J&l railroad case study solution

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

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

DardenBusinessPublishing:217227 P

le as

e do

n ot

c op

y or

r ed

is tr

ib ut

e. C

on ta

ct p

er m

is si

on s@

da rd

en bu

si ne

ss pu

bl is

hi ng

.c om

f or

q ue

st io

ns o

r ad

di tio

na l p

er m

is si

on s.

T hi

s do

cu m

en t i

s au

th or

iz ed

f or

u se

o nl

y by

D el

ph in

e N

de m

an ga

A fo

r.

Page 1 of 15

-2- UVA-F-1053

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.

DardenBusinessPublishing:217227 P

le as

e do

n ot

c op

y or

r ed

is tr

ib ut

e. C

on ta

ct p

er m

is si

on s@

da rd

en bu

si ne

ss pu

bl is

hi ng

.c om

f or

q ue

st io

ns o

r ad

di tio

na l p

er m

is si

on s.

T hi

s do

cu m

en t i

s au

th or

iz ed

f or

u se

o nl

y by

D el

ph in

e N

de m

an ga

A fo

r.

Page 2 of 15

-3- UVA-F-1053

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.

DardenBusinessPublishing:217227 P

le as

e do

n ot

c op

y or

r ed

is tr

ib ut

e. C

on ta

ct p

er m

is si

on s@

da rd

en bu

si ne

ss pu

bl is

hi ng

.c om

f or

q ue

st io

ns o

r ad

di tio

na l p

er m

is si

on s.

T hi

s do

cu m

en t i

s au

th or

iz ed

f or

u se

o nl

y by

D el

ph in

e N

de m

an ga

A fo

r.

Page 3 of 15

-4- UVA-F-1053

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.

DardenBusinessPublishing:217227 P

le as

e do

n ot

c op

y or

r ed

is tr

ib ut

e. C

on ta

ct p

er m

is si

on s@

da rd

en bu

si ne

ss pu

bl is

hi ng

.c om

f or

q ue

st io

ns o

r ad

di tio

na l p

er m

is si

on s.

T hi

s do

cu m

en t i

s au

th or

iz ed

f or

u se

o nl

y by

D el

ph in

e N

de m

an ga

A fo

r.

Page 4 of 15

-5- UVA-F-1053

For example, instead of waiting two months to buy fuel on the open market at the going price,

J&L could enter into the July futures contract on April 25 to buy heating oil at $ 1.4138/gallon

(Exhibit 3). Therefore, when the contract matured in two months,2 J&L could buy heating oil at

exactly $1.4138/gallon regardless of the price of heating oil at the time. This could work for or

against J&L depending on whether prices rose or fell during the two months. For example, if at

maturity of the contract, heating oil was selling at $1.4638, J&L would have benefited by

$.05/gallon by owning the futures. If heating oil was selling for $1.3638 at maturity, J&L would

have lost $.05/gallon on the futures. In either case, however, J&L would pay exactly $1.4138 per

gallon and would face no uncertainty about the net price paid after entering into the July futures

contract.

Fuel producers or distributors who wanted to fix their selling price would take a short

position in the fuel futures. Alternatively, the seller might be a speculator who believed that the

spot price of fuel at maturity would end up being lower than the current futures price. In either

case, futures was a zero-sum game because one party’s gain exactly equals the other party’s loss.

As long as the futures price was an unbiased estimate of the future spot price, the expected

payoff at maturity was zero for both the long and short side of the contract. Thus, although the

buyer and seller were required to pay a modest fee to the exchange to enter a futures contract, no

money was exchanged between buyers and sellers at the outset. If the futures price increased

over time, the buyer would collect, and if the futures price decreased, the seller would collect.

When the contract matured, it was rare for the buyer to request physical delivery of the

commodity, rather the vast majority of contracted futures were cash settled.

NYMEX futures created a few problems for J&L management. First, because J&L would

have to use heating-oil contracts to hedge its diesel-fuel exposure, there would be a small amount

of risk created by the imperfect match of the prices of the two commodities. This “basis,”

however, was minimal owing to the high correlation historically between the two price series. Of

greater concern was that NYMEX contracts were standardized with respect to size and maturity

dates. Each heating-oil futures contract was for the delivery of 42,000 gallons and matured on

the last business day of the preceding month. Thus, J&L faced a maturity mismatch because the

hedge would only work if the number of gallons being hedged was purchased specifically on the

day the futures contract matured. In addition, J&L faced a size mismatch because the number of

gallons needed in any month was unlikely to equal an exact multiple of 42,000 gallons.

Some institutional features of NYMEX futures contracts had to be considered as well.

NYMEX futures were “marked to market” daily, which meant that every investor’s position was

settled daily, regardless of whether the position was closed or kept open. Daily marking-to-

market limited the credit risk of the transaction to a single day’s movement of prices. To further

reduce the credit risk, the exchange required margin payments as collateral. When a contract was

initially opened, both parties were required to post an initial margin equal to approximately 5%

or less of the contract value. At the end of each trading day, moneys were added or subtracted

from the margin account as the futures trader’s position increased or decreased in value. If the

2 NYMEX futures expired on the last trading day of the previous month; therefore, the July futures matured on

June 30, 2009.

DardenBusinessPublishing:217227 P

le as

e do

n ot

c op

y or

r ed

is tr

ib ut

e. C

on ta

ct p

er m

is si

on s@

da rd

en bu

si ne

ss pu

bl is

hi ng

.c om

f or

q ue

st io

ns o

r ad

di tio

na l p

er m

is si

on s.

T hi

s do

cu m

en t i

s au

th or

iz ed

f or

u se

o nl

y by

D el

ph in

e N

de m

an ga

A fo

r.

Page 5 of 15

-6- UVA-F-1053

value of the position declined below a specified maintenance level, the trader would be required

to replenish the margin to its initial margin level. Thus, the combination of daily marking-to-

market and the use of margins effectively eliminated any credit risk for exchange-traded futures

contracts. Still, the daily settlement process created a cash-flow risk because J&L might have to

make cash payments well in advance of the maturity of a contract.

In addition to futures contracts, it was possible to buy NYMEX options on the futures. A

call option gave the buyer the right, but not the obligation, to go long on the underlying

commodity futures at a given price (the strike price) on or before the expiration date. A put

option gave the buyer the right to go short on the futures at the strike price. The typical futures

option expired a few days prior to the expiration of the underlying futures contract to give the

counterparties time to offset their positions on the futures exchange. Options were offered at a

variety of strike prices and maturities (Exhibit 4). Unlike the underlying futures contract, puts

and calls commanded a market price called the premium. A call premium increased as the spread

of the futures price over the strike price increased, whereas a put premium increased as the

spread of the strike price over the futures price increased. The premiums of both puts and calls

were higher for options with more time to maturity. Thus, unlike the futures, option buyers had

to pay the premium to buy the contract in addition to both buyer and seller paying a fee for the

transaction.

The Risk-Management Group at Kansas City National Bank

Walt Bernard, vice president of the risk management group of Kansas City National

Bank, (KCNB) had recently given a presentation to J&L senior management in which he

described the wide range of risk-management products and techniques available to protect J&L’s

profit margin. Each technique used a particular financial product to hedge by various degrees

J&L’s exposure to diesel-fuel price changes. The products offered by KCNB were completely

financial in design (i.e., no actual delivery of the commodity took place at maturity). To hedge

diesel fuel, KCNB offered No. 2 heating-oil contracts, the same commodity traded on the

NYMEX. Also similar to trading on the NYMEX, working with KCNB meant that J&L could

continue to do business as usual with its suppliers and perform its hedging activities

independently.

The primary risk-management products offered by KCNB were commodity swaps, caps,

floors, and collars (see Exhibit 6 for cap and floor quotes). KCNB’s instruments were designed

to hedge the average price of heating oil during the contract period. By contrast, NYMEX

futures and options were contracts designed against the spot price in effect on the last day of the

contract. In a commodity swap, the bank agreed to pay on the settlement date if the average price

of heating oil was above the agreed-upon swap price for the year. Conversely, J&L would have

to pay the bank if the average price was below the contracted swap price. Thus, a swap was

essentially a custom-fit futures contract, with KCNB rather than NYMEX carrying the credit

risk. Because the swap was priced on the average heating-oil price, settlement occurred at the

end of the swap (12 months in J&L’s case) rather than daily as with NYMEX futures. In

DardenBusinessPublishing:217227 P

le as

e do

n ot

c op

y or

r ed

is tr

ib ut

e. C

on ta

ct p

er m

is si

on s@

da rd

en bu

si ne

ss pu

bl is

hi ng

.c om

f or

q ue

st io

ns o

r ad

di tio

na l p

er m

is si

on s.

T hi

s do

cu m

en t i

s au

th or

iz ed

f or

u se

o nl

y by

D el

ph in

e N

de m

an ga

A fo

r.

Page 6 of 15

-7- UVA-F-1053

addition, KCNB would not require J&L to post a margin but would charge a nominal up-front

fee as compensation for accepting J&L’s credit risk. KCNB was currently quoting the 12-month

swap price for heating oil as $1.522/gallon.

KCNB also offered commodity options, referred to as caps, floors, and collars. A cap was

essentially a call option; a floor was a put option; and a collar was the combination of a cap and

a floor. For a cap, KCNB agreed to pay the excess of the realized average fuel price over the

cap’s “strike price.” If the average fuel price never reached the strike price, KCNB would pay

nothing. As for any option, J&L would need to pay KCNB a premium for the cap. The cap

premium varied according to how far the strike price was above the expected price. If the strike

was close to the expected price implied by the futures contracts, J&L would have to pay a

relatively high premium. If J&L was willing to accept some risk by contracting for a strike price

that was significantly higher than the expected average price, the premium would be smaller. In

any case, the cap would allow J&L to take advantage of price decreases and yet still be protected

from price increases above the cap’s strike price.

A commodity collar was used to limit the movement of prices within the range of the cap

and floor strike prices. By choosing a collar, J&L would be selling a floor while simultaneously

buying a cap. KCNB agreed to pay the excess, if any, of the average heating-oil price over the

cap strike price. Conversely, J&L would have to pay if the average price fell below the floor

strike price. Collars could be designed to have a minimal up-front cost by setting the cap and

floor strike prices so that the revenue derived from selling the floor exactly offset the premium

for buying the cap. If J&L management wanted to guard against prices rising above a certain

price (the cap’s strike price) but were willing to give up the benefit of prices falling below a

certain level (the floor’s strike price), a collar could be the logical choice.