 2,500 miles of line throughout the West and the Midwest. Although publicly

owned, J&L was one of the few Class I railroads still managed by the original founding families.

In fact, two of the family members still occupied seats on its board of directors. During the

periods 1983–89, 1996–99, and 2004–08, J&L had invested significant amounts of capital into

replacing equipment and refurbishing roadways. These capital expenditures had been funded

either through internally generated funds or through long-term debt. The investment in more

efficient locomotives was now paying off, despite the burden of the principal and interest

payments.

J&L had one of the most extensive intermodal networks, accounting for approximately

20% of revenues during the last few years, as compared to the Class I industry average of 10%.

Transportation of coal, however, had accounted for only 25% to 30% of freight revenues. With

the projected increase in demand for coal from emerging economies in Asia, management had

committed to increase revenues from coal to 35% within three years. That commitment was now

subject to revision due to slowing global economic activity and the recent fall in energy prices.

Exchange-Traded Contracts

J&L’s exposure to fuel prices during the next 12 months would be substantial. Matthews

estimated that the company would need approximately 17.5 million gallons of diesel fuel per

month or 210 million gallons for the coming year. This exposure could be offset with the use of

heating oil futures and option contracts that were traded on the New York Mercantile Exchange

(NYMEX) (Exhibits 3 and 4). NYMEX did not trade contracts on diesel fuel, so it was not

possible to hedge diesel fuel directly. Heating oil and diesel fuel, however, were both distillates

of crude oil with very similar chemical profiles and highly correlated market prices (Exhibit 5).

Thus, heating-oil futures were considered an excellent hedging instrument for diesel fuel.

Futures allowed market participants to contract to buy or sell a commodity at a future

date at a predetermined price. If market participants did not want to buy a commodity today

based on its spot price, the current market price, they could use the futures market to contract to

buy it at a future date at the futures price. A futures price reflected the market’s forecast of what

the spot price was expected to be at the contract’s maturity date. Many factors influenced the

spot price and futures prices, both of which changed constantly depending on the market news.

With current market conditions, the futures market was expecting price to trend up from the spot

of $1.36 to an average of $1.52 over the next 12 months.

A trader who wanted to buy a commodity would take a “long” position in the contract,

whereas a seller would take a “short” position. Because J&L’s profits fell when fuel prices

increased, the company could offset its exposure by taking long positions in heating-oil futures.

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