Fueling the Future: Saving strategies

With the growing instability of diesel fuel and construction materials prices, heavy equipment fleet managers must develop a strategy.

In recent years, diesel prices have cut deeply into contractors’ wallets. For instance, in 2002 the cost of No. 2 diesel soared 54 percent higher than the previous year, according to the U.S. Bureau of Labor Statistics Producer Price Indexes. And in 2005, damage from Hurricane Katrina caused the price of off-road diesel to increase 47 percent compared to 2004.

Ken Simonson, chief economist for the Associated General Contractors, believes over the next few years there will be an upward movement in the cost of diesel fuel due to the implementation of cleaner forms, such as Low Sulfur Diesel, which took effect this year for use in off-road equipment, and Ultra Low Sulfur Diesel (or ULSD), required for use in off-road equipment by December 1, 2010.

Fortunately, those in the industry can choose from an assortment of solutions to fight high fuel costs, including pass throughs, fuel price adjustments, fuel futures and call options – all of which require careful thought and planning.

Ebbs and Flows
Douglas MacIntyre, senior oil market analyst for the Energy Information Administration, says the past few years’ high prices can be attributed to Chinese demand and hurricanes in the United States. The war in Iraq has also put a strain on the nation’s fuel economy.

While diesel prices dipped in 2006 and early 2007 to hover around a little less than $2, prices have once again been creeping upward over the past few months.

The Bureau of Labor Statistics’ July Producer Price Indexes indicate off-road diesel prices have risen almost 47 cents when compared to January of this year.

According to the EIA, diesel prices will likely remain elevated as long as crude oil prices and world demand for distillates stay high. Thus, Simonson says the volatility of off-road diesel costs leaves a strain on contractors who initially quote a fixed price for a job and later have to pay extra costs because the price of fuel has jumped.

“I’m hearing reports from around the country of jobs being delayed and bids being canceled due to rising fuel costs as well as other rising materials costs,” Simonson says. “It’s not really private, but public agencies that are canceling projects.” He attributes the lack of work to bonds set years ago that won’t cover current costs.

Back to basics
To deal with diesel hikes, Glen Sokolis, president of the Sokolis Group, a fuel management and consulting firm in Warrington, Pennsylvania, says industry professionals must consider several “main ingredients” prior to selecting any cost-saving tool.

  • Understand the fuel cost breakdown
    “One of the reasons those in the construction industry pay more is a lack of understanding when it comes to fuel costs,” Sokolis states. By not knowing what goes into the final price per gallon quoted from the distributor, you risk losing money. “It’s important to identify the vendor’s cost, plus note extras such as sales tax and whatever charge he gives on top of the main price,” he says.

    Normally, Sokolis says his clients are too busy to look up industry data about the going rates. “They hear these numbers (quoted from the vendor) and take the price for granted,” Sokolis says. Knowing the correct rate for a gallon of fuel and negotiating, if necessary, will aid in obtaining a decent price.

  • Put auditing practices into place
    It’s also important to keep track of margins, fuel delivery fees and taxes. “Consulting firms come into play here – we can audit all of a construction company’s bills (in regards to fuel management) to make sure they are getting a fair price,” Sokolis says.

    Auditing also helps so tax charges not mentioned by the fuel deliverer won’t come back to haunt the buyer.

    Sokolis’ company services have three different types of fees. The first is a flat monthly fee based on the size of the account. “This could range as low as $500 a month to as high as $10,000,” Sokolis says.

    Secondly, a service fee may be derived from the percentage of what the customer saves over their benchmarked fuel cost. “This isn’t the price they are paying for fuel, but the price their supplier is buying the fuel for,” he says.

    And lastly, Sokolis says pricing may result from a combination of the monthly fee and the percentage of savings, with both costing less than using only one of these alone. “We do this with clients who want more than just low fuel cost,” he explains. “They want help with hedging programs, fuel additive programs and/or updates on the market.”

  • Track your usage
    While contractors know the amount of earth they’re planning to move, Sokolis notes they typically don’t track how much fuel it took to move the material. “Contractors usually look at dollars spent and not gallons burned on projects,” he says. But keeping up with fuel figures can save you money in the long run.

    For one thing, these records make it easier to estimate fuel costs on future, similar jobs. “This would help out with bids tremendously,” Sokolis says. Knowing a baseline price for fuel usage can also be useful if you try to pass the price on to your customers as a fuel surcharge.

    “Without these basics, contractors can’t even begin to get into hedging or fuel futures – those will just make their heads spin,” Sokolis says.

    Tony Ollmann, director at Virchow, Krause and Company, an accounting and consulting firm based in Wisconsin, also has a few suggestions for staying on budget: develop a rigorous preventive maintenance plan for fleet equipment and monitor your workers’ habits when it comes to using that equipment.

    “Both can have an impact on fuel consumption,” Ollmann says. Monitoring service intervals and matching the proper equipment to the proper job affect your usage more than you’d imagine. “Also, try to minimize your idling time,” he says.

Pass it on
Contractors working on highways or state-funded excavation projects in some states may be eligible for fuel price adjustments.

A fuel price adjustment uses a base period price or index and measures the change as a percentage or cents per gallon. If fuel prices go up, the state pays the contractor an extra amount to compensate. If prices go down, the contractor refunds the state. This same concept can be applied to general contractors’ client contracts, allowing the customer to assume part responsibility for the risk instead of the state. (See diagram on page 40 for participating states.)

“These diesel price adjustments are based on a weekly price survey carried out by the EIA,” Simonson says. The EIA gathers a sample from approximately 350 truck stops and service stations across the United States and compiles the data to produce a U.S. average price. The organization also averages prices for eight regions of the country and California, which usually has higher prices because of state taxes and supply issues.

“Generally, there are lots of similarities between truck stop diesel and off-road diesel,” MacIntyre says. “But seasonal patterns during harvest could make off-road cost more.” The EIA also relies on separate metrics for the fuels because the visibility of on-road diesel prices overshadows off-road diesel prices.

At this point no federal regulation of fuel-cost surcharges exists, so those needing relief from increased diesel fuel costs not covered by fuel price adjustments are left to their own devices. According to the EIA, many transportation companies and freight carriers reference the weekly price results for their own fuel surcharges.

General contractors wanting to cut high diesel costs can also reference these numbers, and build price adjustments into their contracts with customers. “Many contractors in Virginia are doing this,” says Ron White, chief executive officer of Superior Paving near Washington, D.C. It may take awhile, however, to educate your customer base on the way price adjustments work. “You’re basically putting a value on the risk,” White says.

“When a job is quoted, there are certain projections and if these are inaccurate, contractors must take on the risk of job profit fading,” Ollmann says. Also, letting your customers know beforehand that there may be a fuel surcharge in their contract enables them to prepare for the final project cost, instead of seeing an extra charge they weren’t aware of.

Darrell Westmoreland, owner of North State Environmental in North Carolina, uses pass throughs – as industry professionals term the price adjustment – with his customers if necessary. “If the price (of diesel) goes up more than 10 percent we renegotiate to offset the risk,” he says. Explaining this as a direct cost helps customers understand the need for a pass through. “Our clients don’t want to see us lose money – especially the repeat customers.”

Also remember, when deciding whether or not to include price adjustments in your bids, those in the private sector are often less likely to get a pass through than those in the public sector, according to White.

Hedging your bets
Further alternatives for coping with costs involve the use of financial tools and the ability to invest. “A fuel hedge is a valuable investment tool to control fuel cost increases,” Ollmann says. Hedging involves the use of financial instruments called derivatives, of which futures and options are the most widely used.

Futures entail the use of purchasing commodities to hedge (or protect against) fuel costs. The contracts span 36 months and require 42,000-gallon increments to be used on a monthly basis. This form of purchasing, also known as bulk or futures contracts, generally suits more sophisticated or larger purchasers of fuel, according to Ollmann.

“These are commodities traded on the New York Mercantile Exchange and investors can buy at a low point in the market,” Ollmann explains. “Any knowledgeable investor can do this with the help of a broker.”

Fuel futures track the price of crude oil, heating oil and gasoline, but until recently there wasn’t a diesel contract to reference on the market and interest in it has been slow to build. Instead, firms tend to use the heating oil contract as a surrogate for hedging diesel fuel prices. “Heating oil and diesel tend to move together as far as market price goes,” one consultant says.

If the volatility of diesel causes concern, investing in a futures contract will allow the fuel to be obtained at a specific price, or the strike price. If the current price rises above the strike price, the hedge benefits the investor by allowing he or she to pay the lower, set price. In contrast, when the actual price drifts below the strike price the investor must pay the original price.

Prior to locking in a futures contract, Ollmann urges construction professionals to implement a fuel cost strategy with the assistance of an experienced fuel trader. “Start by talking to your commercial banker – not your personal investment advisor- and get a recommendation,” he says.

It’s also important to make sure the implied savings from the futures contract exceed your opportunity costs, Ollmann notes. Therefore, you may not want to enter into this type of investment if you have a limited cash flow.

“With futures, there is no crystal ball,” says Joe Fell, associate equipment manager for Ryan Incorporated. “No matter what you do, you’re taking on somewhat of a risk.”

Fell believes contractors should examine how this contract will affect their ability to get work because that’s most important. “If you lock into a fuel rate and prices go down, you’ll end up paying more than you would have without the contract,” he says.

Fell admits it may be easier to pass off the higher costs to customers by placing a fuel inflator in bids.

Reality check
Having a contingency plan in place helps in times of crisis, as Marilyn Rawlins, director of fleet services for Lee County, Florida, found. “In 2004, we got slammed during hurricane season,” she says. Many local fleet agencies had fuel contracts locked in, but no one could locate a broker that had any fuel available – leaving them to scramble searching for a way to get their fleets back on the road.

Fortunately, Rawlins bought 100,000 gallons of fuel up front from her vendor. “Other agencies began calling because they were in trouble,” she says. “A lot of times in an emergency situation contracts go out the window, so what they had set up before didn’t matter.”

Rawlins’ monitors the Oil Price Index System for the purposes of her fuel contracts and has estimated that her county’s fuel cost will top out a just under $5 million next year. “OPIS documents oil prices so people can watch trends and buy fuel accordingly (through fuel futures),” she explains. “With our pricing, we give vendors some flexibility.”

For instance, Rawlins’ on-going contracts adjust based on OPIS pricing and if prices go up both she and the vendor assume responsibility. If they go down, Rawlins says the contract operates much like state DOT fuel price adjustments.

Since North Carolina doesn’t offer fuel price adjustments, Westmoreland also developed a strategy to offset costs. Previously, his company bought bulk fuel at 7,000 gallons a load to save 10 to 30 cents a gallon. “We got fuel from different distributors and it made a big difference in the past,” Westmoreland says. “But now we do a four-day work week instead.” Not having the equipment running excessively allowed a significant cost savings and the long weekends keep his employees happy. “We still get our hours in the rest of the week if we have to,” he says.

Calling on options
If pass throughs, fuel price adjustments and futures still don’t seem to be satisfactory solutions, fuel management consultants suggest one more approach.

While the techniques mentioned above offer an outlet to absorb rising prices, all of the experts we interviewed agreed that options – or more specifically, call options – might be less of a risk financially. Call options also come in 42,000-gallon increments like futures, but these have a one-time, up-front premium. Investors who use this tool want to protect themselves from prices moving higher. In exchange, if the market goes above the level of protection, investors have the right to be reimbursed.

Differences abound between call options and futures. If prices go lower and you own a call option, you still have the windfall of participating, which suits companies that want to stick to a budget or end up getting fuel for less than originally planned. “At the end of the day, you’ve capped yourself of what you are going to pay (with call options),” Sokolis explains. With futures, you have to put more money in if the market goes up and speculators (or those investing in high-risk commodities) make a profit, Ollmann says.

Both futures and options have an expiration period, but when you buy a futures contract it locks in a price, whereas an option puts a cap on the price and resembles worst-case scenario insurance.

For example, suppose you buy a call option with a strike price of $2.20 a gallon. “You’re fine if that price goes up to $3.00,” Sokolis says. “You still get the fuel for $3.00 – you pay this amount and get the rest of the money (or the $0.80 that you didn’t expect or want to pay) back from the broker afterward. So it’s like you paid $2.20 per gallon.”
Regardless of what happens, investors can opt out at any time and sell their futures contract or call option.

Asphalt woes
In addition to rising fuel costs, paving contractors have also been hit by the increase in liquid asphalt.

According to AGC’s Simonson, liquid asphalt prices soared even more than diesel in 2006. “These prices are higher than they’ve ever been historically and they have not retreated,” Simonson says.

One ton of liquid asphalt now costs around $300 to $325, White says, whereas two years ago the cost was closer to $150 per ton. Prices were stable for years, according to Margaret Cervarich, vice president of marketing and public affairs for the National Asphalt Pavement Association, but now vary by location.

As with diesel, White says some states will grant contractors a pass through on liquid asphalt price hikes.

“A 25-cent increase can be passed through to customers in many cases,” White says. What’s true for one state may vary for others, however. According to White, Virginia has been extremely accommodating because state officials see the benefit of using price adjustments.

To further reduce liquid asphalt costs, Cervarich urges contractors to stretch money by recycling old pavement. “In doing so, you’re bringing down the costs of pavement.”

Milling machines can be used to rip and break up older paved surfaces in order to produce reclaimed asphalt pavement, which suits a number of highway construction applications.

“These applications include use as an aggregate substitute and asphalt cement supplement in recycled asphalt paving (hot mix or cold mix), as a granular base or sub base, stabilized base aggregate, as an embankment or as fill material,” says Dave Newcomb, NAPA’s vice president for research and technology. In most cases processing facilities will accept the reclaimed asphalt pavement. Cervarich says recycled asphalt cement works just as well as virgin material, but using it as an additive to the mix instead of a full mix of virgin material allows contractors to stretch their dollars further.

“Every year, we remove about 90 million tons of old pavement,” Cervarich says. “About 80 percent of it now gets recycled into new pavement.” Highway departments previously used a higher grade of asphalt than was necessary, according to Cervarich. “Now it’s a matter of looking at the project and deciding what’s best.”

Although the price of liquid asphalt cement has gone up, Cervarich says this costs a minimal amount in comparison to the total price, since asphalt cement makes up only 5 percent of asphalt pavement material.

“From a national level, prices are kind of a mixed bag right now,” she says.

Proactive instead of reactive
Judging which money-saving strategy holds the best solution can be tough. Thus, your choice will be contingent upon availability and the dollar amount you can afford to spend. Fuel and asphalt cement price adjustments, pass throughs, futures and call options all have their positives and negatives. But, as Rawlins and Westmoreland demonstrate, developing your own strategy – like administering four-day work weeks or buying fuel from a variety of vendors to get the lowest price – may prove more beneficial for your situation in the long run than anything else.

One thing is for certain, industry professionals who plan ahead will be better prepared than those who sit back and simply watch the prices rise without having a game plan.

“This has been coming for years,” Rawlins says in response to high diesel costs and fuel shortages. “We’ve had advanced notice. There’s no use digging our heads into the sand and acting surprised. We need to be proactive instead of reactive.”

A lesson in financial terms

  • Security- a contract that can be assigned a value and traded.
  • Hedging- making an investment to lessen the risk of price increases. Usually a hedge consists of locking in a price in a similar security, such as a futures contract, to protect against risk. According to Investopedia, investors use this strategy in unpredictable markets, as an ideal hedge can reduce risk to nothing except the price of the hedge itself.
  • Speculation- process of choosing investments with higher risk in order to profit from unanticipated price movement.
  • Derivative- a contract (such as a futures contract or an option) between two or more parties generally used to hedge risk. This security’s price depends on or is derived from one or more underlying assets, such as bonds, stocks, commodities (fuel, for example), interest rates and market indexes. Futures contracts and options are two of the most common derivatives.
  • Financial instrument or financial tool- a real or virtual legal agreement involving some sort of monetary value.
  • Futures contract- derivative in which two parties agree to transact a set of financial tools, such as a fuel contract or an option, or to transact a set of commodities for future delivery at a specific price.
  • Call option- agreement that gives the right to buy (or “call in”) a commodity, stock, bond or other asset at a certain price within a set time frame.

Source: Investopedia

Availability of Fuel Price Adjustments by State DOTs
Data culled from FHWA Price Adjustment Survey Summary, 2005, 28 states in red offer fuel price adjustments:
New Hampshire
New Jersey
New York
North Carolina
North Dakota
Rhode Island
South Carolina
South Dakota
West Virginia

Availability of Asphalt Cement Adjustments by State DOTs
Data culled from FHWA Price Adjustment Survey Summary, 2005, 25 states in blue offer asphalt cement adjustments:
New Hampshire
New Jersey
New Mexico
New York
North Carolina
Rhode Island
South Carolina
West Virginia