A Cap is a paper hedge agreement designed to protect you from rising prices, yet allows you to benefit from falling prices. Also known as “call option”.
Here’s an example of how it works. To begin, you and Global agree upon:
THE MONTHLY VOLUME
AN OFFICIAL ENERGY PRICE INDEX (PLATTS/ARGUS)
A HEDGING PERIOD (E.G. 2 MONTHS)
A CAP PRICE (E.G. 110 PER TONNE)
AN UPFRONT PAYABLE INSURANCE PREMIUM
Monthly average settles at 95 per metric tonne (15 below the cap level). There is no settlement of the Cap, so you will take advantage of the lower spot prices.
Monthly average settles at 125 per metric tonne (15 above the cap level). Global pays you 15 per metric tonne in cash, compensating you for the increase in spot prices.
Protection against increasing prices, yet benefit from falling prices
Maximum payment from you to Global is the insurance premium
At the end of each calendar month, the settlement amount is based on the difference between the monthly average of the price index - and the Cap price
Two good reasons to use this strategy:
- Rising fuel prices would seriously undermine you business
- You would like to benefit from falling prices after having fixed your maximum fuel prices
Protection from price increases, benefit from falling fuel prices & flexibility in physical supply
Premium upfront & potentially some basis risk