If your company isn’t hedged, or hedged enough, against the recent rise in fuel costs, it’s a member of a large club. Experts say many companies have not protected their income statements against the spike in fuel-oil expenditures this year. If crude-oil prices experience another run-up from further political unrest in the Middle East, losses would climb.

Why are many finance departments unprepared? While CFOs can be excused for not foreseeing the turmoil in Egypt and Libya, the experience of 2008 also soured many on hedging. When crude oil shot to $147 per barrel and then plummeted later that year to under $35 per barrel, some companies suffered huge cash losses on fuel hedges — United Airlines, for example, lost $370 million. Many companies that bought forward contracts also got burned. Then, two years later, in the summer of 2010, low prices lulled companies into a false sense of security. “People put numbers into their budgets and then turned a blind eye,” says one market expert.

Now with crude-oil prices volatile and still not far off a two-and-a-half-year high, CFOs need to consider taking action. Luckily, it may not be too late to institute some kind of options-based protection in the event crude-oil prices continue their march northward. True, fuel prices are already high, so options strategies can be expensive. But buying forward is risky: a company could lock in at an extreme high and then see the price decline, says Bryant Lee, managing director of Viking Energy Management, a procurement and risk-management consultancy.

One options strategy Lee recommends now is a “costless collar.” With this instrument, a company sells a put (a right to sell oil at a certain price) and then uses the premium from that to buy a call (a right to buy oil at a certain price). That establishes a ceiling and floor on its fuel costs and could guard against a “complete blowout to the upside,” says Lee.

Cynthia Kase, president of Kase & Co., a boutique energy trading and hedging consultancy, agrees with Lee that options are the way to go. “There’s a trade-off between the risk of future losses and the up-front cost of hedging,” she says. While companies should base their hedging strategies on their individual business models, says Kase, “right now I would be much more of an ‘up-front cost’ person than a ‘risk later’ person — there’s just too much to risk by buying forward.”

A strategy Kase recommends is “legging into a collar,” so called because the user puts on one “leg” of the collar at a time. This involves buying a call and, if necessary, selling a put, and it requires some timing. “You don’t want to sell a put in a rising market and start losing money if the price starts to get very high,” explains Kase. So a company buys a call, and if the price goes so low that the call is out of the money, it sells a put. “But you want to wait as long as possible to sell the put,” she says.

Another way of getting around the potentially high price of options, especially for those seeking long-term protection, is to use a “swaption,” says Kase. A swaption is an early-exercise option, giving the buyer the right to enter into an underlying swap within a particular time period prior to the commencement of the swap. It’s cheaper than a plain-vanilla option because it expires prior to the commencement of the swap.

Say a company buys a swaption now at $100, for example, and the market is at $120 on the exercise date six months from now. The company would exercise the swap and be $20 in the money. In essence, it would be buying crude oil (at least on paper) from the counterparty for $100, and the counterparty would be paying back the company $120. (If the market is below $100 at the exercise date, the company would not exercise the swap and would forfeit the premium.) In the remaining 12 months, the swap would protect the company against a further rise in prices. Oil would subsequently have to fall by more than $20 for the company to lose money on the swap, not counting the premium paid for the initial swaption.

How High Can Oil Go?
Where will oil prices go from here? “[One hundred dollars] will be difficult to overcome without new outside input,” says Dean Rogers, manager of market analysis at Kase & Co. In a recent report, “How High Can Crude Oil Go?” Rogers says a correction of crude-oil prices below $94 would open the way for $88 and possibly an extension toward $78. On the upside, $120 would be a key resistance threshold, he says.

The U.S. Energy Information Administration, which doesn’t take into account market speculation, projects the price of West Texas Intermediate Crude oil will average $102 per barrel in 2011, and rise to an average of $105 per barrel in 2012. That forecast assumes real gross domestic product growth in the United States of 3.3% in 2011 and 3.7% in 2012.

Most experts concur with Kase and Lee that the current price results from hype and speculation. Oil is at a “false price,” contends Kase. “I don’t think oil should be cheap, but I don’t think it should be $100, either.”

“The markets always react very strongly to a disruption [like Libya] and then they drift back down,” says Lee. “With oil, the disruption is never going to be, ‘We discovered a 100 billion-barrel oil field in an environmentally nonsensitive place that we can bring to market immediately.'” Instead, says Lee, “Someone’s going to say, ‘We no longer have a supply problem in oil,’ and the market is going to tank.”