In this continuation of guest posts from Synaptic Decisions, we'll look at an analysis of price peg and slope, and come to a conclusion. If you missed Part 1 of this series, you can click here to read it.
The price "peg" is the minimum fuel index price for the application of the fuel surcharge schedule. When a carrier prices a base line haul rate, they "bake in" a fuel cost at the price peg. A fuel surcharge applies above the peg. Below the peg, the fuel surcharge is zero and the carrier keeps all of the fuel savings. The peg is important and attempts by carriers to raise the peg should be scrutinized. When diesel prices surged to over $4 a gallon in the summer of 2008, many carriers approached shippers with new schedules having a higher peg, offering to keep the total line haul price the same (or adjusting it slightly lower). For example, if a carrier raised the peg from $1.20 to $2.50 they would raise the line haul rate to account for baking in an extra $1.30 per gallon of fuel costs. The new fuel surcharge would be lower by that amount as well. The total rate (base rate plus fuel surcharge) would remain the same. With the total rate unchanged, should a shipper be indifferent? No. Carriers are subtly capturing additional value.
Here's the reason. Again, below the peg, there's no surcharge, and the carrier captures added profit through fuel cost savings. This financial exposure is identical to a put option on diesel price with a strike price equal to the peg. The "time value" of the carrier's put option increases when the peg (strike price) is closer to the prevailing index price. The reason is that there is a higher probability that the index will fall below the peg (strike price) and the carrier will capture fuel cost savings. When diesel prices are $4.00, a put option with a strike price of $1.20 has little to no time value, but a put option with a strike price set at $2.50 has a lot more time value.
The fuel surcharge slope is the incremental change in the surcharge with an incremental change in the index. The fuel efficiency offered to the shipper by the carrier can be derived using the slope of the schedule and other data. Ignoring for a moment the carrier's empty miles on backhauls, in a mileage based fuel surcharge schedule, the implied fuel efficiency is 1 divided by the slope. For example, if the surcharge changes by one cent per mile for every 4 cents per gallon change in the index, the slope is 0.25 -- and the implied fuel efficiency offered by the carrier is 4 miles per gallon. If the empty mile % is 15%, the adjusted implied fuel efficiency is 4.7 mpg. The math is slightly more complex (but easily done in Excel) with an invoice based fuel surcharge schedule.
So if a van carrier with an actual fuel efficiency of 6.5 mpg offers the shipper a fuel surcharge schedule with an implied fuel efficiency of 4 mpg, they can capture 37% added value. If the shipper moves 10 million miles per year and fuel is $3.00 per gallon, the carrier can capture an additional value of $2.8 million per year. The value increases with increasing revenue-miles and higher fuel pricing. After adjusting for empty miles (most van trucking carriers have no more than 15% empty miles), the added value captured by the carrier is still at least $1.75 million per year.
Average fuel efficiency for a carrier's entire traffic portfolio is driven by the following:
- Mix of trip miles (short hauls are less fuel efficient)
- Empty mile % (non-revenue miles driven between a load drop off and the next load pick up)
- Traffic (metropolitan area routes are less fuel efficient)
- Driving practices (e.g., speed control, idle management, tire pressure maintenance, etc.)
- Other (truck class, load weight, equipment aerodynamics and technology, etc.)
There are benchmarks. For example, Class 8 Trucks operated under good driving practices in non-metropolitan areas can achieve fuel efficiencies exceeding 7.0 miles per gallon. So shippers should pay attention to the slopes of their carriers' schedules. It says something about the fuel efficiencies being offered by carriers. The best carriers are continuously striving to raise their fuel efficiencies. (Note: There are ways to discover a carrier's true fuel efficiency, but that's beyond the scope of this article.)
The fuel surcharge schedule is a key tradable in transportation contracts. It can and should be negotiated along with other key tradables of the deal. Consider the following before agreeing to your carriers' fuel surcharge schedules:
- Move to a mileage based schedule: Especially if you have material short haul business
- Match fuel indices to your shipment regions: Consider appropriate regional PADD indices
- Remember that the peg price is an option strike price: All other things being equal, a higher peg means a higher value for the carrier (you can eliminate this by getting a rebate when the index falls below the peg)
- Set a slope that reflects a higher fuel efficiency target: Consider benchmarks and understand contractual methods to incentivize your carriers to achieve higher fuel efficiencies
Spend Matters would like to thank Synaptic Decisions for their analysis. If you're interested in exploring the intersection of commodity strategy, sourcing, hedging and risk management, you owe it to yourself to reach out to Synaptic's Rob Endres, a true expert in the area: rendres (at) SynapticDecisions (dot) com