Sunday, 4 November 2012

Managing Fuel Price Uncertainty in Logistics

Recently the low cost carrier Allegiant Travel announced that it would like to introduce a way of sharing the risk of fuel price fluctuations with its customers. (See Businessweek) It will offer its customers to either go for a fixed high fare or choose a lower ticket price in exchange for sharing the risk that the cost of fuel may increase before takeoff. Taking the latter option customers will pay an additional amount depending on the fuel price developments in the period between booking and flying. FAA regulations don’t allow this way of pricing at this time, but things might change. In logistics carriers typically transfer the risk of severe fuel price fluctuations to their customers, the shippers, using fuel price surcharges. The use of a surcharge on the fuel price introduces uncertainty into the shipper’s decision making and exposes it to the risk of additional costs due to rising fuel prices. This risk became apparent in 2008, when fuel prices skyrocketed, causing many shippers to exceed their transportation budgets by millions of euros. To better manage this fuel price risk, shippers need to make better decisions when selecting carriers.

In a typical supply chain one or more carriers are used by a shipper to transport materials from manufacturing centers to warehouses, distribution centers and/or retail outlets. In selecting a carrier a shipper invites carriers to quote prices at which they are willing to haul loads on the lanes in the shipper’s network. Based on the quotes the shipper selects the carriers and signs a contract with them for a certain amount of time. This contract contains the agreement on the price per shipment the carrier asks for transporting the loads, consisting of a base price plus a fuel surcharge. In most cases a shipper estimates the increase in cost due to the fuel surcharge using the average fuel price of the previous year maybe with a small mark up. This is why things can go very wrong.

Let me illustrate with a small example of a shipping company that wants to organize its logistics between Amsterdam, Berlin, Paris, Madrid and Rome. Each week it is required to transport material between each pair of cities. The shipper has asked 3 carriers for quotes for the lanes in scope. The cost per kilometer, including the surcharge for fuel price is shown in the graph. For small distances (like Amsterdam-Berlin) a higher cost is incurred, than for long distance hauls. The shipper selects its carriers based on the average fuel cost of 2009 (€0.89/Liter) with a markup of 15% (resulting in €1.023/Liter) to capture the uncertainty on the fuel price. Bases on this business rule the Shipper will select Carrier 1 for its long hauls (>1000 km) and Carrier 3 for its short hauls. Now take a look at how the logistic cost develops during 2010.

Although the shipper used a markup on the fuel price to try and capture the fuel price uncertainty, it still faces an increase of weekly shipping cost during 2010 of over 4%. This is due to the way the increase in fuel price kicks in on the line haul cost charged by each of the selected carriers. At a fuel price of €1.08 and above, Carrier 1 even becomes cheaper on the short hauls than Carrier 3 which was selected initially. But at that time the shipper can no longer switch carriers. With hindsight it would have been better to select Carrier 1 for all line hauls.

Fuel prices are uncertain and cannot be influenced by shippers. But they can improve the quality of their decisions by better incorporating fuel price uncertainty. A straight forward way would be to test the robustness of their choice of carriers under various fuel price assumptions, or use more advance modeling methods like Monte Carlo simulation or Robust Optimization that explicitly incorporate the fuel price uncertainty when identifying the best choice of carriers. Also, knowing the negative effect fuel price can have on shipping cost, the shipper can negotiate better conditions on how fuel surcharges are imposed. An example could be to put a cap on the fuel surcharge at a certain fuel price level, so further fuel price are at the carrier’s risk. Again mathematical models can help both the shipper and the carrier decide what would be a fair way of sharing the risk. This of course depends on their risk appetite and the possibility to diversify this risk.