Guidebook for Evaluating Fuel Purchasing Strategies for Public Transit Agencies (2012)

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66 A p p e n d i x A Case Studies Case studies of fuel purchasing strategies were developed for fifteen transit agencies across the United States and Canada based on interviews with transit agency representatives. In general, commonalities are greatest among case studies with similar geographic region and fuel purchase volume. As such, case study pages are shown below organized by these categories. Case Study Region, Fuel Purchase Volume, and Page Small = <1 million gallons per year Medium = 1 to 10 million gallons/year Large = >10 million gallons per year Region Fuel Purchase Volume Transit Agency Page East / South Small Anonymous Gulf Coast Transit System Small Birmingham-Jefferson County Transit Authority Medium Hampton Roads Transit Medium Nashville Metropolitan Transit Authority Large Southeastern Pennsylvania Transportation Authority Large Houston METRO Midwest Small Sioux Area Metro Medium Minneapolis-St. Paul Metro Transit Medium Greater Cleveland Regional Transit Authority Medium Greater Dayton Regional Transit Authority Large Chicago Transit Authority Large Greater Toronto and Hamilton Area Metrolinx/GO Transit West Medium BC Transit Large King County Metro Transit Large Denver Regional Transportation District 66 71 74 77 81 84 88 91 95 99 103 109 113 117 119 Anonymous Gulf Coast Transit System Summary Location: Gulf Coast Region Fleet: 67 diesel buses (35-foot to 40-foot full-size buses) and 17 paratransit vehicles (14 gasoline and 3 diesel)

Case Studies 67 Fuel Volumes: • transit system: Diesel – 624,445 gallons (FY 2009), Gasoline – 9,407 gallons (FY 2009) • city: Diesel – approximately 600,000 gallons, Gasoline – 600,000 gallons The transit system is one of more than 30 departments of the city and serves an area covering approximately 100 square miles. The city provides its residents all of the public utilities. The elec- tricity generation plants are the city’s major user of diesel and natural gas fuels. The transit sys- tem used 624,445 gallons of diesel fuel in FY 2009 at a total cost of $1,314,041, or an average price of $2.10 per gallon. The transit system’s FY 2009 gasoline usage was 9,407 gallons at a total cost of $23,611, or an average price of $2.51 per gallon and the current fuel budget is approximately $2 million. For comparison, the city’s total energy budget is $175 million, so the transit system’s fuel does not represent a major portion of the budget. The city’s FY 2009 fuel use, excluding the transit system, totaled approximately 600,000 gallons of diesel and 600,000 gallons of gasoline. The non-transit system fuel use is for over 2,000 city vehicles, including solid waste collection, utility, police, construction, street and drainage, emergency response, and administrative. Delivery Price Risk Management Fuel Contracting Diesel. Prior to 2009, the transit system purchased fuel using fixed price contracts with a local supplier. The city secures a new fuel purchasing contract through a competitive bid pro- cess every two or three years. Due to geographic location and the fact that all fuels are piped or trucked into the area, the city has only had one fuel supplier respond to the bid since the 1990s. Pricing for delivered diesel fuel is based on the Oil Price Information Service (OPIS) price plus a margin, currently $0.05 per gallon. The transit system is one department on the city’s fuel con- tract, so the city ultimately makes the fuel supply purchasing decisions. The transit system has an open purchase order on the city’s contract for purchasing diesel and gasoline fuel. The transit system’s energy costs on this contract are a direct pass through without an additional user fee. Natural Gas. In 1991, the city purchased natural gas for the electric and gas utilities from the pipeline company. Following industry deregulation, the city’s natural gas purchasing has been done with individual contracts with suppliers for various terms (short-, mid-, and long-term). In early 2002 the city saw a need to diversify fuel suppliers and enhance counterparty creditworthi- ness. A risk management program was initiated and using hedging as a financial risk manage- ment tool began to be investigated (see Commodity Price Risk Management section). Pooling The city does not participate in a fuel purchasing cooperative as there are no candidate orga- nizations to work with. However, a number of large local entities, including universities and large industrial customers, purchase fuel on the city’s contracts, so the total volume is increased. The combined fuel use is sufficient for the city to negotiate acceptable prices with suppliers and allows for maintaining control over all areas of fuel purchase decisions and acquisitions; as such, participation in a cooperative would not likely help to significantly reduce costs. The local enti- ties benefit from the city’s fuel purchasing activities which bring about budget certainty to their operations. Commodity Price Risk Management History Early in 2002, the energy services department hired a financial consultant to evaluate the city’s energy risk management policy and procedures. The consultant suggested utilizing financial tools

68 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies such as hedging on the New York Mercantile Exchange (NYMEX) to lock in fuel prices. This approach required the city to fund a NYMEX margin account for a percentage of the total hedged purchase costs. The preparatory work of the energy services department hedging program was overseen by the city’s Energy Risk Policy Committee (ERPC). The group is composed of city- appointed officials and executive staff from the city’s utility, financial, and administrative units and answers to the city commission. The coordination resulted in the city commission’s February 2002 approval for “[A]n Energy Risk Management Policy and Procedures providing for use for hedging purposes of energy commodity futures and options contracts (“hedge transactions”) on the New York Mercantile Exchange (“NYMEX”).” The hedging policy outlines the allowable hedg- ing practices and includes trade limits for volume, future, and time limits. The financial consultant stressed that the policy language state that the purpose of the hedging program is a budget certainty tool, not an investment tool. The next step in the process was to locate a brokerage firm to actually execute the trades. The city issued a bid and selected a full service brokerage firm in April 2002 with competitive commissions. Another company was hired at this time to supply consulting services related to financial risk evaluation of the city’s overall energy supply portfolio as well as to provide assistance in developing program strategies and tracking hedge transactions. The city began hedging natural gas, used for power generation, in February 2003 on the NYMEX to lock in prices and allow the city to avoid supplier and third-party counterparty risks. The city started with $20 million in the margin accounts and later increased the quantity to approximately $30 million (10% of the hedged fuel cost). Hedging on the NYMEX requires cash in a margin account as there is no credit on the NYMEX. Since the city was using more than $150 million of natural gas annually, the $30 million margin account was inadequate to hedge beyond two years. The city needed to hedge for longer terms, so the energy services department pursued other hedging methods. The city decided to use over-the-counter (OTC) swap con- tracts, rather than exclusively trading on the NYMEX. The city received approval in 2006 to allow hedging with a counterparty using OTC forward pricing contracts. In 2006, the city utilized International Swap Dealers Association (ISDA) contracts to execute OTC transactions. OTC swap contracts are available for a range of commodities, including natural gas. All transactions are financial, not physical, and do not involve delivery. The counterparties negotiate various credit limit levels based on ratings by Standard & Poor’s and Moody’s. The city did not hedge diesel or gasoline purchases until its fuel budget, including the transit system’s, was significantly impacted by the 2008 fuel prices spike. The budget was negatively impacted during a bad economic time, but the city was able to absorb the transit system’s 2008 fuel cost increases in the short-term. The city evaluated the available cost control options for its liquid fuel (diesel and gasoline) purchases and in 2009, the city began purchasing and hedging its liquid fuel purchases for all of its departments, including the transit system. Unfortunately, long-term fuel supply contracts were difficult to secure during this period due to volatility and rising fuel prices. The city waited until fuel prices decreased to begin hedging diesel and gasoline purchases. After fuel prices decreased in 2009, the city initiated hedging of diesel and gasoline, including for the transit system. (Note: since fuel purchasing and hedging is done by the city for all of its departments, including the transit system, the remaining discussion of the city’s hedging program includes the transit system’s fuel use, so the transit system is not dis- cussed separately.) The approvals for hedging and the program structure (i.e., financial advisor, hedge broker, and funded margin accounts) were already in place because of the natural gas hedging program, so the city added an additional account in 2009 to begin hedging its diesel fuel purchases. Strategy The city has 300,000 barrels of storage capacity for No. 6 residual fuel oil (heavy diesel) and diesel that is used by power generation plants. The transit system’s storage capacity is much

Case Studies 69 smaller with 20,000 gallons of diesel (approximately 1.3 weeks’ usage) and 10,000 gallons of gasoline (approximately 3 months’ usage) storage. Onsite storage is a hedge in itself, but the vol- umes are not sufficient for long-term hedging; instead the city’s financial hedging instruments are the primary hedge program tools. The city’s hedging program relies on mean reversion analysis, a mathematical concept that is typically used for analyzing stock investments, but can also be used for other assets such as fuel. The city researches a commodity’s historical prices and identifies the high and low prices. These are compared to the commodity’s average price. Mean reversion analysis assumes that the high and low prices are temporary, and that prices will eventually gravitate towards the aver- age (mean) price over time. In practice, for each point a commodity price decreases the city purchases larger volumes of this commodity for a longer time horizon. As a commodity price increases, the city purchases lower volumes for a shorter time horizon. The city uses forward pricing contracts rather than options. Options provide a range of stabil- ity, but not cost certainty. Forward pricing contracts provide both stability and cost certainty. Hedging contracts typically include a premium for the price certainty they provide; the farther out the hedge, the higher the implied premium. The city has eight to ten accounts for hedging on the NYMEX. One account hedges the transit system’s diesel purchases with No. 2 heating oil futures. The heating oil index is used because the prices of diesel and No. 2 heating oil are highly correlated and generally track each other. The city hedges gasoline purchases with gasoline futures and hedges natural gas purchases for power generation with natural gas futures. The city currently hedges approximately 90% of its gasoline, diesel, and natural gas purchases. It does not hedge 100% of fuel demand to provide flexibility in case demand decreases. The remaining 10% of fuel purchases are purchased on the spot market. As of September 2010, the city has hedged its diesel and gasoline fuel purchases for 18 months out (until March 2012) utilizing a series of one month contracts. Each contract is at a different price, but the overall average fuel price is $1.50 per gallon for diesel and gasoline. The city’s natural gas purchases are hedged for 24 months until September 2012. Using this method- ology, the city has achieved a high level of budget certainty, and as fuel prices increase so do cost savings. Such budget certainty is important for the city because operating expenses for fleet and bus services are fixed in the short-term because of the annual budget; deficiencies must therefore come out of the general fund. Approval and Execution Process Daily execution of the hedging program is done by the Energy Services Department. The group operates within the scope of the hedging policy defined in the Energy Risk Manage- ment Policy and Procedures and communicates closely with the Superintendent of Tran- sit Maintenance for planning purposes. The city’s acquisition timing for executing hedging contracts is not fixed, but rather takes into account market, weather, and other factors. For example, spring fuel prices are historically lower right before summer, and February and March prices are lower if followed by a mild winter. As previously mentioned, in Septem- ber 2010, the Energy Services Department observed what it determined was advantageous pricing on fuel and hedged until March 2012 (18 months out) at an average cost of $1.50 per gallon of both diesel fuel and gasoline, so there will not be much hedging activity for 6 months. If in 6 months the price falls below $1.50, the city will discuss whether it wishes to lock in prices further out. The city has an annual contract with the financial consultant who provides market and credit evaluations. The Energy Risk Policy Committee provides oversight and accountability of the Energy Services Department. The consultant provides an independent perspective,

70 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies and provides third-party information for the city’s hedging activities and assurance to the city Commission that the program is on track. The group develops a plan for the hedge pro- gram for the next quarter or longer and uses scenario analysis to determine how to manage uncertainty. At the beginning of each fiscal year, the transit system opens a purchase order on the city’s fuel contract for, purchasing fuel on the same schedule each month. At the end of the month, the city Financial Department notifies the transit system Superintendent of Transit Maintenance of the hedge fund status, and whether to add or subtract an amount to that month’s fuel invoice to balance the fuel account. Results Since the transit system’s hedging program began, fuel hedging has saved the fleet approxi- mately $20,000 to $30,000 per month. In 2009, over the time the hedge was active, the transit system saved roughly $116,000. The hedging activity has saved the city over $60,000 per month. Just as importantly, however, the city has seen that hedging provides budget certainty, reduces volatility, and protects against extreme fuel price shocks. The city has found that purchasing from the spot market could provide a lower cost, but this increases price volatility. Overall, the hedging program has successfully mitigated price volatil- ity as intended. There has been a positive impact on average fuel prices, and it is believed that hedging will continue to have a positive impact. The city’s hedging of the transit system’s diesel fuel was very successful. It was fortunate, through good timing and planning, to purchase futures contracts during early 2009 when fuel prices had reached a low. The hedging program has also simplified the fuel purchasing process for the superintendent of transit since the fuel contract and hedging program are operated by the city. Tips for Success Diversification Is Necessary Through its experience with volatile energy markets in 2001, the city discovered the need to diversify its resources and to fix prices when necessary for budget certainty. The city determined that working with multiple larger-sized, creditworthy counterparties is a must. The city found that utilizing NYMEX and ISDA forward pricing contracts provided the city with many options for attaining the high degree of budget certainty it desired. Hedging Program Guiding Policies and Oversight Are Needed The agency must have an oversight committee, policies, procedures, and a clear strategy on which to base and evaluate decisions, as well as a strategy for managing unexpected circum- stances such as significant market fluctuations or the disappearance of one’s counterparty. Fuel Price Certainty through Energy Price Risk Management Is Good Since the hedging program started in 2009, the transit system has saved money by avoiding the price increases taking place in the fuel market. As shared by the superintendent of transit maintenance, “the most important aspect has been the ability to budget for fuel and be fairly confident that it will not be a show stopper budget item.” Effective Policies and Procedures Are a Must, Including Energy Risk Management Policy and Procedures Having these items in place enables oversight by all entities including the Energy Rick Policy Committee, formalizes the process, and is useful for succession planning.

Case Studies 71 Interdepartmental Discussions Regarding Hedging Program Purpose and Structure Is Key Interdepartmental communication about the purpose and operation of the hedging program was vital when the transit system was included in the city’s program to explain the program to all involved staff. Birmingham-Jefferson County Transit Authority (BJCTA) Summary Location: Birmingham, Alabama Fleet: 83 buses: approximately 22 35-foot and 20 30-foot diesel buses (FY 2010), 36 35-foot compressed natural gas (CNG) buses, and 5 paratransit vehicles Fuel Volumes: Diesel – 377,000 gallons (FY 2009), natural gas – 120,000 gasoline gallon equiva- lents (GGE)1 (FY 2009) Birmingham-Jefferson County Transit Authority (BJCTA) is the public transportation author- ity that provides fixed-route and demand response service (paratransit) to various municipalities including Birmingham, Bessemer, Fairfield, Homewood, Mountain Brook, Hoover, and Vestavia Hills. The service area includes more than 200 square miles and serves a population of nearly 400,000. Approximately 56% of BJCTA’s transit bus fleet is diesel powered; the remaining 44% is CNG powered. BJCTA began purchasing CNG buses in 2000 to replace diesel buses and plans to transition the entire fleet to CNG buses to reduce its environmental footprint and to improve local air quality. As part of its commitment to this goal, BJCTA owns and operates its own CNG fueling station on the fleet’s property. The station is accessible 24/7 to municipalities, commercial vehicles, and to the public. BJCTA is on target to have the fleet converted to CNG by the end of 2014. The diesel bus fleet used approximately 377,000 gallons of diesel fuel in FY 2009, at a total cost of $1.53 million, and an average cost of $4.04 per gallon. Delivery Price Risk Management Fuel Contracting Diesel. Until 2006, BJCTA used Oil Price Information Service (OPIS) rack pricing plus dif- ferential (includes delivery and profit) for purchasing diesel fuel. Suppliers were selected through an RFP process. Prices were based on the weekly rack price plus a fixed-fee incremental cost for delivery. Starting in 2006 BJCTA realized that the correlation between market prices and the rules of supply and demand were beginning to change. The agency found it more difficult and expensive to lock in low prices with local suppliers because diesel fuel prices at the time were volatile and were becoming increasingly more so because supplies were affected by Hurricanes Katrina and Rita. BJCTA exceeded its fuel budget by $1 million in 2006. This overrun was partially offset by previous savings reserves and additional contributions from the municipalities BJCTA serves through hourly rate increases. As petroleum fuel prices and volatility continued to increase dra- matically in 2006, BJCTA’s procurement officer recommended that BJCTA begin utilizing fixed- price contracts for hedging to protect the agency from even higher fuel costs and to enhance 1GGE is a method to normalize the usage of multiple fuels by their energy content (i.e., British thermal units per gallon, or Btu/gal] using gasoline as the baseline. For example, diesel fuel has an average energy content of 128,400 Btu/gallon while gasoline has an average energy content of 115,000 Btu/gallon. Thus one gallon of diesel fuel has equivalent energy content of 1.12 gallons of gasoline [i.e., 128,400 Btu/gal divided by 115,000 Btu/gal = 1.12])

72 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies budget certainty. The BJCTA procurement officer gave a presentation to the board of directors to educate the members on how forward pricing mechanisms (i.e., hedging) can be used as a budget risk reduction tool to manage price variability and the cost/budget uncertainty associ- ated with the diesel fuel purchases. The board of directors agreed that budget certainty was key and agreed that including hedged fixed-price contracts in the agency’s fuel purchase strategy had merit. BJCTA recognized that fixed-price contracts were the best approach for balancing simplicity, flexibility, and allowable activities regarding investments as established by the Federal Transit Administration. BJCTA approached its supplier to discuss its willingness and ability to offer fixed-price fuel contracts. BJCTA’s supplier is based in Wisconsin, but fuel is delivered from Atlanta, Georgia. The supplier had recently begun servicing BJCTA on a three-year contract that had just started a new contract period. The supplier educated BJCTA on how its fixed-price program worked. The sup- plier operates an in-house hedging program and purchases futures contracts for No. 2 heating oil indexed to the NYMEX to hedge its diesel fuel purchases. The heating oil index is used because the prices of diesel and No. 2 heating oil are highly correlated and typically track each other. This in-house hedging program allows the supplier to offer fixed-price contracts to customers. Each fixed-price contract with customers is for the same amount of fuel that is covered by one futures contract (42,000 gallons). Therefore, the fleet is obligated to purchase this amount of fuel. The fixed-price fuel contracts are arranged by the fleet in the same manner as conventional fuel con- tracts. The fleet calls the supplier to request a price for a certain number of contracts during a certain period and has the option to accept or refuse the offer. The hedged fixed-price contracts are treated just like other contracts or procurements, so even though the supplier is hedging its own position, it is a regular contract for BJCTA. The result of this fuel purchasing option is that BJCTA realizes the fuel price stabilization of fuel hedging without having to operate an in-house hedging program. This method means that the agency does not have the administrative and margin account burden from operating its own program. The supplier has the administrative overhead for the program operation and also assumes the risk for maintaining the margin account. These costs are passed on to BJCTA as a premium, or fee, which is included in the agreed upon fuel price and fuel volume requirement. BJCTA initiated a trial program using the hedged fixed-price contracts in late 2006 by pur- chasing three contracts (42,000 gallons each) to cover 100% of its anticipated three month fuel use. The performance was evaluated and the fleet was pleased with the performance, so it initi- ated a longer six-month, fixed-price contract in 2007 for further evaluation. The six-month trial was also successful, so BJCTA included fixed-price contracts in its available fuel purchasing options. The agency was not required to use fixed-price contracts, so it could purchase as much fuel as it wished using fixed-price contracts. The remaining fuel purchases would be made using OPIS rack pricing plus a differential. Natural Gas. BJCTA has purchased natural gas from the same natural gas supplier since 2000. The supplier provides natural gas to customers at different price levels based on the type of account. BJCTA does not have a contract in place for the natural gas fuel supply, but the agency receives a rate which has lower supply costs than a commercial account would. The resulting cost is approximately half the cost of diesel for an equivalent amount of energy. BJCTA has also received a $0.50 credit from the Internal Revenue Service (IRS) for each gasoline gallon equiva- lent (GGE) of natural gas used for the last three years (even though BJCTA does not pay federal taxes) which further decreases fuel costs. BJCTA did not see much change in natural gas costs during the petroleum fuel spike that occurred in 2007 and 2008, and is pleased with the lack of volatility as well as the lower costs.

Case Studies 73 Approval and Execution Process BJCTA did not require board approval before it began using the fixed-price contracts. The fleet also noted that board approval would not be necessary if it decided to initiate an in-house hedging program. The BJCTA executive director and the procurement officer work together to develop the annual fuel purchases budget based on historical and future fuel requirements and fuel cost expectations. The executive director then presents the recommendations for future actions and methodology to the board of directors for approval, including the pursuit of long-term contracts and the decision to renew an option year for the fuel supplier contract. The procurement officer is responsible for generating reports on the programs’ status and results, and for monitoring the energy markets. The supplier provides recommendations, but BJCTA also subscribes to the OPIS price reports and reviews the daily closing rack prices to track diesel costs on its own. The fleet is comfortable with this level of information so does not use a third-party financial advisor. BJCTA’s supplier does not disclose what its fee is, so BJCTA compares the rack price to what its supplier’s delivered fuel price is to determine if the price being offered is reasonable. This information keeps the agency up to date on the market activity and gives them the knowledge about when to accept the supplier’s recommendations to lock in prices again with one or more contracts. Once a purchase decision is made, the procurement officer contacts the supplier to place an order for the required number of contracts at the agreed upon price. Once the contracts are in place the BJCTA purchasing department can order fuel as it is needed. Results Diesel. Following the budget overrun in 2006, BJCTA’s biggest concern was experiencing another round of fuel price increases that would affect the budget in a similar manner. Enter- ing into fixed-price fuel contracts for 100% of its diesel fuel requirements enabled the agency to achieve a significant level of budget certainty. Budget certainty is the metric for evaluating fuel purchasing program effectiveness. The agency does not compare the money saved/lost relative to what would have been spent if purchasing at the rack price. In late 2007, when oil was over $100 per barrel, BJCTA locked in from October 2007 to March 2008 at $2.30 per gallon. The next fixed price contact was locked in from April 2008 to December 2008 at $2.92 per gallon. Rack prices during this timeframe went over $5.00 per gallon. In both cases, BJCTA achieved the goal of obtaining fuel price certainty. Additionally, in 2008 the fixed-price contract saved the agency a large amount of money. During the April 2008 to December 2008 time period oil prices increased above $112 a barrel and the fleet was not certain prices would not continue to rise. The agency had to attain fuel price certainty even if it meant that it was not purchasing fuel at the lowest cost. The result was that BJCTA locked in prices from January 2009 to December 2009 at $4.04 per gallon. Influenced by the economic downturn, rack prices fell below $2.00 per gallon during this timeframe.2 Witnessing lower rack prices, BJCTA discontinued covering future purchases with fixed-price contracts and resumed purchasing all of its fuel needs in 2010 at OPIS rack pricing plus a differential ($0.0273 per gallon). BJCTA’s tracking of the OPIS price reports will inform the fleet on when to consider locking in prices again with fixed-price contracts. BJCTA made up some of the expense of its locked-in diesel prices during the economic downturn because natural gas prices decreased and natural gas use increased as the CNG bus fleet grew. This resulted in decreased diesel utilization and costs. There is concern that the fleet’s lower diesel fuel usage will not be high enough for the agency’s supplier to continue offering BJCTA a fixed-price contract purchasing option. 2Prices include delivery charges and the agency’s supplier’s premium for fixed-price contracts

74 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies Natural Gas. BJCTA is also managing its future fuel costs by diversifying the fuels used by its buses, in this case by replacing diesel buses with CNG buses. BJCTA has found that natural gas prices are approximately half the cost of diesel and are less volatile than diesel as well. By increasing its CNG bus fleet, and thus its natural gas fuel use, BJCTA expects to decrease future fuel prices, volatility, and budget deficits. In addition, the IRS natural gas usage tax credit saved BJCTA approximately $500,000 last year. As BJCTA replaces more and more of its diesel buses with CNG buses, diesel fuel use will continue to decrease. As a result, the agency may continue to rely on purchasing diesel fuel at rack prices and accept the possible volatility and budget un- certainty for this portion of its fuel budget, rather than using fixed-price contracts which include a cost premium. Pooling BJCTA does not participate in any cooperative arrangements with other agencies in the Birmingham area because it believes that the agency will not receive better price offers than it already does. Commodity Price Risk Management BJCTA does not operate a fuel hedging program. Instead, as discussed above, its fuel vendor hedges its bulk fuel purchases and passes the cost of its hedged position on to BJCTA. The vendor tracks markets and makes recommendations to the transit agency, which has the discretion to act on or reject the recommendations. This allows BJCTA to benefit from fuel hedging without operating its own program. Tips for Success Consider the Best Way to Assess Diesel Fuel Market Risk BJCTA found that assessing diesel fuel market risk has been difficult. BJCTA indicated that starting in 2006 fuel prices have had a closer relationship to the stock market and fluctuations than to the traditional rules of supply and demand. This made it more difficult to attain fuel- price stability than in prior years when traditional forward pricing contracts met the agency’s needs for budget certainty and acceptable costs. BJCTA believes that there are several methods that can be used to achieve fuel-price stability and certainty, so it feels that transitioning its diesel buses fleet to CNG buses will allow it to reduce fuel prices and fuel price volatility. Use Forward Pricing Mechanisms as Insurance BJCTA approached its board of directors for approval of fixed-price contracts as insurance against unexpected and significant fuel price increases. There is a cost for this “insurance” and the agency is primarily evaluating the program based on operating within budget rather than on how much money is saved. Hampton Roads Transit (HRT) Summary Location: Hampton, Virginia Fleet: 185 diesel full-size transit buses, 26 diesel hybrid-electric full-size transit buses, 3 paddle- wheel ferry boats. Fuel Volumes: Diesel – 3.0 million gallons (FY 2009), Gasoline – 0.5 million gallons (FY 2009) Hampton Roads Transit (HRT) is a Virginia state agency and regional public transportation provider that serves seven cities spanning approximately 375 square miles and serving a population

Case Studies 75 of 1.3 million.3 HRT’s fleet consists of 185 diesel transit buses, 26 diesel hybrid-electric buses, and three 150 passenger paddle-wheel ferry boats.4 HRT will continue to add to its diesel hybrid-electric bus fleet and, starting in 2011, will have a light-rail component as well.5 During FY 2009, HRT used just over three million gallons of diesel fuel at an average cost of $3.00 per gallon, and approxi- mately 528,000 gallons of gasoline at an average cost of $2.58 per gallon. Together, these represent approximately 11% of HRT’s annual budget.6 One third of HRT’s funding is from the federal gov- ernment. HRT utilizes vendor-arranged fixed-price contracts to lock in prices and achieve budget certainty, and it also takes advantage of the spot market when it is to the agency’s advantage. HRT’s budget was adversely affected by buying fuel at the Oil Price Information Service (OPIS) price during FY 2006. HRT does not have a dedicated funding source, so in situations where the agency exceeds its budget, it must request funding from its jurisdictions. HRT is not allowed to make a profit. At the end of the year, HRT works with the local jurisdictions it serves to determine what payments between the groups are necessary to balance the previous year’s fuel purchases. An active proposal to restructure this agreement to allow the agency to make a profit, and thereby build some operating reserves, is under discussion. Delivery Price Risk Management Fuel Contracting HRT utilizes fuel vendor-arranged fixed-priced contracts to control fuel costs. Prior to 2007, HRT fuel contracts were set for purchasing on the spot market at Oil Price Information Service (OPIS) prices. This method worked well until FY 2006 when HRT exceeded its fuel budget by $1.5 million when fuel prices increased significantly faster than expected. This experience was the catalyst for HRT to evaluate new fuel purchasing options to more effectively control fuel costs. In response, HRT issued a request for proposal to fuel suppliers in 2007 for a dual-price quote that included two purchasing options: 1) a fixed-price contract option, and 2) an option to pur- chase on the spot market using OPIS prices. The goal is to strategically use both options, with fixed-price contracts being used to lock in fuel prices when management believes they are likely to increase. The use of fixed-price contracts is meant to create price and budget certainty, protect against extreme fuel price fluctuations, reduce volatility, and save money when possible. Locking in fuel prices provides HRT with budget certainty, which is a necessity for an agency without a dedicated funding source. The current fixed-price fuel purchasing contract was signed in 2007 with a fuel supplier. The supplier operates an in-house fuel hedging program to hedge its diesel fuel purchases.7 This in- house hedging program allows the supplier to offer several fuel purchasing risk management options to its customers including fixed-price contracts, fixed-price contracts with downside protection, cap contracts, collars, and swaps. This method means that the agency does not have the administrative and margin account burden from operating its own program. The supplier has the administrative overhead for the program operation and also assumes the risk for main- taining the margin account. These costs are passed on to HRT as a premium, or fee, which is included in the agreed upon fuel price and fuel volume requirement. The result of this fuel pur- chasing option is that HRT realizes the fuel price stabilization of fuel hedging without having to operate an in-house hedging program. 3http://www.gohrt.com/about/ 4http://www.gohrt.com/services/paddlewheel-ferry 5http://www.gohrt.com/about/go-green/ 6Hampton Roads Transit, Consolidated Financial Statements Years Ended June 30, 2009 and 2008, January 13, 2010 7PAPCO, Inc., Distillate Supply and Risk Management Programs, http://www.papco.com/price-programs.html

76 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies Strategy & Risk Management HRT noted that the fuel market in recent years has not followed the fundamentals of supply and demand, but rather has been closely following the stock market. This is problematic because stock market performance has been based on perceptions and not reality, so rationality has been eliminated. HRT’s chief budget officer and director of procurement monitor fuel market information by tracking OPIS prices and the fuel market, and use this information to determine when to lock in fuel prices with fixed-price contracts. HRT’s supplier also tracks the fuel markets and makes fuel purchase timing recommendations to HRT, which the fleet can either approve or reject. The supplier’s advice has been good most of the time and has worked for HRT. HRT continues to work with the supplier to improve fuel price certainty. Should HRT misjudge the market and fuel prices increase beyond the budget, it may have to approach the jurisdictions it serves for financial assistance. This can be difficult due to tight budgets. HRT fuel purchases are designed as a rolling series of fixed-price contracts covering up to 100% of expected diesel and gasoline fuel consumption demand. HRT locks in 100% of its fuel prices if it believes it will be advantageous. When HRT management is uncertain on the direction of future prices, it will only lock in 50% to 75% of the expected fuel requirements and assume the risk of fuel prices increasing for the remainder of its fuel. Individual contracts are typically for 3, 6, or 12 months out. HRT generally has contracts covering a total of 12 months out, but prefers to stay covered for 12 to 15 months ahead for protection against sudden fuel price increases. There are instances, such as when fuel prices are especially volatile, when the vendor’s fee is beyond what is practical for HRT to pay for the level of protection. In these cases HRT purchases fuel on the spot market, relying on OPIS pricing. Results The strategy of using fixed-price contract has resulted in lower fuel costs than if HRT had relied exclusively on purchasing fuel on the spot market at OPIS prices. The cost savings since FY 2006 have been considerable and HRT has been able to establish price and budget expectedness. The fleet plans to continue with this fuel purchasing approach. Pooling HRT does not participate in a fuel purchasing cooperative. HRT maintains full control of its fuel purchasing decisions and quantities by working directly with the fuel vendor. Commodity Price Risk Management HRT does not operate a fuel hedging program. Instead, as discussed in other sections, its fuel vendor hedges its bulk fuel purchases and passes the cost of its hedged position on to HRT. The vendor tracks markets and makes recommendations to the transit agency, which has the discre- tion to act on or reject the recommendations. This allows HRT to benefit from fuel hedging without operating its own program. Tips for Success Consider Overall Level of Risk in Addition to the Approach Used to Manage Risk HRT has found that one risk management approach is not inherently better than another. The relevant issue is how much risk an agency is willing to assume, either short- or long-term. HRT has determined that locking in prices in advance (in the short-term; 12 to 15 months out) with fixed-price contracts is the best approach for the agency.

Case Studies 77 Nashville Metropolitan Transit Authority (Nashville MTA) Summary Location: Nashville, Tennessee Fleet: 200 buses: 12 sixty-foot, 115 forty-foot, 10 35-foot, and 63 cutaway buses sized for 12 to 14 people Fuel Volumes: Diesel – approximately 1.7 million gallons (FY 2009 and 2010) The Nashville Metropolitan Transit Agency (Nashville MTA), as part of its environmen- tal and long-term fuel strategy, is transitioning much of its 60-foot and 40-foot transit bus and paratransit vehicle fleet to hybrid-electric vehicles to reduce fuel usage. Vehicle addi- tions and replacements that took place in fall and winter of 2010 included fourteen 60-foot diesel-electric hybrid buses, four 40-foot diesel-electric hybrid buses, and 35 gasoline-electric hybrid cutaway paratransit buses. Nashville MTA chose gasoline hybrid-electric technology for the paratransit buses because diesel hybrids were not available. In the future, depending on technology and pricing, Nashville MTA hopes to transition to fuel cell vehicles. Fuel usage over the past several years has been similar, but prices have varied due to the fuel market. In FY 2007, 1.4 million gallons of diesel were used at an average cost of $2.07 per gallon. In FY 2008, 1.68 million gallons of diesel were used at an average cost of $2.87 per gallon. In FY 2009, 1.7 million gallons of diesel were used at an average cost of $2.10 per gallon. From July 1, 2009 to June 30, 2010 (FY 2010) 1.7 million gallons of diesel were used at an average price of $1.88 per gallon. Delivery Price Risk Management Fuel Contracting Through spring 2009, Nashville MTA purchased diesel fuel off of the spot market using daily quotes from three to five local fuel suppliers. The initiation of the hedging program (see Com- modity Price Risk Management section) in July 2009 did not change its fuel purchasing method. Though Nashville MTA now hedges its fuel purchases, it is still important to obtain good spot market fuel prices to help ensure consistent correlation with the index prices used in hedging activities. The addition of gasoline hybrid-electric paratransit buses required Nashville MTA to locate a gasoline provider, so the fleet now purchases gasoline directly from one of the Metro- politan Government of Nashville & Davidson Country’s (Metropolitan Nashville) local fuel depot stations. As described elsewhere in this case study, funds from the hedging program offset daily pricing changes. Prior to 2008, Nashville MTA considered working with fuel suppliers to lock in prices using fixed-price contracts. This approach was not selected by the board due to the risk of being locked into high expense, long-term fixed fuel costs should fuel prices decrease. This situation could have resulted in a potentially negative effect on Metropolitan Nashville which provides approxi- mately 48% of Nashville MTA’s funding. Pooling Nashville MTA participated in a cooperative fuel purchasing group, but determined that the group and process became too large and complicated. The decision making control was out of the agency’s hands and did not give it the level of control and results it sought. Nashville MTA then ended its relationship with the group to focus on developing an internal hedging program.

78 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies Commodity Price Risk Management History Amid dramatic increases in market volatility and fuel prices across the nation, Nashville MTA’s average fuel cost increased from $2.07 per gallon in FY 2007 to $2.87 per gallon in 2008. This, along with a fuel usage increase from 1.4 million gallons to 1.68 million gal- lons, significantly increased the agency’s annual fuel cost from approximately $3 million to $5.16 million, surpassing the agency’s 2008 fuel budget by $1 million. Responding to this situation, Nashville MTA was forced to eliminate between five and seven service routes in October 2008 and sought a way to create budget certainty for fuel prices through the use of a commodity hedging program. The Nashville MTA board was in favor of participating in a hedging program, but needed to have others involved for the program to be approved. Nashville MTA was also concerned about the public and political perception of hedging in the event that fuel prices dramatically decreased while the agency was locked in at a higher price. The agency’s goal for the hedging program was to act as an insurance policy against volatile fuel prices, not as a potential revenue stream. As such, the agency was able to garner necessary support from the public and the board to pursue the idea further. Nashville MTA approached Metropolitan Nashville, which agreed to create a partnership to facilitate the development of a fuel hedging program; as part of this process, legislation would be written granting the agencies permission to pursue the use of hedging instruments to pro- tect against fuel price volatility. The hedging program includes several local participant groups including Metropolitan Nashville, Nashville MTA, the Regional Transportation Authority (RTA), and the City of Franklin. An interagency agreement was used to facilitate the collaboration. A hedging program committee consists of the Metropolitan Nashville finance director, the Metro- politan Nashville fleet manager, the Nashville MTA CFO, the Nashville MTA fleet manager, and the city of Franklin finance director. The City of Franklin finance director assumed the lead for developing the legislation that would allow for a hedging program to be used by the participants. Metropolitan Nashville is the program guarantor. The process of developing the legislation and securing support for the bill took about one year. The bill was passed in the spring of 2009 with language that allowed Metropolitan Nashville and its partners to hedge fuel purchases for no more than 24 months forward. The legislation also included a firm end date for the pilot hedging program. At the start of the process of getting the original legislative approval to hedge its fuel pur- chases, Metropolitan Nashville solicited bids from financial institutions to serve as counter- party and to manage the hedging activity. Rather than setting up a hedging account with a financial institution to hedge directly on the New York Mercantile Exchange (NYMEX), Met- ropolitan Nashville opted to pursue financial institutions which use over-the-counter (OTC) swaps as a counterparty. In this way, Metropolitan Nashville could rely on its credit rating and avoid having to fund and administer a margin account. Metropolitan Nashville carries the credit risk for all members of the hedging group, while a large regional bank was selected as the counterparty financial institution. The counterparty worked with Metropolitan Nashville to determine which policies were needed for Metropolitan Nashville, what legislation would need to be in place, and the annual fuel usage for Metropolitan Nashville and Franklin to determine the number of contracts needed to cover fuel purchases of diesel and gasoline. The hedging committee decided that involving a third-party financial advisor was not needed, solely relying on the counterparty financial institution for its outside financial information. The committee worked with the counterparty to discuss its hedging recommendations and to structure the program to meet the group’s needs.

Case Studies 79 The initial hedging legislation became effective in May of 2009. The initial hedge agreement for OTC swaps started July 1, 2009 and was slated to run until June 30, 2011 to lock in the hedge price of $1.88 per gallon for seven contracts of diesel and $1.82 per gallon for three contracts of gasoline. The program was favorably evaluated after completing the first year, so new legisla- tion to create the permanent authority for a hedging program was introduced and passed in May 2010. The legislation did not extend the maximum allowable hedge timeframe, but did allow for the end date to transition to a rolling 24 months from the present. Following the legisla- tive approval, the hedging committee approved another OTC swap with the same fuel volumes as the initial hedge at $2.30 per gallon for diesel and $2.10 per gallon for gasoline for July 1, 2011 to June 30, 2012. Strategy Metropolitan Nashville, Nashville MTA, and the city of Franklin debated how much of the annual fuel purchases should be hedged because there were concerns over hedging too much fuel. The Nashville MTA board and other participating agencies were not comfortable with hedging 100% of needed fuel. The hedging group has a total of seven diesel contracts at 42,000 gallons (1,000 barrels) per contract per month, or a little more than 3.5 million gallons annually. Nashville MTA uses almost three of the contracts with their annual usage of 1.7 million gal- lons. Nashville MTA has found that hedging approximately 85% of fuel purchases has been suc- cessful. Metropolitan Nashville and the city of Franklin hedge approximately 70% of their fuel purchases. The group also has three contracts for gasoline for approximately 1.3 million gallons annually. The remaining fuel purchases for each agency are purchased on the spot market. As mentioned earlier, the hedging instrument employed is OTC swaps with a regional finan- cial institution as the counterparty. The counterparty provides market updates and makes rec- ommendations to the hedging committee every two to four weeks. Fuel prices are indexed to the NYMEX (No. 2 heating oil is used for diesel and gasoline is used for gasoline). The heating oil index is used because the prices of diesel and No. 2 heating oil are highly correlated so typically track each other. The counterparty determined that the NYMEX was still the best index for Nashville, even though they are not geographically close to New York. The initial hedging contract was for two years because of the pilot program structure. Mov- ing forward, the group decided to standardize with one-year contracts. The group’s goal for the hedging program is to act as an insurance policy and to achieve budget certainty for the least amount of program management, so one year contracts provide the level of results, flexibility, and program management the group is comfortable with. Approval and Execution Process The market evaluation, approval for hedge positions, and execution process is straight- forward. The hedging program committee prefers to work in one-year increments, so the group meets once a year to review and discuss the necessary information including market prices, indexes, forecasts, and anticipated fuel consumption. The counterparty participates in these meetings to present a summary of the previous year’s performance and to discuss options for the next year. If fuel prices are favorable, the committee votes to move forward and Metropolitan Nashville locks in prices for an additional year, keeping the hedging contracts within the required rolling 24 months. If the market is not favorable, the hedging program committee meets as often as necessary until pricing becomes favorable to lock in prices for twelve months. The committee has found that this approach keeps the program simple and still ensures budget certainty. The bank compares fuel prices monthly to the relevant indexes and sends Metropolitan Nash- ville either a check or a bill, depending on how the index compares to the price agreed to in the fuel contract. The CFO of Nashville compares the fuel purchasing costs with the NYMEX to

80 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies make sure that the program is on target. The program results are also compared to the state fuel contract prices to gauge as a reference point for local prices. Accounting for the hedging program began in July 2009. Nashville MTA does not have to report to the board on the operation and performance of the hedging program in a formal process. Rather, a footnote about derivatives and disclosures will be included in the agency’s 2010 audited financial report and funds received from the hedge are reported in the financial account- ing records. Results Nashville MTA is very pleased with its hedging program. Fuel prices dropped below the hedge price for the first three months, so Nashville MTA (through the hedging group) was making payments to its counterparty financial institution (also referred to as being “on the bad side of the hedge”). Since then the trend has reversed and the agency is receiving funds from its counter- party. Overall the hedge activities are in the positive (also referred to as being “on the good side of the hedge”). The hedging program has saved Nashville MTA more than $143,000, or 4% of its FY 2010 fuel budget of $3,500,000. Nashville MTA also has found that it gets better fuel prices on the spot market (i.e., without the hedge activity) than if it had participated in the state fuel purchase contract. Nashville MTA notes that it is nice to save money, but as experience in 2008 showed, the pri- mary focus of the hedging program is to serve as a stabilizing factor and insurance policy against price increases and to provide budget certainty. Tips for Success Teaming with Other Parties Can Be Valuable Teaming with other local transportation agencies, government, and cities, allowed Nashville MTA to develop and participate in a hedging program that would benefit many parties and draw on the strengths of each group. For example, the city of Franklin’s finance director brought his expertise for getting legislation passed to bring about the hedging program. The team’s agreed upon input allowed the group to lock in fuel prices for two years at $1.88 per gallon. Keep the Hedging Program Small for Manageability, Local for Control, but Large Enough to Be of Interest to Other Parties Working together allowed Nashville MTA, Metropolitan Nashville, and the city of Franklin to create a hedging program that was large enough to be of interest to a financial institution. Metro- politan Nashville also provided a strong credit background to serve as the guarantor, which was of great value because it removed the cash requirements for funding a margin account. Further- more, the five person hedging committee is composed of local entities, and is small enough to come to quick and balanced decisions without the challenges that a larger committee or bureau- cracy might experience. Consider the Necessity for Energy Price Risk Management Nashville MTA believes that it is becoming increasingly important for transit agencies to have an effective energy price risk management program in place since it appears that speculative market forces are moving fuel prices more than traditional rules of supply and demand. Budget Certainty Is of Great Value Nashville MTA sees its hedging program as insurance for the unexpected, as was experienced in 2008. The program mitigates the necessity for reducing services and difficult budget cutting in the middle of the year.

Case Studies 81 Southeastern Pennsylvania Transportation Authority (SEPTA) Summary Location: Philadelphia, Pennsylvania metropolitan area Fleet: 2,788 vehicles: 1,073 diesel transit buses (primarily 40-foot and 155 sixty-foot articulat- ing), 372 forty-foot diesel-electric hybrid transit buses, 38 forty-foot electric trackless trolley- buses, 185 light-rail cars, 343 elevated subway cars, 352 railcars, and 425 ADA/Shared Ride vehicles (15 to 25 feet long) Fuel Volumes: Diesel – 13,268,000 gallons (July 2009-April 2010), B2 Biodiesel blend – 2,700,000 gallons (May 2010-June 2010), Gasoline – 205,000 gallons, Electricity – 500,400 MWh The Southeastern Pennsylvania Transportation Authority (SEPTA) is the sixth largest transit system in the country and provides fixed route and demand response service (paratransit) to Bucks, Chester, Delaware, Montgomery, and Philadelphia counties. The service area includes 2,184 square miles, serves 400,000 weekday customer trips, and provides more than 300 million rides each year. From July 1, 2009 to June 30, 2010 (FY 2010), SEPTA used 205,000 gallons of gasoline in utility and support vehicles at an average price of $1.88 per gallon. During the same period SEPTA used over 13.2 million gallons of diesel at an average price of $2.35 per gallon. In May 2010 SEPTA transitioned all diesel buses to a 2% biodiesel blend (B2) to comply with a state legislative mandate and used 2.7 million gallons of B2 (a blend of 2% biodiesel and 98% petro- leum diesel by volume) at an average price of $2.43 per gallon. In addition, SEPTA used more than 2.6 million gasoline gallon equivalents (GGE) of natural gas at an average cost of $1.11 per GGE, and over 500,000 megawatt hours (MWh) of electricity were used at an average price of $85.70 per MWh.8 Approximately 80% of the electricity use was for propulsion power for the regional rail system, subway-elevated lines, light-rail lines, and trolleybus routes. The remaining 20% is used to power SEPTA’s General Service (GS) and High Tension (HT) accounts which include Headquarters’ Building, stations, depots, and other locations. Delivery Price Risk Management Fuel Contracting Diesel. SEPTA contracts directly with fuel suppliers and chooses suppliers by issuing an RFP. The supplier with the lowest price that can assure the fuel’s delivery receives the contract. Fuel vendors do not have to be local to compete for the contract. For twenty years prior to September 2010, SEPTA used fixed-price contracts to lock in fuel costs with vendors for gasoline, diesel, and now biodiesel blended fuels. In 2006 and 2007 SEPTA’s longer term fixed-price contracts expired and the agency decided to float on the market (i.e., no fuel contract or other financial mechanism was in place) in anticipation of decreasing fuel prices. Instead, SEPTA surpassed its 2007 fuel budget by $15 million because of a rise in fuel prices and the corresponding increase in costs for fixed price contracts. The agency was able to absorb most of the overages because transit system ridership during the same time increased as a result of high fuel prices, which in turn increased revenue. Diesel fuel prices dropped precipitously in the second half of 2008 from a high of $3.95 per gallon in July 2008. Beginning in March 2009 SEPTA negotiated several short-term fuel con- tracts from a low price of $2.34 per gallon of diesel to a high price of $2.44 per gallon over the 8GGE is a method to normalize the usage of multiple fuels by their energy content (i.e., British thermal units per gallon, or Btu/gal) using gasoline as the baseline. For example, diesel fuel has an average energy content of 128,400 Btu/gallon while gasoline has an average energy content of 115,000 Btu/gallon. Thus, one gallon of diesel fuel has equivalent energy content of 1.12 gallons of gasoline [i.e., 128,400 Btu/gallon divided by 115,000 Btu/gallon = 1.12]).

82 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies 18-month period that ended August 31, 2010. The weighted average market price was $2.36 per gallon over the 18-month contract period and $2.41 per gallon over the last six months of the contract period—slightly lower than the contract price. This was the agency’s last fixed-price diesel fuel purchase contract. Under these agreements, SEPTA was obligated to purchase at least 16 million gallons of diesel fuel per year. Since September 2010, SEPTA continues to utilize an RFP process to purchase both diesel and gasoline fuels. Fixed price contracts continue to be used for gasoline purchases. Diesel fuel purchases, however, are based on the weekly Oil Price Information Service (OPIS) index price (as of Sunday evening) plus a margin (fee). The current diesel fuel supply contract is with one com- pany for a total of 24 million gallons of B2 (16 million gallons for 12 months) over an 18 month timeframe. This fuel purchasing approach was chosen to work in tandem with the agency’s newly implemented (September 2010) fuel hedging program, which is described in the Commodity Price Risk Management section. Electricity. SEPTA has an electricity supply rate tariff agreement with a local utility with rates that were approved by the Pennsylvania Public Utility Commission. The electricity rate cap was slated to end December 31, 2010, so SEPTA and Amtrak developed a strategic partnership to secure market generation electricity supply for their propulsion power accounts. A solicitation was released by Amtrak, but SEPTA assumed full responsibility for the negotiation and award of the SEPTA account contracts. The contracts with two energy companies went into effect on January 1, 2011. The contracts fall under Amtrak’s Master Agreements with the suppliers and are signed by each of the three parties. Each entity has a separate agreement under the bid. The master agreement, proposed by SEPTA’s energy consultant, includes an Emergency Purchase Agreement, which gives SEPTA preapproval to solicit fuel supply contracts with a list of suppli- ers as a precaution if circumstances dictate such an action. This was critical because the decision time was cut from a likely five months to between two and four months. Pooling SEPTA does not participate in a cooperative fuel purchasing arrangement. The agency is large enough to have sufficient negotiating power and prefers to remain in control of fuel purchasing decisions. Because of this, SEPTA works directly with suppliers to meet fuel purchasing needs and maintains full control of all aspects of fuel acquisition. As mentioned above, however, SEPTA and Amtrak did team up to solicit better electricity rates for the propulsion power accounts than they could have received on their own. Commodity Price Risk Management History SEPTA was recently approached by several banks and financial institutions to encourage the agency to initiate a fuel price hedging program. One of these banks, a global financial services company based in Germany, initially approached SEPTA in December 2009 and briefed the agency’s financial department, the CFO, and the purchasing department about the benefits of hedging. SEPTA agreed that implementing a hedging program was the best option for its fuel purchas- ing strategy. To start the program development, SEPTA participated in four educational meet- ings with the bank over the course of about nine months to learn about hedging options. These meetings included SEPTA’s CFO, purchasing department, finance department, fleet depart- ment, and a public financial management (PFM) consultant who served as SEPTA’s financial and investment advisory consultant. This larger group agreed that a hedging program would be an effective solution to establish fuel price and budget certainty; the level of customer service the

Case Studies 83 bank could provide was also ranked highly. The ability to achieve budget certainty was critical because of concerns over decreasing transit funding due to the recession. The program was able to be quickly initiated by the CFO, in consultation with the general manager, by using the emer- gency purchase agreement for critical commodities; board approval was therefore not needed. (The board had originally implemented this provision to ensure that SEPTA would not miss opportunities such as this.) The Authority’s fuel hedging agreement with the bank was finalized by the SEPTA CFO in April 2010. The hedging program went into effect in September 2010. The goal of the hedging program is to protect against price shocks, reduce price volatility, and to create price and budget predictability/certainty. The program is not intended to operate as a revenue stream. The agency is finalizing internal accounting arrangements in accordance with the Governmental Accounting Standards Board and has set up an account with the bank for its hedging activities. Strategy SEPTA’s diesel buses were transitioned to operating on B2 biodiesel blends in May 2010 to comply with a state legislative mandate. Thus, SEPTA’s hedging activities correspond with the purchase of B2 biodiesel blended fuel. SEPTA’s fuel purchasing strategy is to maintain two sepa- rate arrangements: 1) a supply agreement with a fuel supplier (as described earlier), and 2) an over-the-counter swap hedging agreement with a financial service company as the counterparty. SEPTA has a very good bond credit rating so the requirement to maintain funds in a margin account was waived. SEPTA employs a dynamic, situational hedging strategy and hedges 100% of its fuel purchases. Biodiesel fuel prices are hedged against New York Mercantile Exchange prices of No. 2 heating oil. The same approach would have been used if 100% petroleum diesel fuel were used. The hedging program costs (fees and payments) are accounted for as part of the overall fuel expense on the balance sheet and in the budget. Approval and Execution Process SEPTA’s fuel hedging decision-making process is a collaborative effort among the operating budget, treasury, and purchasing departments. The counterparty bank also provides a summary of SEPTA’s daily and monthly fuel prices and fuel volumes at the end of each month to show the current performance of the program. SEPTA’s asset treasurer tracks the fuel market on a daily basis. Longer-term trends and projections developed internally, by third-party advisors or by the bank, are analyzed. Joint recommendations are developed and presented to the CFO and general manager for final decision making purposes. Results Since the program was initiated in September 2010, SEPTA has entered into three separate consecutive swap agreements at different prices, though each was for the same monthly fuel usage quantities. The first agreement was for four months (September 1, 2010 to December 31, 2010) at a price of $2.38 per gallon for 5.4 million gallons. The second agreement (Jan 1, 2011, to June 30, 2011) was for 8.1 million gallons at a price of $2.32 per gallon. The third agreement was for 8.1 million gallons (July 1, 2011 to December 31, 2011) at $2.20 per gallon. As of this writing, SEPTA was not hedged for the final two months of its fuel supply contract; SEPTA planned to reassess this situation as the year progressed. SEPTA expects to have another hedge in place by spring or summer of 2011. As of September 2010, during the first four months of the agreement, the heating oil futures rate was fixed at $2.38 per gallon. SEPTA’s hedging program is too new to evaluate its effectiveness. SEPTA tracks fuel expenses closely. Although the agency wrote a check to its counterparty bank for September and October to balance the account (as prices have been lower than their agreement), expectations are that fuel prices will rise and SEPTA will save money over what would have been paid on the spot

84 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies market. There is no formal process for evaluating the program effectiveness. The assistant trea- surer reports on hedging program status and performance to the CFO in monthly meetings. The agency’s guidelines for evaluating the effectiveness of the hedging program include: 1) the quality of the working relationship with the counterparty, 2) the amount of administrative work the hedging program creates for SEPTA, 3) how well SEPTA works with its fuel suppliers, and 4) the effectiveness at achieving budget certainty, which is key. Tips for Success Finding the Right Partner Is Key SEPTA’s hedging program was initiated in September 2010 (one month prior to this writing), so it is too early to evaluate the program’s effectiveness. After being approached by different banks and financial institutions, SEPTA’s CFO and financial department staff saw the need to find a partner willing to educate them, handle large scale transactions, and minimize counter- party risks. The agency noted that the process takes planning and education and that it is still learning, but that it sees great value in being able to mitigate pricing fluctuations to achieve budget certainty. Houston METRO Summary Location: Houston, Texas Fleet: 1,374 buses, 18 rail cars (FY 2009) Fuel Volumes: Diesel – 13.2 million gallons (FY 2009), Gasoline – 0.8 million gallons (FY 2008 projected), electricity for propulsion – 7.555 million kWh (FY 2008 projected) Metropolitan Transit Agency of Harris County (Houston METRO) is the public transit agency serving the Houston metropolitan area, a service area of 1,285 square miles. The agency’s fleet is primarily composed of diesel-powered buses, but it also contains 18 electric rail cars. In 2009, Houston METRO consumed 13.2 million gallons of diesel fuel at a hedged price of $3.59 per gal- lon. Beginning in 2005, Houston METRO attempted several fuel price hedging strategies, including bulk purchases and fixed price contracts, before implementing a financial hedging strategy in 2008. Delivery Price Risk Management Fuel Contracting Houston METRO’s procurement department conducts bids by posting bid requests to an online platform and alerting potential bidders. In 2009, the agency had a 12-month contract with a floating price calculated as the Platt’s index price for ultra low sulfur diesel (ULSD) in the Gulf Coast plus a fixed per gallon differential. Houston METRO includes a special clause in its diesel contracts to ensure that the agency can purchase fuel on a priority basis in the event that hurricanes disrupt the region’s fuel supply. The contract stipulates that 30,000 barrels (1.26 million gallons) of diesel be available to the agency on a priority basis during hurricane months. Houston METRO only allows bids from producers that control the racks from which the fuel is dispensed to ensure availability of fuel. In previous years, Houston METRO had ensured fuel availability by leasing a 105,000-barrel storage facility. However, this lease was cancelled in 2010 because Houston METRO considered that availability of fuel could be assured through a fuel contract with a priority clause and by utilizing the storage capacity at Houston METRO’s facilities.

Case Studies 85 Commodity Price Risk Management History In 2005 Houston METRO began exploring ways to control fuel costs after the agency’s fuel budget nearly doubled over three years from $10.37 million ($0.65 per gallon) in FY 2002 to $19.00 million ($1.13 per gallon) in FY 2004.9 Under the assumption that prices would continue to rise, Houston METRO CEO Frank Wilson directed the agency to make a 12-month bulk purchase of diesel fuel from a local refiner in January 2005. The bulk purchase essentially locked in the January 2005 price of diesel, although Houston METRO had to pay a storage fee to hold the fuel over the course of the year as it was consumed. As a result, the agency saved more than $5 million on its fuel expenditures.10 In November 2005, as January’s bulk fuel supply began to dwindle, the agency entered into a six-month fixed-price future delivery contract with a supplier. Under the contract, the sup- plier sold set volumes of diesel fuel to Houston METRO at a fixed price. The agency had con- tacted several refiners and dealers seeking a fixed price contract and one refiner offered a much lower fixed price than other suppliers. Overall, the fixed price contract saved the agency roughly $0.75 million over six months. The contract was in Houston METRO’s favor but was set to expire in May 2006 and neither the supplier nor other local fuel dealers were willing to extend the con- tract at a similar price level. When the contract expired in May 2006, Houston METRO made a one-month purchase from a local fuel storage facility, saving another $0.29 million versus the rack price.11 Overall, Houston METRO’s aggressive fuel purchasing strategies saved roughly $6.2 million versus purchasing at market prices in FY 2005 and FY 2006. Despite these savings, however, rising oil prices continued to impact Houston METRO’s fuel budget; the agency’s diesel budget rose to $22.83 million ($1.52 per gallon) in FY 2005 before surging to nearly $27.55 million ($1.90 per gallon) in FY 2006.12 Faced with out-of-control fuel costs and a lack of fixed-price options, Houston METRO turned to the financial markets for ways to manage its fuel prices. A banking consultant put Houston METRO in contact with a fuel price consultant based in Dallas, who helped craft a fuel price risk management policy to fit the agency’s needs. The policy was presented to Houston METRO’s board of directors in February 2006. The board was made up of local businessmen who understood the need for fuel price hedging to control costs. The board approved the policy and later authorized implementation of the fuel hedging program. Once the program was authorized by the board, Houston METRO’s attorneys drafted a master swap agreement that favored the agency. The agency also established a credit rating, a prerequisite for funding swap margin accounts. With the help of its consultant, Houston METRO identified eight potential counterparties made up of highly-rated financial institutions and trading subsidiaries of major energy corporations. Houston METRO solicited these potential counterparties to prequalify a short list of those who would like to enter a swap agreement. Houston METRO’s attorneys then worked to negotiate mas- ter swap agreements with interested parties that had been prequalified, a task which took months. Once the master agreements were in place, Houston METRO could procure a swap agreement for a particular month (or strip of months) through a competitive telephone bid process. 9http://www.ridemetro.org/AboutUs/Publications/Pdfs/FY2007BudgetBook.pdf (p. 56) 10FY 2007 Budget Book (p. 56) 11FY 2007 Budget Book (p. 56) 12FY 2007 Budget Book (p. 15) http://www.ridemetro.org/AboutUs/Publications/Pdfs/FY2008_Bus_Plan_Budgets.pdf

86 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies Strategy and Process The goal of Houston METRO’s fuel price risk management strategy is to minimize oper- ating budget variance attributable to fuel price variability. The philosophy behind Houston METRO’s fuel price risk management strategy is to engage in discrete, situational hedging. This policy requires the agency’s management to develop an executable hedge plan by setting specific diesel price targets with a corresponding authorized quantity of fuel to hedge. This plan is to be executed by fuel transaction clerks in the agency’s procurement department. The policy allows Houston METRO to hedge up to 100% of the agency’s fuel consumption for a period of up to 24 months by entering into fixed price contracts, financial swaps, collars, or caps.13 Houston METRO’s hedging policy prohibits the agency from taking on basis risk (the risk that hedge price movements will not perfectly offset movements in the agency’s physi- cal fuel prices). As a result, Houston METRO can only use hedge instruments that follow Platt’s Gulf Coast ULSD pride index (the index used to calculate Houston METRO’s physical fuel bills). Procurement Manager Michael Southwell was designated as one of Houston METRO’s fuel transaction clerks charged with implementing the telephone bid process. Southwell, with the help of Houston METRO’s financial department and a consultant in Dallas, monitors the oil market waiting for price dips. When an attractive price environment is identified, Southwell consults the financial department and then approaches Houston METRO’s CEO with figures for consideration. If the CEO and METRO’s financial department are comfortable with the price environment, the CEO authorizes Southwell to contract a swap at or below a target price. South- well then initiates a telephone bid by contacting two or three pre-qualified institutions to bid swap prices. From this list Southwell selects the best offer that is at or below the target price and then sends the swap agreement to the agency’s financial department for processing. Altogether, the telephone bid process takes three to four minutes. Results Despite being authorized for FY 2007, Houston METRO’s hedging program did not take off until FY 2008. The original hedging program called for FY 2007’s diesel fuel to be hedged by July 2006. In June 2006, however, diesel fuel swaps were being bid in the $2.30 to $2.42 per gal- lon range. Including a transportation and TxLED fee of eight cents per gallon, this would have brought the agency’s pre-tax fuel budget to $2.38 to $2.50 per gallon compared with a diesel fuel budget of $2.08 per gallon plus tax in FY 2006.14 Locking in at the higher prices would have added $4.5 to $6.3 million to Houston METRO’s fuel budget and management did not believe it to be prudent to hedge all of its FY 2007 consumption at those prices.15 The management decided to remain unhedged and wait for lower prices before entering a swap agreement. Instead of hedging with swaps in FY 2007, Houston METRO entered into NYMEX-based fixed price future deliv- ery contracts covering the first six months of the fiscal year and storage fuel was used over the last six months.16 Despite these measures, Houston METRO’s diesel fuel budget surged nearly $10 million in FY 2007 to $37.02 million. Houston METRO finally began implementing its financial hedging program in January 2007, when it executed two financial swaps for diesel fuel for FY 2008. A total of 13.5 million gallons (98%) of the required diesel for FY 2008 was hedged at an average market price of $1.83 per gallon 13Fuel Price Risk Management Policy, February 16, 2006 14http://www.ridemetro.org/AboutUs/Publications/Pdfs/FY2007BudgetBook.pdf (p. 57) 15FY 2007 Budget Book (p. 57) 16http://www.ridemetro.org/AboutUs/Publications/Pdfs/FY2008_Bus_Plan_Budgets.pdf (p. 16)

Case Studies 87 (excluding $0.0893 additional for additives and transportation). The details of the swaps are listed in the following chart: These swaps settled monthly from October 2007 to September 2008 (Houston METRO’s fis- cal year) and resulted in a gain of $17.25 million in FY 2008. In particular, Houston METRO’s hedging strategy allowed it to avoid the sharp run up in fuel prices between January and July 2008 as crude oil prices surged from $100 to nearly $150 per barrel. The swaps also gave Houston METRO budget certainty after several years of volatile, upward trending fuel prices.17 Houston METRO’s experience in FY 2009 was less positive. During FY 2008, the agency had entered into seven commodity swaps with two counterparties covering 13.6 million gallons of diesel fuel. These contracts settled monthly from October 2008 to September 2009 and repre- sented 98% of the agency’s diesel consumption. This time Houston METRO bought high and sold low; the swaps effectively locked in an average price of $3.55 per gallon over FY 2009.18 As oil and diesel prices precipitously declined over the course of the fiscal year, Houston METRO realized a net loss of $26.7 million on its swap contracts.19 In FY 2010 Houston METRO hedged 14.5 million gallons (100%) of its anticipated diesel fuel purchases at an average price of $2.62 per gallon. These contracts, together with contracts covering 8.9 million gallons for FY 2011, had a negative value of $8.85 million at the beginning of FY 2010.20 Some of the swaps for FY 2010 were entered in 2008 while others were initiated in 2009. Tips for Success Consider the Pros and Cons of Different Strategies for Determining When to Hedge The greatest difficulty with Houston METRO’s strategy is the selection of a price target. The agency’s hedging policy stipulates that management develop a price target as part of an execut- able hedge plan. However, the development of a price target requires a reasonable forecast of where prices are headed over the hedge horizon (24 months). Price targets are also tricky because they raise the possibility that swap prices may never exactly meet the target price, causing the agency to remain unhedged and exposed to price further price increases. In practice, Houston METRO enters into swap agreements when prices “sound good” to the management. This adds pressure on those executing the strategy. Timing decisions by Houston METRO’s management could lock in prices that save or cost the agency millions of dollars. Selecting the right time to hedge is one of the key challenges of discrete, situational hedging 17http://www.ridemetro.org/AboutUs/Publications/Pdfs/2008-AnnualReport.pdf (p. f44) 18http://www.ridemetro.org/AboutUs/Publications/Pdfs/FY2010-Budget-Summary-21-September-2009.pdf (p. 4) 19http://www.ridemetro.org/AboutUs/Publications/Pdfs/2009-Annual-Report.pdf (p. c61) 20http://www.ridemetro.org/AboutUs/Publications/Pdfs/2009-Annual-Report.pdf (p. f61) Vendor Gallons Date of Purchase Avg. Price per gallon Cost Vendor 1 7,014,000 1/10/07 $1.88 $13,179,466 Vendor 2 6,510,000 1/17/07 $1.77 $11,516,148 Total 13,524,000 $1.83 $24,695,614 Source: http://www.ridemetro.org/AboutUs/Publications/Pdfs/FY2008_Bus_Plan_Budgets.pdf (p. 16)

88 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies strategies. Continuous, rule-based strategies, on the other hand, rely less on timing decisions because futures contracts are purchased on a continual basis. Well-executed situational strate- gies can potentially outperform rule-based strategies over time but can also require more active, higher pressure management decisions. Using a Range of Hedging Tactics Might Improve Results Although Houston METRO’s hedging policy authorizes it to use several hedging tactics including swaps, caps, and collars, Houston METRO has only used swaps to date. Michael South- well attributes this to the difficulty in getting management to understand and approve use of all of the tactics at the agency’s disposal. Reliance on one tactic means that Houston METRO has only two options: 1) lock in a particular price, or 2) remain unhedged and exposed to further price increases. This limits the agency’s flexibility to adapt its hedging strategy to different price environments. For instance, in 2008, as diesel fuel prices skyrocketed to above $4 per gallon, Houston MET- RO’s hedging consultant recommended purchasing caps for FY 2009 rather than locking prices in with swap agreements. Employing caps would have placed a ceiling on further upward price movements while at the same time allowing the agency to benefit if prices crashed. At the time, the consultant had recommended buying the protection at $5 per gallon. Houston METRO management thought this cap was too high and the premium on the cap was never priced. In hindsight, this strategy would not have paid out as diesel prices never surpassed $5 per gallon. Nevertheless, employing caps rather than swaps would have allowed the agency to take part in falling prices in FY 2009. Given the extreme volatility of oil prices in 2008, a cap would have been a better fit for the price environment than locking in at a high rate or remaining unhedged. Situational Hedging Programs May Benefit from More Flexible Hedge Horizons In early 2009, after oil prices crashed to below $40 per barrel, Houston METRO saw an oppor- tunity to purchase swaps for FY 2010 and FY 2011 at bargain prices. Michael Southwell quickly began arranging swaps as far out as 24 months—the maximum horizon allowed under the agency’s hedging policy. As the current months expired, Southwell would purchase the next month out if the price looked good to management. In this depressed price environment, it would have been advantageous for Houston METRO to hedge further out—perhaps 36 or 48 months—to secure low (and certain) fuel prices for years to come. However, Southwell was limited by the hedging policy, which restricted the program to a maximum of 24 months. Under discrete, situational hedging strategies, practitioners may benefit from having flexible hedge horizons. Sioux Area Metro (SAM) Summary Location: Sioux Falls, South Dakota Fleet: 54 buses: 29 twenty-nine-foot diesel buses, 22 twenty-seven-foot cutaway diesel buses, 2 thirty-foot diesel trolleys buses (seasonal), 1 gasoline passenger van (FY 2010) Fuel Volumes: Diesel – 216,500 gallons (FY 2009) Sioux Area Metro (SAM)21 is the public transit agency that serves the city of Sioux Falls, South Dakota. SAM’s service area covers approximately 100 square miles. The agency provided over 21Sioux Area Metro was formerly known as Sioux Falls Transit until the name was changed in December 2009.

Case Studies 89 one million passenger trips in FY 2009, and “operates 12 regular fixed routes, three school tripper routes, paratransit services for the elderly and disabled, and a seasonal trolley service in down- town Sioux Falls.”22,23 The city contracts with another company to operate and maintain the city’s transit fleet. The majority of the operating funds come through fare box revenue, city funds, and federal government grants.24 The fleet consists of 54 diesel powered buses, including two seasonal diesel trolleys, and one gasoline passenger van. The diesel bus fleet used almost 217,000 gallons in FY 2009, with an average cost of $2.01 per gallon, and a total cost of $436,000 (price includes all fees). Fuel costs in FY 2009 accounted for approximately 6.0% of transit operations budget and 5.1% of the total transit budget.25 The city’s transit division total annual budget was $8,547,963 in 200926 and $7,419,258 in 2010.27 For more historical reference, in FY 2006 SAM used 232,000 gallons of diesel at an average cost of $2.40 per gallon. In FY 2007 238,000 gallons of diesel were used at an average cost of $2.44 per gallon. In FY 2009 216,500 gallons of diesel were used at an average cost of $2.01 per gallon. A fuel reporting issue caused erroneous data to be collected in 2008 so is not reported. Delivery Price Risk Management Fuel Contracting Prior to 2007, SAM purchased fuel on the spot market, as did all other city departments, through a pool of four local fuel vendors. The supplier which offered the lowest costs (including delivery and other fees) was selected. Since 2007, this fuel purchasing method continues to be used for nine months out of the year (July to March). For the remaining three months (April to June), the city secures a three-month fixed-price contract from the fuel supplier that can guar- antee delivery of the required fuel volume at the lowest price. SAM is required to purchase fuel on the contract during this three-month period. This approach provides the city, and SAM, with budget certainty for these three months, and avoids long-term obligations and premiums that might arise from locking in fuel costs at higher than market prices for the rest of the year. SAM is restricted from entering into its own fixed-price contract for the nine month period from June to March. SAM works with the city fuel purchasing department’s team to develop a fuel usage and costs estimate for the next year’s budget request. The analysis includes SAM’s average miles per gallon, total expected miles to be traveled, and the team’s forecasted fuel price. SAM’s anticipated fuel use, along with the anticipated usage from the other city departments, provides the city purchas- ing department with the necessary information to request price quotes from the four vendors two months before the April to June contract period begins. Strategy The city’s fuel purchasing strategy is to use price competition among four local vendors for fuel delivery for June to March, and to lock in prices with a fixed-price contract for April to June. 22Mayor’s Recommended Budget 201: City of Sioux Falls, South Dakota, http://www.siouxfalls.org/~/media/documents/ finance/2010/2011_mayors_recommend_budget.ashx (p. 110) 23Transit Management Agreement Audit: Internal Audit Report 8-02, http://www.siouxfalls.org/~/media/documents/auditors/ 2008/transit_audit_report_08_02.ashx (p. 1) 24Id. 25City of Sioux Falls, South Dakota 2009 Budget for the Fiscal Year Ended December 31, 2009, http://www.siouxfalls.org/~/ media/documents/finance/2008/2009_budget_summary.ashx (p. 5) 26Id. 27City of Sioux Falls, South Dakota 2010 Budget for the Fiscal Year Ended December 31, 2010, http://www.siouxfalls.org/~/ media/documents/finance/2009/2010_Budget_Summary.ashx (p. 1)

90 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies The city believes that this approach allows it to receive the most competitive pricing as fuel costs fluctuate, and to take advantage of locked-in pricing at a time of year when prices are generally lower. The city also believes that this approach avoids any cost premiums or long-term obliga- tions from June to March. Approval and Execution Process SAM is authorized to purchase fuel directly from local vendors at spot market prices for the open nine months of the year (July to March). During this timeframe, SAM sends a fax request approximately every two weeks for bids to the four local vendors for a 7,500 gallon load of diesel fuel. The vendor with the lowest price (including delivery and other fees) receives the order. Dur- ing the April to June timeframe, SAM informs the city’s purchasing department when it needs a load of fuel. The city places the order for delivery to SAM’s storage tank and sends an invoice to SAM for the fuel cost. Results In FY 2006, before the three-month fixed-price contracts were used, SAM purchased fuel on the spot market through local vendors throughout the year and used 232,000 gallons of diesel at an average of $2.39 per gallon. In FY 2007, the first year the three-month fixed-price contracts were used, the city locked in prices for the second quarter. SAM’s total annual fuel use was 238,000 gallons, at an average of $2.31 per gallon. In 2008, SAM purchased diesel fuel on the city’s April to June supply contract for approximately $2.80 per gallon instead of the then-market price of $4.20 per gallon during the high price volatility period; this saved SAM roughly $75,000. The city attempted to get a contract extension, but the fuel supplier did not agree to extend the contract. For all of 2008, SAM used 187,000 gallons of diesel fuel, averag- ing just over $3.26 per gallon, at a total of $611,000. In this instance, the three month fixed price contract saved SAM 10.9% over the whole year. Even with the $75,000 savings, SAM exceeded its fuel budget. SAM eliminated unnecessary spending, but did not reduce service to eliminate/reduce the overage. Additional funding was still needed to close the budget gap. Funding was approved by the city council to cover the remaining $100,000 overage. That year (FY 2008) was the only instance where SAM had a budget issue due to fuel costs, indicating that its budgeting and purchasing system generally proves to be effective, even though it is very straightforward. Pooling SAM does not participate in, nor is pursuing, any cooperative arrangements. Pooling has never been investigated as a fuel purchasing option. Commodity Price Risk Management SAM does not utilize commodity risk management strategies for its fuel purchases. Tips for Success Select a Fuel Purchasing Strategy Appropriate for the Agency’s Size SAM believes that it is difficult for an agency of small size to have the resources to dedicate staff or hire a consultant to stay ahead of the fuel pricing market. The agency acknowledges that doing so could save a significant amount of money and possibly provide more budget certainty. In many ways, the current approach is to self-insure. The method has proven effective since SAM’s fuel costs are not a major part of the city’s budget.

Case Studies 91 Minneapolis–St. Paul Metro Transit Summary Location: Minneapolis-St. Paul, Minnesota Fleet: 910 buses: 658 conventional diesel 40-foot buses, 67 diesel-electric hybrid 40-foot buses, 166 articulated diesel 60-foot buses, 19 over-the-road diesel coach buses; and 27 rail cars. (Bus figures are for FY 2010, rail is for FY 2008.)28,29 Fuel Volumes: Diesel – approximately 6.9 million gallons (FY 2009) Metro Transit is part of the Metropolitan Council (the Council), which is the regional plan- ning agency for the Minneapolis-St. Paul seven-county metropolitan area.30 Additionally, the Council provides programs which service metro-wide transportation services, waste water pro- cessing, housing, parks, and land use planning. Metro Transit is one of the largest transit agen- cies in the United States with an annual ridership of approximately 78 million passenger trips. It serves a major portion of the cities of Minneapolis and St. Paul, as well as surrounding suburbs. In addition to its transit bus fleet, Metro Transit operates both a light-rail line and a commuter rail line. Delivery Price Risk Management Fuel Contracting Metro Transit works directly with suppliers to meet fuel purchasing needs and maintains full control of all aspects of such fuel acquisition. Metro Transit represents about 90% of the Coun- cil’s diesel fuel consumption; the remaining 10% is consumed by the Council’s Metro Mobility group. Prior to 2005, Metro Transit purchased fuel from a local refiner/distributer through fixed price contracts. This contract/arrangement also allowed Metro Transit to lock in prices for a future period. Under this arrangement, Metro Transit was subject to paying a premium for a fixed- price contract over a floating price contract. The option to lock in prices some of the time was recognized as a valuable but expensive service. After the final fixed-price contract ended, Metro Transit’s fuel price management process was divided into two pieces: 1) a floating-price fuel sup- ply contract solely, and 2) a hedging program that used futures contracts to lock in future prices, thus giving a high degree of “budget certainty.” The hedging program is described below in the Commodity Price Risk Management section. Pooling Metro Transit does not currently participate in a cooperative diesel fuel purchasing arrange- ment. The state of Minnesota provides such a service. Generally, the cooperative locks in a price on a given date for the next 12 months, thus giving exposure to one price which may be the high or low in fuel prices for the year, but more likely is somewhere in between. Commodity Price Risk Management History Cost certainty is critical for government agencies since they operate on a fixed annual budget; thus, hedging was seen as a potential solution. Prior to implementing its own hedging program, 28Metro Transit, About Metro Transit, http://www.metrotransit.org/about-metro-transit.aspx 29Metropolitan Council, 2008 Comprehensive Annual Financial Report, http://www.metrocouncil.org/about/CAFR2008.pdf 30Metropolitan Council, About the Metropolitan Council, http://www.metrocouncil.org/about/about.htm

92 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies the agency tracked its fixed-price contracts and compared them to what price would have been paid if it had floated by paying market prices. Metro Transit was confident after the analysis was completed that instituting an in-house hedging program had the potential to meet its fuel price risk management goals at a lower average cost than by using fixed-price contracts with its fuel suppliers. To establish its hedging program, Metro Transit’s director of purchasing and contract ser- vices approached the Council’s treasury department, Transportation Committee, and the divi- sion’s general manager to educate the Council’s policy body on the importance of managing fuel price volatility risk and the opportunity for enhanced budget certainty at a lower cost. Following the presentation, the Council supported the program’s concept and allowed Metro Transit to move forward with establishing the hedging program. With the assistance of a consultant/advisor, the Council decided to handle the planning, execution, and operation of the hedging program in-house because the Council had the required depth of financial expertise to effectively man- age the program. The Council’s state-governed investment policies at the time did not allow for using forward pricing mechanisms (i.e., hedging) for energy purchases. Staff from Metro Transit and the Council worked with the state legislature to educate the legislature about using hedging as a financial tool to mitigate future fuel price volatility, with the goal of the legislature authorizing Metro Transit to use hedging for its fuel purchases. Initially, due to a certain stigma associated with the term hedging, the Council was careful to characterize its risk management strategy as forward pricing. The hedging activity can be viewed as an insurance policy against future fuel price volatility for a defined time period. The Council also emphasized that the proposed hedging strategy was not speculative, but rather was a budget stabilization tool intended to create fuel price certainty in an unstable commodity, the opposite of a risky venture. The state legislative body saw the merits of a fuel hedging program for Metro Transit and the agency located a legislation sponsor. The legislative process took two years over multiple legislative discussions to complete. The leg- islation was passed in June 2005 and enabled the creation of the hedging program and allowed the Council to hedge up to 100% of Metro Transit’s projected fuel consumption.31 While the legislation was working its way through the legislative process, anticipating a posi- tive result, the Council worked closely with their third-party financial consultant (a commodity trading advisor, or CTA), brokerage firms, and other entities to build their knowledge base on fuel price hedging. The CTA, which has a focus on hedging for the transportation industry, was selected through a bidding process. The CTA brought its experience to the table and assisted the Council in developing the fuel hedging program, as well as reviewing the necessary policy and procedures. These detailed documents outline the hedging program’s policy, purpose, imple- mentation, and accountability. To be conservative, management stipulated that the total hedged position would be limited to 90% of projected diesel fuel purchases. The lower percentage allows for some unpredictable reduction in fuel demand to avoid over-hedging. The policy document also emphasized that the hedging program was structured for achieving fuel price stability, not for speculation. Strategy Once the fuel hedging program was approved by the state legislature, the Council’s treasury department, which operates the hedging program within the Council, chose to purchase its initial futures contracts incrementally over approximately five months so as to spread out the fuel acquisition cost (the net of hedging). (One futures contract is equal to 42,000 gallons of fuel.) The initial contracts were at the best available rate and covered a significant portion of the 31http://www.house.leg.state.mn.us/hrd/bs/84/HF1481.html#_Toc104630735

Case Studies 93 near-term fuel use. Subsequently, the Council’s approach evolved into a rolling hedges purchases strategy where it bought futures contracts without regard to whether the current market price was high or low. The rolling contract purchase strategy approach is intended to mimic dollar cost averag- ing rather than trying to time the market. The agency is continually in the market with this approach, so it experiences the average price for the coming year. This approach was more easily explainable to larger audiences. The strategy allowed The Council to purchase contracts from the program’s start, rather than having to time the market to wait for the best price to purchase all of the contracts at the same time.32 Metro Transit purchases futures contracts on the New York Mercantile Exchange (NYMEX) via a brokerage firm which actually secures the contracts. Diesel fuel purchases are hedged with No. 2 heating oil. The heating oil index is used because the prices of diesel and No. 2 heating oil are highly correlated, i.e., they typically track each other’s price changes. The NYMEX requires that a margin account be maintained that covers purchases or adjustments due to price changes of commodities being traded. The NYMEX also requires a separate margin account be main- tained for each commodity type. The margin account value is adjusted daily, and includes cash, money markets, and US Agency bonds that cover a percentage of the amount of fuel that the Council is hedged for at all times. When Metro Transit began hedging, 7% of the amount hedged was required to be maintained in the margin account. This amount has decreased slightly over time because of the Council’s good credit and the seasoning of the contracts relative to price changes. The money market accounts and US Agency bonds accrue interest, so surplus cash is moved out of the account as necessary. Generally, the program’s accounting and cash manage- ment are treated separately, e.g., when there are realized gains the cash is not usually physically moved out of the account and back to the Council’s pool; rather, the cash is moved only periodi- cally. Excess cash in the margin account is always invested and is ready to support price reversals on futures contracts still on the books. Metro Transit’s high fuel use requires frequent fuel purchases. The Council’s treasury depart- ment reviews Metro Transit’s projected diesel fuel consumption and coordinates with its broker- age firm to purchase and liquidate up to four futures contracts per week. (Liquidation occurs at the time of the corresponding consumption of the fuel.) Over the course of a year, the Council purchases approximately 150 contracts and liquidates a like amount. The Council now uses the financial consultant occasionally to receive feedback for hedging implementation and fuel purchase planning. The futures contracts typically have an expiration date of between 20 to 23 months forward. In total, the contracts cover approximately 90% of the fleet’s projected fuel consumption, even though the Council is able to hedge 100% of the projected fuel consump- tion. Hedging approximately two years out allows Metro Transit to set the next year’s budget knowing that 90% of the fuel costs will be locked in. The strategy of locking in only 90% of the projected fuel use allows for a margin of error to give flexibility for unanticipated fuel consump- tion changes that occur during the year.33 Looking retrospectively, Metro Transit can see that hedging two years out provides significant price certainty, but in some cases a time premium is paid for this insurance. At first, the Council hedged only diesel fuel purchases, but after the hedging program proved to be effective, a natural gas hedging component was added to the program to manage natural gas usage costs in buildings. Natural gas purchases were hedged with natural gas futures con- tracts. The Council used the same rolling hedges strategy for natural gas purchases. Only 80% 32Metropolitan Council, Procedure—Energy Forward Pricing Mechanism (p. 4) 33Metropolitan Council, Procedure—Energy Forward Pricing Mechanism (p. 2)

94 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies of projected natural gas consumption was hedged due to more volatile price movements asso- ciated with natural gas. Hedging of natural gas was performed for four years, but the Council ceased purchasing natural gas futures contracts at the end of November 2010 for the following reasons: 1) natural gas was then inexpensive and expected to remain that way due to excess supply, 2) the price risk of purchasing on the open market was low, 3) cash reserves were suf- ficient to ride out high variability, and 4) natural gas purchases were not a very large portion of the budget. Metro Transit’s fuel supply acquisition and costs are separate from the hedging process. Hedg- ing activity revenue (gains) and expenses (losses) are added to, or subtracted from, the fuel expense budget line item for accounting purposes. Approval and Execution Process The Council’s treasury department performs the in-house management of the hedging pro- grams’ price risk strategy. Staff obtain a periodic fuel “consumption report based on the relevant frequency of commodity consumption” from the Metro Transit director of purchasing. The data are used to determine the future hedging needs. Ultimately, the department makes the decision about when to purchase new futures contracts and/or make adjustments to previous hedge positions. Authorized treasury staff contact the agency’s brokerage firm and place the required orders. The annual brokerage fee for this level of diesel price protection is approximately $15,000, which is a relatively small amount of money compared to the fuel purchase costs. Council staff record the trade confirmations and financial transactions in a subsidiary accounting system. The Treasury Department is responsible for ensuring the margin account is funded at the proper level.34 The treasury department also provides a quarterly investment report to the Coun- cil’s Investment Review Committee and Management Committee which includes the status of the EMPM hedging accounts referencing realized and unrealized gains or losses. Results The Council evaluates the hedging program effectiveness based on its performance for creat- ing fuel price budget certainty. The program’s goal was to stabilize fuel prices and create budget certainty; it was not necessarily intended to minimize costs. Since the hedging program began in 2006, it has financially broken even (realized gains approximate realized losses). Most impor- tantly, Metro Transit emphasized that the hedging program has neutralized energy price spikes and dips, and has established budget certainty for 90% of its fuel costs as intended. For 2010, Metro Transit paid $2.67 per gallon of diesel fuel (net of hedging activity). On average there have been no negative outcomes resulting from the diesel hedging strategy. Tips for Success Planning and Communication Are Key Factors Finding support for initial legislation that enabled the creation and operation of the hedging program and communicating clearly that the program’s purpose was for achieving budget cer- tainty, and not speculation, was essential. The hedging program has been a positive experience for Metro Transit and the Council. Hedging has provided budget certainty and reasonable fuel prices, even if they are not always the lowest. This result is acceptable to the agency because of the added cost certainty. 34Metropolitan Council, Procedure—Energy Forward Pricing Mechanism (p. 3)

Case Studies 95 Find the Best Advisor for Your Agency, Be Careful About Doing It Yourself Metro Transit stressed that agencies that are interested in operating an in-house hedging pro- gram need to have sufficient funds for the margin account and also need to have substantial in- house expertise covering investing and accounting (and/or access to a good consultant). Agencies must first determine their risk tolerance and understand the potential upsides and downsides to hedging. Even with Metro Transit’s expertise it was recommended that the agency work with a financial consultant/advisor experienced in hedging petroleum markets. The Council’s financial consultant plays a critical role by providing the hedging expertise as well as the knowledge of applicable pieces of the market. The consultant is used to recognize and respond to risk, and makes the program manageable for the Council. The consultant is also used to keep the program on track and avoid problems. The agency stressed that it is important to take the time to research potential financial consultants to find the right firm for the agency, noting that there are many generalist advisors without significant experience in commodity hedging. The agency must also have the right contacts and make sure that its financial situation can support the activity. Similar to purchasing other types of insurance, it is important to make sure that the board or council understands the nature of this type of program and what is required for it. Different Firms Offer Different Abilities, Expertise, and Focus The financial consultant’s focus for the Council is on the advisory piece to the commodity programs, not the brokerage activities. Other firms may offer both the advisory and the bro- kerage hedging functions. Researching, understanding, and finding the right entities is crucial. Initially, futures contracts seem relatively straightforward; however, mismanagement can cause problems and misunderstandings can cause a reversal of support for the program. More com- plicated and sophisticated hybrid forward pricing mechanisms (e.g., options contracts) require more complicated accounting practices; there are firms that can handle the tracking of these activities if agencies need the assistance. Focusing on the budget certainty aspects will help maintain focus. Greater Cleveland Regional Transit Authority (RTA) Summary Location: Cleveland, Ohio metropolitan area Fleet: 492 diesel-power buses Fuel Volumes: Diesel – 5.0 million gallons (2010) The Greater Cleveland Regional Transit Authority (RTA) is a public transit agency serving the Cleveland metropolitan area. RTA covers 458 square miles and serves 1.3 million people. The agency operates 492 diesel-powered buses on fixed routes and provided an estimated 17.1 million service miles in 2009.35 RTA is a political subdivision of the state of Ohio and all power and authority granted to RTA is vested in, and exercised by, its board of trustees. About one-fifth of RTA’s budget comes from operating revenues, including passenger fares and adver- tising/concessions. The remainder of the agency’s budget is funded through sales/use taxes, grants, and other forms of funding. RTA’s 2009 diesel fuel expenditures were $17.4 million, accounting for about 7.3% of agency’s operating expenditures.36 This expense was expected to fall in 2010 and 2011. RTA launched an energy price risk management program in 2009 which has experienced favorable results. 35http://www.riderta.com/annual/2009/ 36http://www.riderta.com/annual/2009/

96 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies Delivery Price Risk Management Fuel Contracting Prior to 2006, RTA purchased diesel fuel on the open market. Worried about rising fuel prices, RTA used physical fixed-price contracts to cover fuel purchases in 2007 and 2009. For 2010, RTA fixed its fuel prices by hedging with financial instruments including exchange-traded futures and fuel price swaps with financial counterparties. Since then, RTA has purchased diesel via long-term contracts tied to the spot Oil Price Information Service (OPIS) price less a discount of 1.1 cents. Pooling RTA does not belong to a fuel purchasing cooperative. Commodity Price Risk Management History RTA’s fuel hedging program is a relatively new initiative that grew out of the record high fuel costs and extreme volatility of the mid-to-late 2000s. In 2006 and 2008, RTA entered physical fixed-price contracts to lock in prices for fuel consumption in 2007 and 2009, respectively. In 2008, with extreme volatility as the new reality for fuel prices, RTA sought to employ new tools to ensure better performance in the management of its fuel costs, and the agency started looking into the creation of an energy price risk management (EPRM) program, also known as a fuel hedging pro- gram.37 Neighboring Ohio transit agencies in Dayton and Cincinnati had maintained fuel hedging programs for several years and Cleveland hoped to launch a program under the same authoriza- tion. Ohio’s attorney general had issued an opinion that fuel hedging programs were permissible under existing state law, but Cleveland RTA’s lawyers would not allow the agency to move forward with the program because they did not believe the opinion provided adequate authority. RTA managed to insert authorization for the program into the state’s budget legislation. State-level authorization was not enough for RTA to launch its EPRM program. Before it could begin hedging, RTA needed to convince its board of trustees to allow it to move forward with a program. This proved to be a difficult task. The board was skeptical of hedging with finan- cial products and some board members considered the practice to be a “speculative investment” even though the budget legislation that authorized the program said that hedging was not specu- lative so long as the quantity of fuel hedged was less than total fuel consumption. Convincing the board to approve the hedging program required a lot of education. The manager of RTA’s Office of Management and Budget, RTA’s procurement manager, and an outside commodity trading advisor were the principal advocates of the program. After several meetings with the board, the program’s advocates eventually convinced the board to approve the program. By January 2009, the hedging program was finally ready to be launched. Strategy The overall objective of RTA’s fuel hedging program is to decrease energy price volatility, increase the certainty of future fuel costs, stabilize and control the budget, and lower overall long term energy costs. The fuel hedging program’s strategy uses a process that: 1. Addresses market opportunities and market risk; 2. Holds the risk of exceeding budget at or below an acceptable level; 3. Uses historical pricing ranges as pricing parameters; 37http://www.riderta.com/pdf/budget/2010/2-3PerformanceManagement.pdf (p. 12)

Case Studies 97 4. Is continuous; 5. Will use a dollar-cost averaging approach; and 6. Mitigates transaction-timing risk by making numerous smaller volume transactions (i.e., 42,000 gallons per transaction). RTA’s hedging strategy is unique in that it utilizes two instruments simultaneously. RTA hedges with both exchange-traded futures contracts (home heating oil futures traded on the New York Mercantile Exchange [NYMEX], the diesel correlate) and with over-the-counter fuel price swaps with financial institutions certified by the International Swaps and Derivatives Associa- tion (ISDA). Although hedging with futures contracts is less expensive than hedging with swaps, RTA chose not to hedge fully with futures because it feared that margin calls on its NYMEX margin accounts would potentially tie up too much of the agency’s limited funds. Hedging with NYMEX futures requires the agency to set aside a margin account of about 15% of the contract’s value. Thus, if RTA decided to hedge a large percentage of its fuel consumption or hedge far out into the future, the NYMEX would require the agency to fund a large margin account, which would be credited or debited as prices fluctuate. RTA’s over-the-counter fuel price swaps, on the other hand, do not require the agency to maintain a margin account or post collateral to back its investments. Swap dealers, however, lock in prices at premium—usually about 3.5 cents per gallon—over the futures price. RTA’s hedging policy dictates that the maximum hedge ratio will not be more than 90% of the forecasted consumption and that hedges can only go out 36 months into the future (this was extended from 24 months in mid-2009).38 RTA does not hedge all of its fuel in a single futures purchase or swap agreement. Instead, it hedges its forward fuel consumption over a period of several months, thereby minimizing transaction-timing risk. RTA also practices “dollar-cost averaging”: entering more futures contracts and swap agreements when prices decrease and buying less as they increase. By spreading out its hedging decisions across several months, RTA removes the risk of making a single-point decision that could be costly to the agency. Execution Process RTA’s fuel price hedging strategy was developed and implemented in concert with an out- side commodity trading advisory firm. The trading advisory firm is responsible for the daily execution of the program, including the execution of transactions, generating reports on the program’s status and results, and monitoring the program and energy markets.39 RTA’s EPRM committee—four officers from RTA’s budget and procurement offices led by the directors of these offices—works closely with the trading advisor. When the program was first launched this committee met often. However, as the agency gained experience with hedging, communication was reduced to quick email exchanges. The director of the budget office communicates regularly with the trading advisor and keeps the EPRM committee apprised of program activities. In practice, the trading advisory firm regularly monitors the market and identifies opportuni- ties to lock in low prices. They contact the manager of RTA’s Office of Management and Budget when buying opportunities present themselves and the RTA manager decides whether or not to hedge after receiving input from the EPRM committee. Both RTA’s Office of Management and Budget manager and the head of procurement are fully authorized to place hedging orders, although RTA’s general manager signs off on all transactions. The activities of the hedging program are also closely monitored by RTA’s internal auditor to ensure that the program is 38http://www.riderta.com/pdf/budget/2010/2-3PerformanceManagement.pdf (p. 12) 39http://www.riderta.com/pdf/budget/2010/2-3PerformanceManagement.pdf (p. 12)

98 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies legitimately doing what it was approved to do and that participants are not engaging in “specula- tive” investment activity. Results RTA’s experience with fixed-price contracts and financial hedging has yielded mixed results in terms of performance against spot market purchases. However, both hedging strategies achieved their stated goal of stabilizing the fuel budget and allowing the agency to adequately budget for the future. RTA first began hedging in 2006. Faced with runaway fuel prices, it joined a consortium to obtain a firm, fixed-price fuel supply contract with a local fuel supplier for 2007. RTA obtained what it believed was a fair price, but almost immediately after entering the agreement spot fuel prices dropped by 30 cents and RTA was caught paying a higher rate than the market. As 2007 wore on, however, fuel prices increased significantly, and by the end of the year RTA was breaking even on the fixed-price contract. Towards the end of 2007, RTA attempted to enter a fixed-price contract covering its 2008 purchases with a request for bids that was released in November 2007. RTA looked at the initial bids and believed that the agency could probably get a price that was 7 cents cheaper, so it kept the bid open and waited for a lower price. This proved to be an ill-advised decision. Prices con- tinued to increase between November 2007 and January 2008 when RTA officially closed the bid. RTA refused to hedge at higher prices, continuing to believe that prices would drop, and fuel purchases remained unhedged through the volatile oil price spike of 2008. In 2008, RTA’s cost per gallon for diesel fuel ranged from $2.54 to $4.18 and the decision to not hedge led to an increase in the fuel budget of $7.4 million compared to 2007, or about $3.6 million higher than RTA’s planned 2008 fuel budget.40 While RTA struggled to get a financial fuel hedging program authorized in 2008, fuel prices continued to increase. In July 2008, however, prices peaked and then began precipitously declin- ing. RTA watched as prices declined from a peak of $4.18 per gallon in July to $3.12 in September. In September prices appeared to have bottomed out and were beginning to increase again. RTA had not yet received authorization to hedge with financial instruments. Fearing it would lose an opportunity to lock in at the market bottom, RTA entered a physical fixed-price contract cover- ing its 2009 fuel purchases at $3.17 per gallon. RTA’s decision to lock in prices in September 2008 proved to be premature. Shortly after RTA locked in its contract for 2009, panic in the financial markets quickly reversed the brief spike in fuel prices. Prices continued to decline precipitously through 2008 and into 2009, and although RTA’s overall fuel costs fell from $19.3 million to $17.4 million between 2008 and 2009, costs could have fallen much more had RTA not hedged and instead purchased at the market rate.41 By the first quarter of 2009, RTA’s financial hedging program had been approved and was ready to commence. Having already locked in its 2009 fuel prices with a fixed-price contract, RTA began positioning its 2010 hedge portfolio. Seizing on record-low fuel prices in the first half of 2009, RTA hedged 100% of its projected 2010 fuel usage (five million gallons) with futures and swap contracts.42 The agency’s performance objective was to establish a 2010 fuel cost at or below $2.20 per gallon.43 RTA’s 2009 hedges locked in a projected 2010 fuel cost of $9.4 million (an average of $1.88 per gallon), roughly $1.6 million under the performance target.44 Taking 40http://www.riderta.com/pdf/budget/2010/2-3PerformanceManagement.pdf (p. 12) 41http://www.riderta.com/pdf/budget/2010/2010Budget_Full.pdf (p. 110) 42http://www.riderta.com/pdf/budget/2010/2010Budget_Full.pdf (p. 280) 43http://www.riderta.com/pdf/budget/2010/2-3PerformanceManagement.pdf (p. 12) 44http://www.riderta.com/pdf/budget/2010/2010Budget_Full.pdf (p. 280)

Case Studies 99 advantage of the attractive buying opportunities in early 2009, RTA also hedged its fuel con- sumption for as many months in 2011 as the agency’s hedging policy’s 24-month forward limit would allow. Realizing the potential of locking in low prices for the long term, the EPRM com- mittee quickly returned to the RTA board and, after two sessions, convinced the board to extend the forward hedging limit to 36 months. After the extension was granted, RTA locked in prices for the remainder of 2011. Tips for Success Spread out Hedging Decisions to Reduce Transaction-Timing Risk RTA has learned that it is important to spread the risk of timing decisions when entering hedge agreements. Prior to launching its financial fuel price hedging program, RTA locked in prices in single-point decisions to enter (or not enter) physical fixed-price contracts. Poor timing with a fixed-price contract in September 2008 led to an overpayment of millions of dollars versus the spot market price in 2009. By hedging with financial swaps and futures, RTA was able to make hundreds of smaller hedging decisions—each covering 42,000 gallons—that could be spread out across several months. With hundreds of contracts entered at different times, above-market (out-of-the-money) hedge contracts will typically be offset by an equal number of below-market (in-the-money) contracts. It Is Important to Be Nimble When Prices Are Volatile When RTA first launched its financial fuel price hedging program in January 2009, prices were the lowest that they had been since 2005. Prices were also relatively stable. This meant that timing decisions were not very important to the overall hedging strategy. By May 2009, however, fuel prices again began to exhibit significant volatility and RTA realized it needed to adjust its methodology to adapt to the new environment. RTA found that it had to be more nimble with its hedging decisions. The volatile market exhibited peaks and valleys and it was now important to monitor the market for the best hedging opportunities. When the program was first launched, RTA would announce to its counterparties that it intended to hold a bid one day before it was held. With prices exhibiting significant changes daily and even hourly, RTA shortened this window to just 20 minutes. A Clear Methodology Helps to Win Board Approval for Your Hedging Program One of the biggest challenges that RTA faced with implementing its hedging program was getting board approval for the program. RTA found that educating the skeptical board required a clear hedging methodology and enough data to show how the market is trending and explain the risks of not hedging. Even when a methodology was clearly presented, RTA found that it was still difficult for some board members to understand. Convincing the board requires assurance that the intent of the program is to stabilize the fuel budget rather than make money. Greater Dayton Regional Transit Authority (GDRTA) Summary Location: Dayton, Ohio Fleet: 276 buses: 113 forty-foot diesel buses (FY 2010), 10 forty-foot electric-diesel hybrid buses, 4 thirty-foot diesel buses, 54 forty-foot electric trolley buses, and 95 project buses <30- feet (FY 2010) Fuel Volumes: Diesel – 1.9 million gallons (FY 2008)

100 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies The Greater Dayton Regional Transit Authority (GDRTA) is the public transportation author- ity that serves the Greater Dayton metropolitan region, an area of more than 500 square miles that includes 19 communities within two counties, and more than 11 million passenger trips per year. GDRTA’s fleet is composed primarily of conventional diesel-powered buses. Dayton is the smallest city in the United States to operate electric trolley buses. Ten diesel-electric hybrid buses were added to the fleet in the spring of 2010 and the fleet expects to add ten more buses by the end of 2010 to further improve fleet average fuel efficiency and reduce greenhouse gas emissions. The bus fleet used approximately 1.9 million gallons of diesel fuel in FY 2008. Delivery Price Risk Management Fuel Contracting Between 1989 and 2007, GDRTA contracted its fuel purchases using an invitation for bids pro- cess issued to local fuel suppliers to secure annual fixed-price fuel supply contracts. This allowed for fair competition between local suppliers for GDRTA’s business and resulted in the best price and delivery of diesel fuel for GDRTA’s transit buses. GDRTA generally locked in prices 6 to 12 months out, but sometimes went out as far as 18 months. GDRTA found that prior to 2005 the diesel fuel market fairly consistently followed the rules of supply and demand, so fixed-price fuel supply contracts were an effective approach for purchasing fuel with price certainty. This correlation began to shift after 2005, and by late 2007 fewer fuel providers were willing to agree to offer fixed-price contracts as fuel costs increased, even for terms as short as three or six months out. If providers were willing to offer fixed-price contracts, they charged high premiums for the price inflation risk. GDRTA had to increase the annual fuel budget from 2005 to 2009 and eliminate some services to help avoid extensive fare increases. GDRTA initiated a financial fuel price hedging program in 2008 (see Commodity Price Risk Management section), so switched its fuel purchasing method to use fuel supply contracts (one year base period plus option years) with prices based on the Oil Price Information Service (OPIS) market plus a fixed margin of $0.08 per gallon. Pooling GDRTA investigated, but does not participate in, any cooperative purchasing arrangements. GDRTA’s size and fuel utilization volume is sufficiently large to have sufficient buying power to garner the best fuel prices. Purchasing fuel on its own terms also allows GDRTA to maintain control of its fuel purchases. Commodity Price Risk Management History In the years leading up to 2005, GDRTA primarily used fixed-price fuel supply contracts with local suppliers to lock in prices for up to 18 months out. As the correlation between market prices and supply and demand began to change during the next three years (2006 to 2008), GDRTA found it harder and more expensive to lock in prices with local suppliers over the long-term. In 2007, the GDRTA Investment Advisory Committee began considering using hedging strategies to address fuel price volatility. GDRTA’s board of trustees (board) had already authorized the use of forward pricing mechanisms in 1989 “. . . as a Budget risk reduction tool to manage price variability and cost/budget uncertainty associated with the purchase of diesel fuel,” so the legal groundwork was already in place establish a financial fuel hedging program. GDRTA issued an RFP in late 2007 to acquire a third-party fuel advisor. A Minneapolis-based company was selected, and assisted GDRTA to locate a futures brokerage firm and to create its Energy Price Risk Management Statement of Policy & Strategy. This strategy document addressed

Case Studies 101 the purpose of the risk management program, the program infrastructure, the physical supply of fuel, the strategy process, the program execution, and the monitoring and reporting require- ments of the program. The program document was adopted by the board in March 2008 and was subsequently revised in July 2010.45 The fuel advisor was paid a set monthly fee for services. The brokerage firm would also be paid a set fee for each hedging transaction. GDRTA was required by the New York Mercantile Exchange (NYMEX) to create and fund a margin account to cover a percentage of its hedged fuel purchases for potential projected losses. In addition, GDRTA also issued an RFP for fuel suppliers to deliver fuel based on the OPIS market prices plus a fixed margin of $0.08 per gallon (see Delivery Price Risk Management section). Strategy GDRTA’s primary fuel purchasing strategy objective is to attain the lowest fuel cost for both the short- and long-term and to maintain costs at, or below, the budgeted amount without speculat- ing or considering its EPRM as an investment. The strategy encompasses several elements. On the physical fuel purchasing side, GDRTA makes smaller, more frequent fuel purchases to take advantage of dollar cost averaging and to mitigate transaction timing risk. Physical purchases are made in 42,000-gallon increments, corresponding with the size of No. 2 heating oil futures contracts traded on the NYMEX. The heating oil index is used because the prices of diesel and No. 2 heating oil are highly correlated so typically track each other. The physical fuel purchase price is based on the daily OPIS market prices plus a fixed margin of $0.08 per gallon as outlined in the contract with the local fuel supplier. GDRTA is exposed to basis risk because physical fuel purchases are based on OPIS prices and the futures contracts are based on NYMEX prices. The financial side of the EPRM program employs a continuous, rule-based hedging strategy that utilizes historic price ranges as parameters and includes a process that addresses the market opportunities and risks. When a physical fuel purchase is made, GDRTA simultaneously sells a futures contract which ties the price of fuel to the price of No. 2 heating oil on the contract creation date. Initially, GDRTA’s hedging policy allowed for covering up to 80% of its antici- pated fuel purchases. The policy was revised in 2008 to allow GDRTA to cover up to 95%. This provided additional flexibility and enables GDRTA to have a high level of budget certainty and protection from large fuel price increases. In July 2010, GDRTA enacted a maximum hedged fuel price limit of $100 per barrel to avoid issues that come with a volatile fuel market. If the price exceeds this limit, the GDRTA Investment Advisory Committee will hold a special meeting to vote on necessary action and make decisions as to purchasing futures contracts when crude oil prices are above $100 per barrel. This policy was put in place to have the board and Investment Advisory Committee become more involved at that threshold to make decisions to protect the budget and future costs in the event that prices shifts downward where GDRTA could be locked in at unreasonably high prices. Approval and Execution Process The Investment Advisory Committee, which includes the CFO, works with the fuel advisor to develop recommendations on future fuel purchase decisions. The Investment Advisory Com- mittee makes the final decisions according to plan within the scope of the risk management policy and strategy. The CFO and fuel advisor are responsible for executing the transactions. The CFO and the fuel advisor are also responsible for the continual monitoring of the energy markets and for generating reports on the program’s status and results. The brokerage firm also submits daily and weekly reports to GDRTA that show the past few weeks’ activity and what the futures markets look like. The CFO and the fuel advisor also develop weekly status and results 45Energy Price Risk Management Statement of Policy & Strategy, Greater Dayton Regional Transit Authority, Initial Adoption/ Effective Date: March 20, 2008, Revised: July 15, 2010

102 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies updates to keep the involved parties informed. Monthly status and results reports are generated, which also include a risk analysis and a summary on the futures account activities. Oversight for the program is primarily the responsibility of the Investment Advisory Committee, and the board of trustees is updated on the performance of the program periodically as the board deems necessary. Results GDRTA began purchasing futures contracts of No. 2 heating oil on the NYMEX exchange in April 2008 through the brokerage firm. In accordance with the then-upper limits of GDRTA’s risk management program, GDRTA purchased futures contracts to cover 80% of anticipated fuel use for the next 24 months. Diesel fuel prices rose dramatically after this time to $4.07 per gallon, and market analysis indicated that prices would continue to rise. The board of trustees took these circumstances into account and approved a change to the agency’s hedging policy to allow for hedging of up to 95% of the forecasted fuel consumption. With new upper limits in place, and in anticipation of expected fuel price increases and shorter supplies, GDRTA purchased futures contracts each month to maintain coverage for 95% of the anticipated fuel purchases 24 months out. The contracts were purchased near the peak of the oil prices (July 2008). The bus fleet used approximately 1.9 million gallons of diesel fuel in FY 2008 at an average cost of $3.41 per gallon, including the hedging activities. Because of the unexpected decline in fuel prices, by the end of 2008 GDRTA experienced realized losses of $368,737 and unrealized losses on the remaining open contracts of $3.1 million corresponding to the expectation of lower fuel costs in upcoming fiscal periods.46 As fuel prices precipitously declined in 2009, GDRTA discontinued purchasing futures con- tracts so the agency was not locked in to paying significantly more than current market prices. The average diesel fuel cost in FY 2009 was $3.27 per gallon. The fuel purchases were within the budget, partially because the fuel budget was increased due to higher fuel costs. At the end of 2009, the investment committee resumed the hedging program by purchasing new hedging con- tracts, but with a slower approach than during the period of much more volatile price fluctua- tions that took place in 2007 and 2008. The next Investment Advisory Committee meeting was scheduled for January 2011 to determine the next steps, which most likely would include locking in prices starting in April/May 2011. GDRTA’s fuel price FY 2010 forecast was $2.30 per gallon, but through the first three quarters the average diesel fuel cost was $2.42 per gallon. In light of current diesel fuel prices and prior experience, GDRTA reassessed its hedging strategy and planned to have a new approach in place for when its futures contracts expired in April of 2011. Overall, GDRTA’s risk management program has provided the agency with a level of budget certainty and protection from extreme price increases at a time when expectations and market indicators pointed to even higher inflation of oil costs. GDRTA evaluates the hedging program effectiveness by a comparison of the unrealized gains/losses and by whether they operate within the fuel budget. Tips for Success Develop Risk Assessment Experience Assessing risk has been difficult, especially in light of the volatile fuel prices of 2008 and the ensuing economic downturn. Additionally, GDRTA has found that fuel prices now have a closer relationship to stock market values and fluctuations than to supply and demand, which has made 46Audit Report for the Years Ended December 31, 2008 and 2007, Greater Dayton Regional Transit Authority, http://www. i-riderta.org/assets/1/workflow_staging/AssetManager/332.pdf, March 29, 2009 (p. 27)

Case Studies 103 it far more difficult to implement an effective hedging strategy compared to prior years when forward pricing contracts were used. GDRTA notes that it takes experience to have an educated understanding of fuel pricing, supply and demand, and the ability to factor in how Wall Street speculation and current events affect fuel and hedging prices. Be Cautious When Locking in Prices GDRTA noted that there is a cost to locking in prices, but does not view its hedging program as an insurance policy; rather, it is a means to locking in a budgeted number. However, a point can be reached when the upside protection becomes too expensive and can result in a long-term negative effect in the event prices drop when the agency is locked in at high prices. This situation has deep effects, not just in terms of realized and unrealized gains/losses, but also in terms of actual money being spent that could either be saved or go to other programs or needed services. It is necessary that the board understand these factors and their effect on the public’s perception of GDRTA. Chicago Transit Authority (CTA) Summary Location: Chicago, Illinois Fleet: 1,782 diesel buses, 1,190 electric rail cars Fuel Volumes: Diesel – 22.1 million gallons (2009), Electricity – 408,000 MWh (traction power) The Chicago Transit Authority (CTA) operates the nation’s second largest public transporta- tion system, serving the Chicago metropolitan area with a fleet of 1,782 diesel-powered buses and 1,190 electric rail cars along eight rail lines. CTA is an independent government agency created by state legislation and governed by the Chicago Transit Board, which is appointed by the mayor of Chicago and by the governor of Illinois. CTA generates revenue from both farebox collections and non-farebox revenues, and receives supplemental funding for operating expenses from the Regional Transportation Authority.47 In 2010, CTA’s diesel fuel costs were $52.1 mil- lion, representing an average fuel price of $2.71 per gallon. CTA participates in a fuel purchas- ing cooperative for non-revenue vehicles only. The agency has maintained an energy price risk management program since 2003. CTA’s hedging program has evolved over time from a discrete, situational hedging strategy to a strategy with a continuous, rule-based approach. Delivery Price Risk Management Fuel Contracting CTA purchases fuel through a supply contract which is obtained through a competitive bid- ding process. CTA’s most recent diesel fuel contract is an 18-month contract running from April 2010 to October 2011. The contract follows a “rack plus margin” pricing method whereby CTA pays the rack price for No. 1 ultra low sulfur diesel (USLD) plus a fixed differential of $0.095 per gallon to account for the distributor’s profit margin, trucking fees, insurance, office overhead, etc. CTA is a large purchaser of diesel fuel and bids are highly competitive with respect to the differential. However, the rack or wholesale portion of the fuel price fluctuates with the market. CTA believes that it could obtain a fixed price contract (with both a fixed differential and a fixed rack price) but that doing so would be prohibitively expensive. 47http://www.transitchicago.com/about/facts.aspx

104 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies Pooling CTA participates in a fuel purchasing cooperative for its non-revenue vehicles only. A number of other municipal departments and sister agencies belong to this cooperative. Commodity Price Risk Management History CTA’s energy price risk management program was first initiated in 2003. In that year, the agency was looking for innovative ways to mitigate budget variance. Jim Burns, CTA’s general manager of treasury management at the time, had significant experience with hedging programs and recommended to the CFO, Dennis Anosike, that CTA explore the opportunity. Anosike submitted a request to the Chicago Transit Board to allow CTA to test a pilot hedging program to bring the agency’s fuel budget under control. The board authorized Anosike to move forward with a pilot hedging program that would cover up to 50% of CTA’s fuel requirements. Once authorized to begin hedging, CTA issued an RFP for fuel hedge counterparties and received responses from five to six financial institutions and energy companies. Based on a set of evaluation criteria, the agency narrowed these proposals to two qualified financial institutions. CTA’s lawyers then performed the time-consuming task of negotiating master swap agreements with the two chosen counterparties. Meanwhile, CTA’s accounting department began to deter- mine how to handle hedge accounting and accurately record the program’s monthly cash settle- ments under the proposed swap agreements. In November 2003, with the legal and accounting measures finally in place, CTA entered a one- year swap agreement with monthly payments based on a notional amount of 950,000 gallons of NYMEX No. 2 heating oil, equal to about 50% of the agency’s annual fuel consumption.48 The pilot program was very successful. Despite higher consumption, CTA’s fuel costs increased by only 23% between 2003 and 2004 while spot diesel prices increased by more than 30%.49 In 2004, the board authorized a permanent program that allowed CTA to hedge up to 100% of its fuel requirement. Strategy CTA’s current energy price risk management policy was put in place with the help of an energy consultant in 2008. Prior to 2008, CTA’s hedging program was managed by Jim Burns in CTA’s trea- sury department. This policy allows CTA to use derivative instruments to hedge the price of diesel fuel. The policy does not allow financial instruments to be used to hedge electricity and natural gas. However, these commodities may be hedged through the use of physical fixed price contracts. CTA’s energy price risk management policy allows the agency to hedge up to 100% of the agency’s diesel fuel requirement for a period of up to 18 months, and 50% of volume from 18 to 24 months. No hedging is allowed beyond 24 months. CTA’s hedging policy allows the agency to use several derivative instruments, including over- the-counter (OTC) swaps, and other contracts, such as caps, floors, and collars. CTA uses finan- cial instruments to hedge when they: 1. Reduce expected fuel costs; 2. Hedge fluctuations in fuel prices and/or; 3. Gain efficiency in structuring fuel-related transactions. 48http://www.transitchicago.com/assets/1/finance_budget/cta2003fin.pdf (p. 39) 49http://www.transitchicago.com/assets/1/finance_budget/cta2004fin.pdf (p. 8) and http://www.eia.gov/dnav/pet/hist/Leaf- Handler.ashx?n=PET&s=RHONYH&f=A

Case Studies 105 The policy stipulates that CTA use OTC swaps that reference the price of the NYMEX No. 2 heating oil futures contract, which effectively tracks the price of ULSD with little basis risk. Swaps are allowed in increments of 42,000 gallons, equivalent to one futures contract on NYMEX No. 2. Because CTA purchases its fuel based on a regional diesel rack price and its swap contracts are based on NYMEX prices for fuel delivery in New York Harbor, the agency is exposed to adverse basis risk (the possibility that the local price will go up and the NYMEX price will go down), causing CTA to simultaneously pay more for physical fuel and lose money on its derivative contracts. However, historical price analysis shows a strong correlation between the NYMEX and the regional rack price, and the adverse basis risk has been determined to be low. Historical instances where the two indexes have diverged have been rare and would not result in significant losses for CTA. CTA’s strategy involves entering swap contracts in a layered approach. Instead of entering a single swap agreement covering an entire year’s fuel requirement, CTA enters quarterly strips (three consecutive months of OTC swap contracts) with higher coverage for near months but lower coverage for months farther out. As current months expire and future months approach, CTA enters additional swap agreements to increase its near-month coverage. As a result, each month is hedged by two to four layers of separate swap agreements initiated at different times with reference prices that reflect the market at the time of initiation. This strategy ensures that no single reference price is overly weighted in the hedge portfolio, thus lessening the risk of lock- ing in a price for the year at the height of the market. This continuous, rule-based approach to hedging provides direction to CTA’s hedging program and requires less monitoring of market conditions. CTA’s hedging policy also allows the use of stop orders that initiate swap contracts with counterparties (upon CTA management approval) when certain trigger prices are reached. When prices are rising above market, stop orders initiate swaps that allow CTA to lock in a price to keep the agency within its fuel price budget for the year and set a cap on further fuel price increases. When prices are falling, below-market stop orders allow CTA to lock in a low fuel price before prices rise again, thus taking advantage of temporary market dips. Although CTA’s strategy of continuous, rule-based hedging does not require constant mar- ket monitoring, CTA’s hedging policy directs it to actively manage its derivative contracts. This entails frequent monitoring of market conditions by CTA’s energy advisor (a separate company) to identify emergent hedging opportunities and risks. Based on analysis of the market, CTA may modify its existing swap positions including: • Early termination; • Shortening or lengthening of contract terms; • Adjustments to stop order: • Sale or purchase of options; • Use of basis swaps; and • Entering into offsetting derivative contracts.50 These modifications are allowed if management determines that they will maximize the ben- efits and minimize the risks that the agency carries on its derivative contracts. The policy does not allow modifications of existing positions for speculative purposes. CTA implements its hedge strategy through written agreements with approved counter- parties. The agreements are based on the generally accepted ISDA Master Agreement of the industry and any special clauses agreed upon by CTA and the counterparty. In addition to typical 50Energy Price Risk Management Policy, Chicago Transit Authority, November 2009 (p. 3)

106 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies qualification criteria related to creditworthiness and experience with derivative instruments, CTA also requires that its counterparties be willing to accept one-way cash collateral. This means that CTA can require its counterparty to post cash collateral to back up its swap position, but the counterparty cannot require CTA to do so. CTA’s hedging policy prohibits it from entering into swap agreements that require it to post cash collateral unless “it is clearly in the best interest of the Authority.”51 Instead, CTA’s swap agreements include a credit support agreement under which CTA pledges general obligation dollars to meet its requirements under the swap contract. Approval and Execution Process CTA’s Energy Price Risk Management Committee (a group made up of members of the agency’s budget, treasury, and purchasing departments) reviews CTA’s hedging program on a monthly basis to develop a plan to define acceptable energy costs, review and evaluate recom- mended price risk management transactions, and determine whether proposed transactions are consistent with CTA’s hedging policy. If the EPRM committee determines that additional hedging is needed, the treasurer/CFO will recommend the transactions to the board chairman for approval. This process may involve setting milestones requiring a certain percentage of fuel be hedged by a certain date. When setting the hedging schedule, the EPRM committee receives hedging advice from CTA’s energy adviser. Once board approval for the hedging transactions is obtained, execution is handled by the CFO’s designee, CTA’s general manager of treasury management. The general manager works with CTA’s energy advisor to determine the best time to execute the approved hedging strategy. In practice, CTA’s advisors contact the general manager when they believe they have identified a hedging opportunity within the framework of the EPRM committee’s hedging directives. The company sends the general manager pricing charts and the general manager cross checks these charts against Bloomberg data. If comfortable with moving forward, the general manager con- tacts CTA’s two qualified counterparties to obtain price quotes (typically for quarterly strips) and then selects the counterparty based on the price offered and counterparty risk concentration. CTA evaluates its hedging results along two criteria: 1) how the actual fuel expenditures fare against the fuel budget, and 2) whether CTA is receiving or paying money on the swap con- tract. The general manager of treasury management sends swap payment information to CTA’s accounting department, which evaluates fuel payments against the budget. Monthly commodity reports showing fuel expenditures are prepared by CTA staff and provided to select committee members. Results CTA’s pilot hedging program, which limited hedging to 50% of annual fuel consumption, was a successful venture, saving the agency at least 7% on its 2004 diesel fuel costs versus the spot market. Following the successful pilot program, which ended at the end of October 2004, CTA received approval for a permanent program that allowed the agency to hedge up to 100% of its fuel requirements up to 18 months and 50% of its requirements from 18 to 24 months. With a permanent program in place, CTA decided to take a layered approach rather than hedging all of its fuel consumption under one swap agreement. At the end of November 2004, CTA entered a 12-month swap agreement with monthly payments based on 285,000 gallons of NYMEX heating oil futures.52 Over the course of the 12 months, the swap covered 3.42 million gallons of fuel, or roughly 16% to 17% of the agency’s annual fuel consumption. Then, CTA methodically entered into five separate 12-month swap agreements on the first day of the first 51Energy Price Risk Management Policy, Chicago Transit Authority, November 2009 (p. 3) 52http://www.transitchicago.com/assets/1/finance_budget/cta2004fin.pdf (p. 40)

Case Studies 107 five months of 2005. Each of these contracts covered 16% to 17% of its annual fuel consump- tion.53 Thus, by the end of May 2005, CTA had fully hedged its 2005 fuel requirements and had partially covered itself for 2006. CTA’s 2004–2005 hedging program again paid dividends. By the end of 2004, CTA’s 2004 commodity swap held a fair value of $3.6 million and by the end of 2005 the agency’s January-May 2005 swaps had a fair value of $1.3 million. In October 2005, CTA continued its layered approach by executing two 12-month swaps cov- ering 16.8 million gallons through October 2006.54 Soon after entering these contracts, prices declined and their fair values initially dropped to negative $0.6 million at the end of 2005.55 However, prices rose again over the course of 2006 and the two contracts had a fair value of $0.3 million by the end of the year. In June 2006, CTA began executing 12-month swaps for 2007, and by September 2006 had hedged 22.8 million gallons or 95% of CTA’s annual usage. Falling oil prices led to a negative fair value of $8.6 million at the end of 2006, but by the end of 2007 the fair value was $0.85 million. In July 2007, Jim Burns, the general manager of treasury management who led the day-to-day activities of the energy price risk management program at CTA, left the agency. This left the pro- gram with a considerable knowledge gap. CTA responded by appointing a new general manager to Burns’s position and eventually bringing in an outside company as an energy consultant. The hedging process was also reformed so that hedging transaction decisions would be made by the EPRM committee and the consultant rather than by one individual. This restructuring allowed the program to continue through the changeover in management and made it so that no single person had complete authority. Following its energy consultant’s guidance, CTA changed its strategy from a discrete, situ- ational approach to a continuous, rule-based approach. Rather than entering 10–20 swap agree- ments in a single month to cover the year’s fuel consumption, the consultant suggested pursuing a layered approach in which swap agreements are entered into on a quarterly basis (see Strategy section). According to the new general manager, Paul Murray, the new approach was more logi- cal and disciplined because it did not involve speculation or trying to predict the direction of the market. By breaking hedging transactions into numerous, smaller agreements spread out in time, the new rule-based strategy took the uncertainty out of making market timing decisions. The consultant also suggested the use of stop orders at prices above or below the current market price to either set a cap on the price and limit exposure to higher prices or take advantage of a drop in price. CTA’s hedges from its 2007 hedging program expired at the end of the year and the agency remained unhedged over the first few months of 2008 as the new hedging program with its consultant was being put into place. Amid soaring fuel prices in the spring of 2008, CTA’s board of directors asked the agency to expedite hedging transactions. CTA executed twelve new swap agreements with effective dates between May 2008 and January 2010 and terms of 7 to 13 months. When oil prices collapsed in the second half of 2008, CTA’s swaps began to lose money. By the end of 2009, the twelve contracts had a fair value of negative $62.1 million.56 This experience led to the development of a stronger, more disciplined hedging program. In 2009, CTA entered 28 new swap agreements covering 2009 and 2010. Of these contracts, six covered volumes in 2009. These contracts had a fair value of negative $3.8 million by the end of the year. CTA’s hedges from 2008 had locked in record-high prices and over the course of 2009 53http://www.transitchicago.com/assets/1/finance_budget/cta2005fin.pdf (p. 48) 54http://www.transitchicago.com/assets/1/finance_budget/cta2005fin.pdf (p. 48) 55http://www.transitchicago.com/assets/1/finance_budget/cta2006fin.pdf (p. 50) 56http://www.transitchicago.com/assets/1/finance_budget/cta_financialstatements_2009-2008.pdf (p. 67)

108 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies CTA’s average fuel price was $4.55 per gallon. Illinois retail diesel prices averaged about $2.00 per gallon in the same year.57 At the end of 2009, the 22 swap agreements hedging 2010 consumption covered 14.1 million gallons of fuel (about 77% of projected usage of 18.4 million gallons) and had a fair value of negative $1.8 million, with some contracts holding positive values and others holding negative values.58 As diesel prices increased in 2010, many of the futures contracts with negative values turned positive. At the end of 2010, CTA’s average fuel price was $2.71 per gallon and CTA reduced its settlement payments by $47.9 million from 2009. By the end of 2010, all contracts had a fair value of $2.3 million. Despite the negative results from hedging in 2008 and 2009, CTA remains committed to its hedging program. The original goal of the program was to mitigate budget variance, and in this respect it has been successful. Although hedging at the height of the market led to adverse results, the experience has helped CTA to develop a stronger, more disciplined hedging program. 57http://www.eia.gov/dnav/pet/pet_pri_dist_a_EPD2D_PTC_cpgal_a.htm 58http://www.transitchicago.com/assets/1/finance_budget/cta_financialstatements_2009-2008.pdf (p. 66) Source: 2011 CTA Budget Book Tips for Success Continuous, Rule-Based Hedging Is Easier to Implement Than a Discrete, Situational Strategy The continuous, rule-based approach to fuel price hedging recommended by CTA’s energy consultant and implemented by CTA since 2008 was easier to implement than the discrete, situational hedging strategy that CTA had practiced in prior years. Under the situational strat- egy, the CTA’s general manager of treasury management, Jim Burns, had full control over the hedging decisions. Timing decisions on swap agreements were made based on Burns’ personal analysis and predictions on the direction of oil markets. Burns had experience with hedging and CTA trusted his judgment. When Burns left in 2007, CTA was left with a significant knowledge gap and the agency was not comfortable entrusting hedging decisions to a single staff member. Instead, CTA switched to a rule-based strategy, whereby decisions were made by a committee (with the help of an outside adviser) and implemented according to a rule-based schedule with swap agreements executed over the course of a year rather than at a single point in time. The CTA staff responsible for implementing this strategy has found it more logical, disciplined, and easier to implement since it removes much of the stress of timing decisions. This strategy also prevents any single individual from having too much control over the hedging process and ensures con- tinuity of the program in the event of staff turnover.

Case Studies 109 Market Orders Offer Additional Price Controls CTA has included market orders in its hedging strategy since 2008. Market orders initiate swap contracts when certain target prices are reached. For example, if CTA has a price target of $3.00 per gallon and prices are rising, CTA may let them float and only lock in the price if it hits a particular target (say $3.50) that, when locked, will cause the average price for the year to stay within the budget of $3.00 per gallon. The target price will constantly move based on the realized (paid) prices earlier in the year. It Is Difficult to Exit Hedge Positions without Cash Flow Availability During the tumultuous price collapse of 2008–2009, Murray and other CTA staff considered unwinding their hedged positions in order to take advantage of further price decreases, but they were prevented from doing so by the exiting costs and the agency’s cash flow availability. Unwinding its swap agreement would have required CTA to cash-out its future, unrealized losses at a single point in time at the current mark-to-market price. This would have required CTA to pay out millions of dollars in a single transaction (rather than several smaller transactions over several years as the contracts reached maturity). Because CTA is funded by general obligation dollars and does not maintain a margin account, adequate cash was not available to unwind the agency’s positions. Alternatively, CTA could have exited its position by entering into additional swap agreements and taking the short (rather than long) position. However, doing so would have required a new swap agreement, which may have involved a lengthy negotiation process. A Good Hedging Adviser Is Worth the Cost The CTA staff responsible for implementing the hedging program believes that the return from hiring an energy adviser is worth the outside cost. Greater Toronto and Hamilton Area Metrolinx/GO Transit Summary Location: Toronto, Ontario, Canada Fleet: 360 forty-five-foot coach buses, 62 locomotives, and 491 rail cars Fuel Volumes: Diesel – 11.6 million gallons (FY 2009) Metrolinx/GO Transit (GO Transit) is Canada’s first, and the Province of Ontario’s only, inter- regional public transportation service for the Greater Toronto and Hamilton Area of Southern Ontario (approximately 4,000 square miles). GO Transit’s fleet includes 360 diesel coach buses, 62 diesel locomotives, and 491 rail cars. GO Transit runs 185 train trips and 2,045 bus trips daily, carrying about 217,000 passengers on a typical weekday—180,000 on trains and 37,000 by bus. The combined rail and bus system handles nearly 55 million riders annually. GO Transit is in the process of transitioning to new locomotives that are capable of pulling 12 cars (up from ten cars with the current locomotives). Fuel consumption of the locomotive will increase as a result of the new locomotive’s larger size, but fuel consumption per car will be lower. Delivery Price Risk Management Fuel Contracting GO Transit operates on a fixed income; roughly 80% to 90% of operating costs are covered by fares. A fixed government subsidy covers the remaining operating costs. The agency is required to operate on a balanced budget, so achieving price certainty is critical. The agency cannot afford wild fuel price swings, so locking in prices is critical. If it exceeds (or does not reach) its budget,

110 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies the agency must request (or return) additional funds from (to) the government. To meet these requirements, GO Transit’s fuel purchasing strategy emphasis is to establish and maintain cost certainty in its budget. GO Transit has utilized fixed-price contracts through suppliers with the ability to hedge for the last nine years. GO Transit selects fuel suppliers through an RFP process and currently contracts with one supplier to meet the majority of its total fuel requirement. The contract with this supplier was a one year agreement with four option years; the contract is now in its fourth year (Option Year 3). The contract stipulates that the supplier must have the ability to hedge and pass along these benefits to GO Transit by giving the option to lock in fuel prices. This requirement provides GO Transit with the budget certainty it need without operating an in-house hedging program. Not all fuel is purchased under the fixed price contract, so the base contract can also be used to provide fuel at a discount from the Bloomberg index that is below rack price for that week, plus a delivery fee. GO Transit can also buy fuel from the spot market. In the current arrangement, Ultramar operates an in-house hedging program and purchases futures contracts (in 42,000-gallon increments) for NYMEX No. 2 heating oil to hedge diesel fuel purchases used to supply its customers. The heating oil index is used because the prices of diesel and No. 2 heating oil are highly correlated so typically track each other. The supplier then passes the benefits and costs of its hedging program on to GO Transit by means of fixed forward pricing contracts. Hedging on the NYMEX also adds an exchange rate risk for both the supplier and GO Transit. This risk is included in the hedging fees the supplier charges GO Transit. GO Transit received board approval and then approval from the Ministry of Finance before initiating this approach for using hedged fixed price contracts to lock in long-term fuel prices. The approvals were not difficult to get since the fleet already had a commitment to purchase the volume of fuel to meet service requirements, so there was no need to change its investing policy or take any legislative action. The result of this arrangement is that GO Transit realizes the benefits and price stabilization of fuel hedging without having to operate an in-house hedging program. This method also means that the GO Transit does not have the administrative and margin account burden for operat- ing its own program. The supplier assumes the up-front administrative overhead, the program operation, and assumes the credit and financial risk for maintaining the margin account. These costs are passed onto GO Transit as a premium, or fee, which is included in the agreed upon fuel price and fuel volume purchase requirement. The downside to this approach is that because the RFP requires vendors to have the ability to hedge to offer fixed-price contract options, it limits the list of potential fuel suppliers. This is limiting, especially recently because fewer fuel suppli- ers are offering this service. One difficulty that was experienced with this arrangement was that the supplier’s credit rating was negatively impacted by the economic downturn in the summer of 2009. To address this, the supplier considered reneging on its fixed-price contract obliga- tion with GO Transit. Ultimately, this did not happen and the supplier honored its contractual commitment to GO Transit, so the agency was not affected. The agency did experience contract purchasing delays and a period of uncertainty about the ability to continue having the option of fixed-price contracts. Strategy GO Transit’s fuel purchasing policy does not place an upper limit for the hedged fuel purchase percentage, so it can hedge up to 100% of its fuel purchases. GO Transit, however, is not required to hedge its fuel purchases, so it could buy all of its fuel on the spot market if that was the best option. Based on previous experience, GO Transit chooses to hedge conservatively, typically entering fixed-price contracts targeting 80% of its diesel fuel purchases. Hedging this percentage of fuel use allows the agency to have reasonable budget certainty while maintaining the flexibility

Case Studies 111 to deal with unexpected circumstances, such as budget cuts or strikes. The remaining 20% of fuel purchases are purchased on the spot market. One company currently supplies approximately 90% of GO Transit’s fuel requirements (most under contract, some on the spot market). The remaining fuel purchases take place with vendors at local depots on the spot market. For example, in August 2010, approximately one million gal- lons of diesel came from the supplier (766,000 gallons for rail and 238,000 gallons for buses), while 132,000 gallons (13.1%) came from third-party suppliers. GO Transit prepares its annual budget request with a target fuel price in mind. Hedging incre- mentally through the year allows GO Transit to lock in prices at its target price. By necessity, GO Transit will often initiate fixed-price contracts well before the agency has an approved budget for the following year from the Ministry of Finance. Because of this, it is imperative to have a financial buffer in place in case the Ministry of Finance reduces GO Transit’s budget. GO Transit purchases diesel fuel using one-year, fixed-price fuel contracts, reflecting the maximum contract timeframe its supplier will offer fixed-price contracts. Each contract is for 42,000 gallons (1,000 barrels) of diesel fuel. The diesel fuel is hedged on the New York Mercan- tile Exchange (NYMEX) against a corresponding volume of a No. 2 heating oil futures contract, which is purchased by the fuel supplier. The heating oil index is used because the prices of diesel and No. 2 heating oil are highly correlated so typically track each other. The agency has several contracting timing options including initiating multiple contracts to cover a whole year of fuel, initiating a single agreement, and incrementally initiating multiple contracts throughout the year. For example, if GO Transit is purchasing on a longer-term basis, it may hedge 20% of the annual demand and wait to see how prices trend and respond accordingly. For example, as of this writing, GO Transit is not hedged from April 2011 to April 2012. Approval and Execution Process GO Transit collaborates with its major supplier and a third-party financial consultant to advise the agency on market fundamentals. The supplier provides GO Transit with a daily list covering fixed-price contract availability for the next 12 months. The manager of accounting works with the director of finance to monitor the market and GO Transit’s supply needs, and communicates daily with the supplier for fuel purchases. The financial consultant understands GO Transit’s methodology, need for budget stability, and has a good understanding of the fuels market. The consultant provides advice directly to GO Transit and is responsible for communicating on when to hedge based on market fundamentals throughout the year. Purchase decisions, however are ultimately GO Transit’s decision. GO Transit’s CFO, director, managing director, and manager of accounting meet periodically on an ad hoc basis to review diesel purchases strategically and to make long-term contract purchase decisions based on the available information to match the agency’s long-term strategic plans. Adjustments are made as necessary during the year. The direc- tor of finance can at any time contact the supplier to order a specific amount of fuel, at a price not to exceed a fixed ceiling to initiate a fixed-price contract. Based on the request “at a price not to exceed a fixed ceiling,” it may take days or even weeks for the supplier to fill the order depend- ing on market prices. It is also possible that the market never reaches the requested price; in this case the order goes unfilled. Normally, GO Transit places orders that it believes are achievable in a couple of days. Once a contract is approved, GO Transit notifies its supplier (located in Montreal, Canada), which in turn purchases the futures contract(s) to cover the fixed-price order through its trading desk in California. Since the futures contract(s) are purchased on the NYMEX, the price includes the prevailing US exchange rate. GO Transit receives a monthly invoice from its supplier based on the rack price and fees per the contract agreement. The supplier adds a credit or debit to GO Transit’s account balance based on the performance of the previous months’ hedge.

112 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies GO Transit’s financial statements disclose its financial obligations through contracts with fuel suppliers. There is no need to maintain a margin account or for separate accounting because the supplier executes the hedging. Results Over the long-run, GO Transit’s hedging strategy has broken even. GO Transit considers this a successful result because the agency considers budget certainty to be the primary program objec- tive. The fuel purchasing program effectiveness is not evaluated in any other way. For example, GO Transit does not do a “win/lose” analysis that evaluates the financial gains/losses from the hedging activity. GO Transit does not second-guess hedging decisions that result in paying a higher price for fuel; the focus is, and will continue to be, cost certainty. GO Transit is, however, considering other options for hedging fuel purchases by establish- ing an in-house hedging program to increase flexibility and potential savings in costs through competition among suppliers. GO Transit will need program approval from the Ministry of Finance and then will amend its operating policy to include hedging activities. It is likely that the program would have to limit itself, at least initially, to selecting simpler and less risky financial products to hedge with. GO Transit will also have to consider the exchange rate risk since most petroleum products in Canada are hedged using North American indexes such as the NYMEX. GO Transit was negatively impacted by market timing decisions. In one instance, GO Transit delayed locking in a price because it did not want to lock in above its targeted budget price. Diesel prices rose dramatically, and GO Transit purchased diesel from its supplier at market prices. Pooling GO Transit does not participate in, nor is pursuing, any cooperative arrangements. Consid- eration has been given to this approach through discussions with the other ministries. Inves- tigation found that each ministry had its own policies and contract dates, which would prove difficult for implementing any cooperative agreement. Though potentially proving beneficial to others, it would not necessarily reduce the fuel price paid by GO Transit. GO Transit has found that its fuel utilization volume is of sufficient size to have buying power to garner the best fuel prices while maintaining control of its fuel purchases. Commodity Price Risk Management GO Transit does not operate a fuel hedging program. Instead, the fuel vendor hedges its bulk fuel purchases and passes the cost of its hedged position on to GO Transit (see Delivery Price Risk Management section). Tips for Success Fewer Suppliers Willing to Hedge Equals Higher Costs As fuel prices have grown more volatile in recent years, GO Transit has found that fewer sup- pliers are offering fixed-price contracts, and that those that do offer fixed-price contracts charge a high and increasing premium for the service. As a result, the agency is considering working with financial institutions to establish an in-house hedging program. A significant benefit of this approach is the expansion of the number of hedging options which GO Transit will have access to for pursuing fuel price certainty. This will also allow GO Transit to have access to better fuel purchasing pricing since more vendors will be involved in the competition for GO Transit’s business.

Case Studies 113 To establish an in-house program, GO Transit will need to develop an amendment to the agency’s investment policy that would allow for the utilization of hedging instruments and define which instruments are to be utilized. This amendment will have to be approved by GO Transit authorities and then by the Ministry of Finance. Have Experienced Members on Your Team to Provide Appropriate Advice In order to achieve budget certainty, GO Transit works with suppliers that can offer fixed-price contracts through the suppliers’ own hedging efforts. This approach limits competition; once under contract, the supplier recognizes the agency’s need for budget certainty and not necessar- ily the lowest price, so there is little incentive for the supplier to offer the best prices. Because of this, GO Transit relies on the expertise of its financial consultant to monitor the market and to understand how the supplier is calculating costs based on the NYMEX, the exchange rate, basis risk, and the premium being charged for that risk (in offering a fixed-price contract). The con- sultant then informs GO Transit if the fee being charged is appropriate, or advises GO Transit to consider renegotiating. BC Transit Summary Location: British Columbia, Canada Fleet: 1,030 buses, minibuses, and vans Fuel Volumes: Diesel – 5.8 million gallons, biodiesel – 0.26 million gallons, hydrogen – some (2009/10) BC Transit is a provincial Crown Corporation responsible for coordinating the delivery of public transportation within British Columbia, Canada, outside of Metro Vancouver. The agency has con- tracts with 20 private management companies and 15 non-profit agencies to operate BC Transit’s fleet of 1,030 conventional and double-deck buses, minibuses, and vans. Although operations are outsourced, BC Transit reserves the right to contract for fuel. In 2009/10, BC Transit used 5.8 mil- lion gallons of diesel fuel blended with roughly 0.26 million gallons of biodiesel. The agency also operates a fleet of 20 hydrogen fuel cell buses. As a quasi-governmental agency, BC Transit is pro- hibited from hedging with financial products. Nevertheless, the agency has been effectively hedging its fuel purchases for more than 20 years by entering fixed price contracts with fuel suppliers. Delivery Price Risk Management Fuel Contracting BC Transit is responsible for purchasing fuel for each of its transit fleets, which are spread out in many cities in British Columbia. BC Transit typically contracts fuel for terms of 12–24 months. The agency purchases fuel at three different rack locations: Vancouver, Vancouver Island, and Kamloops. The fuel market in British Columbia is fairly competitive, with multiple fuel suppliers operating in the area. These suppliers all offer floating price contracts, which are calculated as the local rack price less a discount for large volumes. In addition, some suppliers offer fixed price options, as well as contracts with maximum price clauses (caps) and maximum/ minimum price clauses (collars). In 2006, BC Transit’s fuel procurement was complicated by the introduction of a 5% renew- able fuel content mandate for biodiesel. In addition to the mandate, new tax incentives made it attractive to blend conventional diesel with as much as 20% biodiesel in the spring and summer months. Prior to 2006, BC Transit had taken possession of diesel fuel at its bulk storage tanks

114 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies and the agency’s fuel supply contracts included both fuel and freight. After the mandate, how- ever, fuel suppliers would not allow biodiesel to be blended at their delivery trucks. As a result, BC Transit had to take possession of the diesel fuel at the rack, contract a trucking company to haul the fuel to a biodiesel storage facility, purchase biodiesel, and “splash blend” biodiesel in the truck’s tank, before finally delivering the blended product to BC Transit’s bulk storage tanks. This new supply method split up the diesel purchase, biodiesel purchase, and delivery into separate contracts. In 2010, however, several fuel suppliers began offering B5 (conventional diesel blended with 5% biodiesel) at its rack terminals, allowing BC Transit to contract for a single product with freight included. Pooling BC Transit has the exclusive right to operate public transit in British Columbia outside of the Greater Vancouver area. Although it contracts operations to private management companies, BC Transit retains procurement of parts and fuel. By retaining these procurement activities, the agency increases its buying power. However, this arrangement is distinctly different from a fuel purchasing cooperative because the private management companies do not have an option of buying independently. Commodity Price Risk Management History As a Crown Corporation, BC Transit is prohibited under the BC Transit Act from entering directly into financial commodity contracts. However, the agency has been effectively hedging for more than 20 years through the use of fixed-price, fixed-volume contracts offered by local suppliers. Following the unprecedented oil market volatility from 2005 to 2009, BC Transit’s manage- ment began developing a long-term commodity price risk management program. The program, which was to be implemented in FY 2009/10 (March 2009 to March 2010), was designed to mitigate the volatility risk and thereby reduce BC Transit’s budget risk to its provincial and local partners. BC Transit’s management considered several fuel price risk reduction strategies including fixed-price contracting and financial commodity derivative contracts.59 BC Transit’s current fuel supplier explained to the agency how it set up financial hedges to provide fixed-price contracts to its customers. BC Transit management determined that executing these financial hedges on their own and buying physical fuel at the rack price could be less expensive than signing up for fixed-price con- tracts. In 2009, the agency’s management approached British Columbia’s Ministry of Finance with a plan to begin a financial hedging program. However, the ministry’s treasury board has a prohibition against any agency entering into commodity derivatives unless it has a full-service treasury group, including in-house expertise on commodity derivatives. Lacking both in-house experts and approval from the treasury board, the ministry did not approve BC Transit’s finan- cial hedging program. Although the new risk management program did not include financial hedging, BC Transit retained the ability to enter into fixed-price physical commodity contracts, a practice which has been governed under formal policies and is subject to limits established by the board of directors. Strategy BC Transit’s strategy is to enter into fixed-price, fixed-volume contracts when the agency determines, over the length of the contract, that the premium paid will provide budget stability 59http://www.transitbc.com/corporate/general_info/pdf/BC_Transit_200910_Annual_Report_Final_WEB.pdf

Case Studies 115 in a time of expected volatile price increases. This strategy is aimed at protecting against extreme price shocks and creating budget predictability. The agency would like to explore the direct use of financial hedging contracts but is prohibited from doing so by the agency’s governing bodies. Results Prior to 2000 and prior to the recent run-up in oil prices, entering a fixed-price contract was a fairly easy exercise for BC Transit. Fuel suppliers would provide “cost-up” pricing which was very transparent. Fuel companies would show all the associated cost items (transportation, exchange rate, profit margin) in their quotations. The oil futures market was also in “backwardation,” meaning that futures prices were trading below the current spot price. This characteristic of the market allowed BC Transit to lock in fixed prices at rates below the current market price. Hedging with fixed-price contracts in this environment was a very successful strategy for BC Transit. Over the 2002/03 fiscal year (ending in March 2003), the agency locked in a fixed-price contract at US$21.50 per barrel (US$0.51 per gallon) for diesel fuel while fuel prices hovered near US$30 per barrel (US$0.71 per gallon). This contract expired in March 2003. In April, BC Transit, expecting further price increases, entered a 23-month contract at a price of US$24.68 per barrel (US$0.59 per gallon).60 By the time the nearly two-year contract expired in March 2005, spot oil prices had risen to US$58 per barrel (US$1.38 per gallon). Overall, this contract resulted in a savings of C$6.0 million (about US$5.0 million) versus the best available rack rates.61 By 2005, however, fuel vendors had started pricing differently and BC Transit was no longer able to obtain a fixed-price contract at a discount to the market. Rather than providing fixed- price contracts at a discount to the spot price, suppliers began charging a premium because the futures market had gone into “contango,” meaning that the price of oil for future delivery was more expensive than the current spot price. Furthermore, exchange-traded futures prices, which typically track the crude oil price in Cushing, Oklahoma and the heating oil price in New York Harbor, began to exhibit a correlation disconnect (basis risk) from West Coast fuel pricing. As a result, suppliers began adding additional premiums to cover “market risk conditions” on fixed- price contracts. In this increasingly uncertain market, suppliers became reluctant to provide a build-up of indicative pricing for fixed price contracts, and contract pricing essentially became a black box to BC Transit. Instead of locking in prices for the long-term, BC Transit shortened its hedging horizon, entering into a six-month, fixed-price, fixed-volume contract at C$0.79 per liter (about US$2.57 per gallon) in March 2005. When this contract expired in September, BC Transit renewed the contract for 3 months at a fixed price of C$0.91 per liter (US$2.94 per gallon).62 With total fuel volume approaching 19 million liters in 2005/06, increased cost aggregated to C$5.9 million (US$4.9 million).63 After the 3-month hedge expired in December, BC Transit monitored short- to-medium term futures prices but fixed-price contracts continued to command a significant premium over rack purchases. As a result, BC Transit decided to remain unhedged and purchase on the weekly rack rate during the last quarter of the 2005/06 fiscal year. BC Transit continued to purchase diesel at the weekly rack rate as the oil market grew increas- ingly volatile over the 2006/07 and 2007/08 fiscal years. BC Transit preferred to remain flexible in the short-term rather than lock in future prices at a premium to the rack rate.64 In 2007/08, crude 60http://www.cawvidc.bc.ca/gvta/News%20Archive/transit_maps_out_cuts_in_routes.htm and http://www.transitbc.com/ corporate/pdf/20050628_ar_2005.pdf (p. 40) 61http://www.transitbc.com/corporate/pdf/20050628_ar_2005.pdf (pp. 39–40) 62http://www.transitbc.com/corporate/pdf/20060725_service_plan.pdf (p. 12) 63http://www.transitbc.com/corporate/pdf/20060614_ar_2006.pdf 64http://www.transitbc.com/corporate/pdf/20070709_annual_rep_06_07.pdf (p. 35) and http://www.transitbc.com/ corporate/pdf/20070709_annual_rep_06_07.pdf

116 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies oil prices surged from US$70 to US$108 per barrel and the futures market remained in contango. In its 2007/08 annual report, BC Transit explained that the its decision to remain unhedged despite unprecedented volatility was due to the significant hedging premium in western diesel markets and the inability to develop synthetic instruments to cover price fluctuations in the extremely volatile market.65 BC Transit remained exposed to market fluctuations, and by July 2008, at the height of the market, the agency was paying a rack price of C$1.25 per liter (roughly US$4.72 per gallon). Unwilling to hedge amid high premiums and facing a rapidly expanding fuel budget, BC Transit engaged fuel purchasing specialists to monitor and evaluate the agency’s diesel purchas- ing strategy.66 The specialists, anticipating that the market would soon peak, advised BC Transit to continue its strategy of remaining unhedged rather than locking in high prices. This strategy paid off as oil prices precipitously collapsed during the 2008/09 fiscal year. By May 2009, oil prices had fallen to approximately US$60 per barrel and the rack diesel price had fallen to C$0.77 per liter (about US$2.47 per gallon). Despite inherent volatility in fuel pricing and relatively low diesel prices in early 2009, BC Transit continued to remain unhedged, once again due to the con- tango in the futures market and the significant hedging premium in the western diesel market. In 2009, BC Transit began developing a fuel price risk management program but failed to receive authority to engage in financial hedging (see History section). Instead, BC Transit man- agement continued to monitor and compare weekly rack rates and fixed physical price premi- ums. In September 2009 the agency decided to lock in over 90% of its estimated annual bulk fuel consumption at a price of C$0.90 per liter (about US$3.35 per gallon) with a six-month, fixed- price fuel supply agreement.67 The contract resulted in savings against BC Transit’s fuel budget, but the supplier did not extend the fixed-price agreement after expiration in March 2010 and the agency returned to rack pricing. Tips for Success Keep Fixed Price/Volume Contracts Less Than Full or Near-Full Consumption In 2009, BC Transit contracted over 90% of its annual bulk fuel volumes under a fixed-price, fixed-volume contract. As with most contracts of this type, the contract had a “take-or-pay” clause, which required the agency to take and pay for all contracted volumes or pay for volumes not taken. That year BC Transit’s projections of fuel consumption were slightly off due to an assumption that seasonal fuel-use swings were similar among its systems throughout the prov- ince. The agency ended up being over-contracted by 1.6%, which was equivalent to roughly 1,000 barrels. The fuel could not be used immediately and BC Transit had its fuel transporter store the fuel at its storage tanks. The fuel transporter used the fuel to supply its other clients and then replaced the fuel when BC Transit was ready to use it in April 2010 (at which time the fuel cost was less than the rack discount price). In this case, BC Transit’s fuel transporter did not charge a fee for storing the fuel, but in other cases, a storage charge could be added. This experience has resulted in three changes at BC Transit: 1) fuel needs are projected based on tracking of actual fuel use at each system; 2) no more than 90% of its annual bulk fuel con- sumption can be hedged; and 3) for fixed-price, fixed-volume contracts, the fuel vendor now provides the option that for any under-lifted monthly volumes, BC Transit can pay any positive difference between the current rack rate and its fixed price, or if the fixed price is lower than rack, a small administration fee is applied. 65http://www.transitbc.com/corporate/pdf/20080717_AR_2008.pdf 66http://www.transitbc.com/corporate/pdf/20080717_AR_2008.pdf 67http://www.transitbc.com/corporate/general_info/pdf/BC_Transit_200910_Annual_Report_Final_WEB.pdf (p. 26)

Case Studies 117 King County Metro Transit Summary Location: Seattle, Washington metropolitan area Fleet: 1,300 vehicles Fuel Volumes: Diesel – 11.9 million gallons (2009), Gasoline, Electricity King County Metro Transit operates a fleet of about 1,300 vehicles, including standard and articulated coaches, electric trolleys, dual-powered buses, hybrid diesel-electric buses, and street- cars. The agency serves an annual ridership of 100 million trips within a 2,134 mile area.68 Metro Transit is a division of the King County Department of Transportation. Nearly 60% of Metro Transit’s operating budget comes from the state sales tax, while the remainder comes from pas- senger fares and federal grants.69 The Metro Transit operations fleet currently consumes diesel and gasoline, and until 2009 it also consumed biodiesel. Metro Transit purchases fuel through the state of Washington’s bulk fuel contract and purchased fixed-price contracts for biodiesel in 2007 and for conventional diesel in 2008 and 2009. In 2009, Metro Transit paid an average price of $2.09 per gallon of diesel fuel. Metro Transit is currently seeking approval to begin hedging fuel prices with financial products. Delivery Price Risk Management Fuel Contracting Metro Transit contracts diesel fuel under the state of Washington’s bulk fuel contract and con- tracts directly with a city-owned utility for trolley power. The state’s five-year bulk fuel contract is procured by rolling over existing contracts and holding periodic request for bids. The state’s current fuel contract in King County is with a local fuel distributor. Under this contract, Metro Transit has the option of hedging through procuring fixed-price contracts or by purchasing at the OPIS daily average rack price plus a delivery and profit margin. Pooling Metro Transit pools its diesel fuel purchases with other state agencies under the state of Wash- ington’s bulk fuel contract. Commodity Price Risk Management History Prior to 2009, Metro Transit only had authority from the state to hedge its fuel prices through physical, fixed-price contracts with fuel distributors. This authority was included in the state department of transportation’s budget bill. Metro Transit first began hedging through fixed-price contracts in 2007 due to the agency’s unease with volatile biodiesel prices. At the time, Metro Transit was increasing its biodiesel blend from 5% to 20% and the agency sought security from its exposure to the volatile B100 market. Metro Transit decided to hedge this exposure through a fixed-price bulk contract for up to two million gallons of B100 but continued to purchase the base diesel fuel at the OPIS rack price. The fixed-price B100 contract was successful in stabilizing the agency’s biodiesel budget. How- ever, when the contract expired at the end of 2007, B100 prices had skyrocketed, and the agency 68http://metro.kingcounty.gov/am/metro.html 69http://metro.kingcounty.gov/am/budget.html

118 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies reduced its biodiesel consumption by more than half. By 2009, Metro Transit completely discon- tinued the use of biodiesel. The year 2008 was turbulent for fuel prices with oil prices spiking to nearly $150 per barrel. Amid this volatility, Metro Transit contacted the state and made arrangements to start hedging its diesel fuel under the state’s existing authority allowing physical fixed-price contracts. The results of this hedging are presented later in this case study. After hedging with physical fixed-price contracts from September 2008 through the end of the 2009, Metro Transit began working to gain approval for a fuel price hedging program that would involve the use of financial derivatives, such as exchange-traded futures contracts and options. They gained state approval in 2009 by pushing for hedging language to be inserted in a state law authorizing a Smart Fuels buying program that covered several aspects of fuel procurement procedures for state agencies. However, Metro Transit still needs approval from the Metropolitan King County Council before it can begin financial hedging. It has not yet received this approval. Strategy Metro Transit’s hedging program in 2008 and 2009 was not guided by a formal strategy. Fixed- price contracts were entered on a regular basis, roughly every one to two weeks, with a target not to heavily exceed 70% of expected fuel consumption (the agency was worried that snow storms might cut service during the winter months, leaving it over-contracted for fuel). The agency monitored the oil markets and sought occasional advice on when to avoid entering contracts (due to temporary spikes caused by refinery shutdowns, pipeline disruptions, etc.) from an advi- sory firm based in Minneapolis, Minnesota. Execution Metro Transit arranged its fixed-price contracts with a local fuel distributor, which in turn obtained fixed-price contracts from a major oil company that hedged its price exposure through the purchase of exchange-traded diesel futures. This fixed-price contract was essentially passed through from the oil major, through the local distributor, to Metro Transit. Decisions on when and how much to hedge were made by two managers, Gary Prince and Ralph McQuillan, from the agency’s business and finance department, and they did not require further approval from upper management. Results Metro Transit’s experience with fixed-price contracts has yielded mixed results. In August 2008, Metro Transit entered into two different six-month, fixed-price, fixed-volume contracts, each covering 42,000 gallons of diesel fuel starting in September. These volumes represented about 9% of the agency’s monthly consumption. As diesel prices plummeted in the second half of 2008, Metro Transit entered additional fixed-price contracts, locking prices for more than 73% of fuel consumption over the first quarter of 2009. Metro Transit’s 2008 fuel hedges suffered from bad timing. In 2008, the agency locked diesel prices at delivered rates of $2.02 to $3.66 per gallon, while spot fuel prices fell below $2.00 to record lows towards the end of 2008 and over much of the first half of 2009. As a result, Metro Transit significantly overpaid for fuel under its initial fixed-price diesel contracts, but did achieve pricing stability and budget certainty. Metro Transit continued to obtain fixed-price contracts during the first four months of 2009, managing to lock in historically low diesel prices—ranging from delivered rates of $1.79 to $2.21 per gallon—for about 50% of its fuel requirements over the remainder of the year. These con- tracts had positive value for the agency as diesel prices began to increase over the second half of 2009. Despite the success of the fixed-price contracts it entered in 2009, the agency was not able to hedge beyond December 31, 2009 because the state prohibits entering fuel delivery contracts

Case Studies 119 across its biannual fiscal period. In 2010, Metro Transit began the process of seeking approval to start hedging with financial derivatives rather than relying on fixed-price contracts. Tips for Success Hedging with Financial Derivatives Allows Greater Flexibility in the Agency’s Hedging Strategy To date, King County Metro Transit has only hedged through physical fixed-price contracts, although the agency is currently working to gain approval for full-fledged hedging program that would allow the use of financial derivatives, such as exchange-traded futures contracts and options. Hedging with financial products—as opposed to physical fixed-price contracts—would allow the agency to achieve fuel price stability without requiring it to actually take delivery of the fuel. This would allow the agency to safely increase the level of its coverage to as high as 100% of its fuel consumption without the risk of over-committing to the delivery of fixed volumes in the event of lower-than-expected fuel consumption. Financial derivatives would also be advanta- geous because they would allow Metro Transit to hedge further out (beyond the state’s biannual fiscal period), thus allowing the agency to lock in lower prices for a longer period of time. Finally, financial contracts can be closed out at any time prior to maturity, thus allowing the holder to exit an overpriced contract before prices decline further. Hedging with Financial Derivatives Is Less Expensive Than Hedging with Fixed-Price Contracts When it hedged, Metro Transit received its fixed-price contracts through a local fuel dis- tributor, which in turn procured fixed price contracts from a major oil company, which in turn hedged through a broker who buys exchange-traded financial products. Each organization in this process requires a profit margin to cover its risk. Metro Transit believes that by hedging directly with financial products it could save roughly 20 cents per gallon. Metro Transit estimates that maintaining a financial hedging program would cost approximately $100,000 per year and would save more than $2 million annually compared with fixed-price contracts. Have a Clear Plan When Selling a Financial Hedging Program to Upper Management Starting a financial hedging program at Metro Transit requires a change in state law (which was achieved in 2009) and approval by the Metropolitan King County Council (an effort that is still ongoing). Metro Transit has put together a clear Energy Price Risk Management (EPRM) policy and submitted the policy to the council for approval. The policy makes clear in its mis- sion statement that the purpose of the program is price stability and not to make or lose money. Denver Regional Transportation District (RTD) Summary Location: Denver, Colorado Fleet: 1,032 buses (FY 2010): 118 sixty-foot articulated diesel buses, 148 forty-five-foot diesel buses, 577 forty-foot diesel buses, 160 thirty-foot diesel buses, 14 twenty-two-foot diesel cutaway buses, 15 assorted contingency fleet diesel buses, and 336 paratransit and “Call-n-Ride” cutaway buses; 125 electric light-rail trains Fuel Volumes: Diesel – 10.4 million gallons, electricity – 45.2 million kWh (FY 2009) The Regional Transportation District (RTD) is the primary public transportation agency in the Denver metropolitan area. RTD’s fuel purchasing goal is to achieve budget certainty in a

120 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies volatile market, while operating within the constraints of the state of Colorado’s tax laws. RTD used approximately 10.4 million gallons of fuel in FY 2009 at an average cost of $3.10 per gallon, and expected to use about 10.5 million gallons of fuel in FY 2010. Diesel fuel accounts for less than 8% of RTD’s operating budget.70 Light-rail trains used 45.2 million kWh of electricity in FY 2009 at a cost of just over $3.7 million.71 Funding for RTD is partially provided by a Denver metropolitan area sales tax of 0.6%. Like- wise a 0.4% sales tax goes to the FasTracks project, which funds a region-wide transit network expansion to include commuter rail service to the Denver airport and eventually outlying areas. Delivery Price Risk Management Fuel Contracting Diesel RTD has utilized fixed-price fuel contracts for more than 20 years. RTD has pur- chased diesel fuel from the same supplier since 2005. Its current contract with its supplier started in January 2007 and was structured with a one year base period and four option years, ending in 2011. Approximately six months before a contract period ends, RTD will issue an RFP for a new fuel contract. RTD uses the RFP process, instead of an invitation for bids, because it pro- vides RTD with flexibility to ensure price, quality, delivery, and vendor performance to select the best supplier. RTD protects its business by including fuel delivery guarantees as a key aspect of the contract requirement. The contract includes a performance bond that requires the supplier to deliver the fuel at the agreed upon prices and can supply the required fuel volume. In one instance, the supplier’s failure to meet these requirements resulted in a $750,000 payment to RTD. There is a cost associated with ensuring fuel delivery, but RTD has found that this cost is worth the expense when compared to placing fuel contracts based solely on the lowest delivered cost. Experience has also shown that the lowest price may come with lower quality fuel, which increases maintenance costs, and fuel supply issues can result in fuel shortages; both of these issues can potentially be more financial damaging than higher priced fuel. RTD’s fuel purchasing contracts include two purchasing options: 1) locking in a price for a specific gallon amount for a specific period of time, and 2) purchasing on the spot market using indexed prices plus a margin that includes fees, taxes, and delivery charges. RTD is experienced in basing fuel prices on several indices, including the New York Mercantile Exchange (NYMEX) No. 2 heating oil index,72 the West Texas Intermediate (WTI) crude oil index, and the Gulf Coast Index (GCI). Since RTD is located in the Rocky Mountain region, which is relatively isolated from the pipeline and fuel distribution networks serving the rest of the country, its experience has shown that the WTI index is typically the most accurate index for its operations. However, the WTI is not always the best option, so RTD monitors the market trends and shifts future purchases to another index if needed. When RTD purchases fuel on the spot market under the current contract, diesel fuel prices are based on Oil Price Information Service (OPIS) Petro- leum Administration for Defense District IV prices, plus the contract-specified differential per gallon. RTD has determined that locking in a price for the long-term lowers the administrative burden because managing fuel prices by floating requires additional costs for administrative responsibilities. RTD’s supplier operates an in-house hedging program which allows it to offer fixed-price contracts to customers. The hedged fixed-price contracts are treated just like other contracts 70RTD 2010 Adopted Budget, http://www.rtd-denver.com/PDF_Files/Financial_Reports/Adopted_2010.pdf, November 17, 2009, (p. 27) 71Science Applications International Corporation, Fuel Purchase and Price Risk Management Survey, August 2010 (p. 1) 72The heating oil index is used because the prices of diesel and No. 2 heating oil are highly correlated so typically track each other.

Case Studies 121 or procurements, so even though the supplier is hedging its own position, RTD can treat it as a regular contract. The supplier has also offered RTD the option of including downside protection in the contract agreement. Downside protection can be thought of as a form of additional insur- ance in the event fuel prices drop below the fixed-price contract amount. In this case, with a stan- dard fixed-price contract RTD would pay more per gallon than the market price. With downside protection, the supplier will share the savings with RTD, protecting against both increases and decreases in prices away from the fixed-price amount. As with all insurances, this additional protection requires an added premium, which amounts to a few cents per gallon. The result of this fuel purchasing option is that RTD realizes the fuel price stabilization of fuel hedging without having to operate an in-house hedging program. This method means that the agency does not have the administrative and margin account burden of operating its own pro- gram. The supplier has the administrative overhead for the program operation and also assumes the risk for maintaining the margin account. These costs are passed on to RTD as a premium, or fee, which is included in the agreed upon fuel price and fuel volume requirement. Electricity. RTD’s utility provides the agency with special low electricity rates for the light- rail service. These rates are lower than the rates RTD pays for facilities and other usages (e.g., park-n-Ride facilities). RTD is investigating working with the Western Area Power Administra- tion for purchasing wind and hydropower electricity to improve the agency’s greenhouse gas signature. Strategy & Risk Management RTD is primarily funded through sales and use taxes, passenger fares, capital grants, federal operating assistance, and investment income, so it is difficult for agency leaders to request addi- tional funding midway through the budget year. Because of this, RTD’s main fuel purchasing strategy is to manage fuel price risk and achieve budget certainty through the use of fixed-price contracts for fuel purchases. RTD’s fuel purchases must comply with the Colorado Tax Payers Bill of Rights (TABOR) law, which requires it to operate on a year-to-year basis and precludes RTD from fuel price hedging in the commodities market. The fixed-price contracts with its supplier are traditional contracts, even though the supplier hedges its bulk fuel purchases. RTD’s legal department evaluated this fixed-price contract option and found no conflict with the TABOR law requirements. RTD has been approached by third-party consultants to provide market analysis and purchase recommendations, but has opted not to use this option because of the high level of financial and purchasing expertise RTD possesses. The RTD purchasing agent and senior manager of materials management monitor and report on the fuel markets to determine when RTD should float the market and when to lock in fuel prices. The purchasing agent and senior manager of materials management, work closely with all departments (e.g., finance, bus operations, maintenance) to determine the upcoming year’s fuel requirements. This input and expertise is critical for making sound projections. These future fuel requirements and market data are evaluated for the follow- ing 12 to 24 months. This analysis includes continually reviewing a wide range of fuel-related information sources such as futures market data, various fuel indices (NYMEX, WTI, and GCI), weekly OPIS prices, and other information resources such as the British Petroleum Risk Man- ager and the US Department of Energy’s Energy Information Agency (EIA) data. The analysis also includes non-fuel market information such as money market trends (including the U.S. dollar, euro, and British pound) and external influences that artificially drive demand or price (e.g., weather, hurricane season, stabilizers that may be reflected in futures, near-term military conflicts, value of currencies, how the economic bailout is proceeding). RTD’s purchasing agent has done this trend analysis for the last ten years and has found it helpful to discuss it with RTD’s fuel supplier’s trading group.

122 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies The results of these evaluations and discussions determine the purchasing recommendations regarding when RTD should float or lock in fuel prices for the following budget year. The final purchasing recommendations are presented to the RTD general manager and senior leadership team officials for discussion and approval. This process allows the team to provide feedback to the general manager and senior leadership about how they arrived at the conclusions being presented. RTDs’ purchasing agent noted that quick action is needed to take advantage of this knowledge since markets can change quickly. The purchasing agent begins following fuel prices in January and starts assessing trends in the March/April timeframe. Financial assumptions and discussions begin in June for the following year’s budget, which begins in January. Prior to 2007, RTD was able to float and still meet the allotted fuel budget. The last three to four years have been challenging for RTD, as market volatility and world events have impacted fuel price planning. RTD noted that ten years ago average fuel prices might have increased one cent per year, but now the agency sees substantially greater price swings, such as a change in the OPIS for diesel of ten cents in just one week (see Results section). Over the years, RTD has locked in fuel prices both all at one time and also incrementally throughout the year. There are risks involved with both approaches; for instance, locking in before a fuel price drop results in higher fuel costs. For RTD, each one-cent change in fuel cost equals a $100,000 difference in the budget. For the incremental approach, portions of the fol- lowing year’s fuel usage are locked in at a time. RTD has found that in some cases it is better for the agency to float the market during volatile periods than to make a decision to lock in prices with the possibility of fuel prices dropping. For FY 2011, RTD locked in prices for 90% of planned fuel purchases, or about 9.5 million gallons of diesel, in two increments. It was decided to lock in only 90% of the fuel purchases to maintain flexibility in the event of service cuts or other circum- stances that would reduce fuel use. The first purchase covered 25% of the projected fuel demand at $2.25 per gallon, the second purchase covered the remaining 75% at $2.39 per gallon (prices include the differential). The remaining 10% of fuel purchases are purchased on the spot market. RTD contracts half of its total services to other transportation service provider companies (contracted services), 40% is for fixed-route services, and the remaining 10% is for demanded routes. RTD developed a secondary strategy for managing fuel costs from their contracted service providers. With the volatility in fuel prices over the last five years, RTD realized that each con- tracted services provider was factoring additional costs into their bids to protect themselves from fuel price volatility concerns. RTD was able to remove this variable. Since RTD knows the routes, mileage, and fuel usage for each contracted services provider, it includes this fuel volume in the total volume used when arranging its fuel contract(s) (either fixed-price or float). The contrac- tors are then allowed to purchase fuel using the same contract (using the same fixed-price or float price). The contracted services provider contracts state that RTD will reimburse them for fuel costs; however, RTD will pay no more than RTD’s current fuel price. This method ensures that RTD only pays the locked-in price for fuel which allows it to main- tain control of its fuel costs and eliminates the additional contractor expenses. An additional benefit for RTD has been reducing the administrative burden by not having to scrutinize the contracted services providers’ fuel price expenses. RTD does compare the fuel volumes being charged by contracted services providers to the expected fuel usage to ensure they are realistic. Approval and Execution Process The RTD General Manager was granted the direction and authority by the board of directors (board) to make fuel purchasing decisions without board approval. This authority is critical because it allows the agency to move quickly enough to take advantage of pricing opportunities and secure fixed-price fuel contracts. The fuel purchasing process requires that the board be noti- fied of what steps RTD is considering regarding the target price range and how the related activities

Case Studies 123 address RTD’s requirement for meeting budget certainty and guaranteed delivery. The senior manager of materials management, upon approval of a fuel purchase recommendation, places the order with the supplier to lock in at a particular price when a fixed-price contract is selected. Because fuel prices may be locked in before the budget has been finalized, the contract includes a clause that states that the contract is based on funds being available (i.e., budget approval), thus working within TABOR requirements. Results The RTD Purchasing Agent evaluates the fuel purchasing program’s performance at the end of each year by comparing the indexed weekly float price with the price RTD paid. Over the last 25 years, with the exception of 2009, RTD has had positive, but not perfect, performance. During FY 2005, RTD’s budget forecasted diesel fuel costs at $1.67 per gallon and approxi- mately 90% of the year’s planned fuel purchases were locked in late in FY 2004 at $1.99 per gal- lon. Overall RTD saved $64,000 in 2005 compared to floating the market. This may not seem to make sense, but this implies that the average annual float price was higher than the average fixed price RTD paid, even though the forecasted price was lower than the locked-in price. In FY 2006, the forecast was for $2.22 per gallon; RTD locked in at $1.99 per gallon, and saved $1.16 million compared to floating the market. In FY 2007 the results were even better. The forecasted price was $2.35 per gallon and the fleet locked in at $2.07 per gallon, which resulted in a savings of $1.83 million compared to floating. Results for 2008 were still positive, even with locking in late in 2007 during a period of increasing price volatility. The forecasted price was $2.62 per gallon, and RTD locked in at $3.21 per gallon, saving $123,000 compared to floating. FY 2009 was RTD’s most difficult year. In June 2008 RTD had to make challenging fuel pur- chasing decisions with forecasted diesel prices at $4.50 per gallon, which were coupled with increasing ridership which helped offset the higher costs. Rather than go through the lengthy process of public hearings to reduce services during a period of increased demand for their ser- vice, RTD elected to stabilize service to meet ridership needs. RTD’s market evaluation showed fuel prices consistently over $4.00 per gallon (with a peak of $4.26 per gallon in mid-July) and futures for 2009 projected to be in the same price range. Budget certainty is RTD’s key fuel pur- chasing goal, but achieving optimum pricing given the market is also an important secondary goal. RTD locked in prices in September 2008 when prices were at $3.10 per gallon. This was a significant improvement over the forecasted prices, but prices had “not yet made the final adjustment for trading influences.”73 The result was a $7.8 million loss compared to floating because prices decreased down to $1.49 per gallon at the end of December. RTD noted that even though they were able to avoid drastic service cuts during this period, it would have been worth the risk to have added downside protection for 2009. These prices and costs are summarized in the table below. Year Budget Forecast Price Lock Price Annual Cost Delta (Lock Price - Average Annual Float Price) 2005 $1.67/gal $1.99/gal $64,000 2006 $2.22/gal $1.99/gal $1.16 MM 2007 $2.35/gal $2.07/gal $1.83 MM 2008 $2.62/gal $3.21/gal $123,000 2009 $4.50/gal $3.10/gal -$7.8 MM 2010 $2.65/gal $2.25/gal $242,000 2011 n/a $2.37/gal >$3 MM (10/2011) 73RTD, Senior Manager, Materials Management, response to project survey, November 2010

124 Guidebook for evaluating Fuel purchasing Strategies for public Transit Agencies RTD’s FY 2010 fuel price forecast was for $2.65 per gallon and the fleet locked in prices at $2.25 per gallon. Market prices were below $2.25 per gallon for much of the beginning of the year, but prices rose towards the end of the year. At the end of the third quarter of 2010, RTD’s fixed-price contracts had saved approximately $22,000, but by year’s end the agency expected to have saved more than $150,000 on the 90% locked-in portion of fuel purchases. RTD reiterated that floating the market results in a flat price differential, while a premium is paid to lock in prices. RTD’s key fuel purchasing performance metric is not to receive the lowest prices (although good pricing is not overlooked), but rather is whether the price was managed within the budget, even in volatile markets. Achieving budget certainty and maintaining service for its customers constitute RTD’s combined goal. For FY 2011, RTD expected to use approximately 10.5 million gallons of fuel in 2011 and locked in prices incrementally. Again, RTD planned to lock in prices for 90% of its anticipated fuel use (9.5 million gallons). The budget forecast was for $2.64 per gallon. RTD locked in 25% of anticipated fuel use at $2.29 per gallon of diesel on July 8, 2010, and locked in the remaining 75% of the anticipated fuel use at $2.39 per gallon on August 12, 2010, giving an overall average price of $2.36 per gallon. Pooling RTD is a member of the Rocky Mountain Governmental Purchasing Association, a regional association that includes members from various agencies throughout the Rocky Mountain region. Through their participation as one of the largest diesel fuel purchasers in Denver, other participating agencies can buy diesel fuel off the RTD fuel contract. The additional purchases by other members have not significantly increased the pool fuel volume, so RTD has not received better prices from its supplier. The biggest impact of pooling for RTD has been the allowance of RTD’s contracted services providers to purchase fuel from this contract with the same terms and conditions as discussed in the Strategy & Risk Management section. Commodity Price Risk Management The Colorado TABOR law precludes RTD from fuel price hedging in the commodities market. RTD stated that the ability to directly hedge its fuel purchases is not necessary considering its needs and the performance of the current approach, but it did believe that it would be a bonus. Tips for Success Determining the Right Index for Your Agency Is Important NYMEX and other indexes had been a good source for the last eight years or so, but have not been as accurate and advantageous recently. RTD has found that the best index for its current fuel purchases has been the WTI. Authority to Quickly Execute to Achieve Target Price Is Imperative Until several years ago, RTD did not have the necessary authority to execute the quick, but educated, fuel purchasing decisions that are required in the current market to take advantage of favorable prices. (This should not be confused with the approach of “timing the market.”) To remedy this, the RTD board of directors entrusted the general manager with the authority to make the purchasing decisions to lock in fuel prices. Fuel prices change by the minute, so mak- ing decisions at monthly or weekly board meetings is not ideal. When prices enter the target price range the purchasing team can quickly get approval from the general manager, make the purchase to lock in the price, and not miss the brief moment of opportunity waiting for board approval. To support the board of directors and its oversight, the purchasing team (see Strategy

Case Studies 125 and Risk Management section) studies and reports on the market and other factors, and provides the board with update reports that factor in budget assumptions, including a target range for fuel prices. In this way, the board understands what decisions are being made and can assure its constituents that they are getting services at market driven prices. RTD notes that this approach takes trust on both sides, but is important for reaching targets. Have a Good Working Relationship with Fuel Suppliers and a Method of Contracting That Works for Your Organization RTD noted that it is important to have a good working relationship with the fuel supplier. The agency also noted that working with suppliers that are willing to negotiate is important. RTD believed that using an RFP to secure contract bids opens up negotiation opportunities that benefit both parties compared to the method of using an invitation for bids. One example of this came from the current supplier’s proposal which stated that RTD’s desired index (NYMEX) may not be the best option for RTD. The supplier explained that it had seen during the last five years that the WTI offered a lower average price than the NYMEX in RTD’s region, so proposed using WTI instead. The supplier presented the differences and potential savings (for RTD and the supplier) for making the switch. RTD agreed and both parties benefited. RTD noted that its fuel supplier has worked very well with the agency in regards to billing, timing, and supplying fuel, with both parties making sure that there is mutual agreement and benefit to each party. Have an Accurate Fuel Usage Forecast The larger the agency, the more important and challenging it can be to accurately forecast the total fuel demand, including contracted services. This forecasting is imperative and covers a number of areas including fleet composition, total miles and mile per gallon of fuel for each vehicle, service on the street, deadhead time, etc. RTD works hard to make sure lines of com- munication are open across all departments in order to get accurate information in determining anticipated fuel usage. This has resulted in RTD accurately forecasting fuel demand. If RTD exceeds its expected fuel usage, then the agency must go to the spot market which can easily prove more expensive than anticipated. In general, this amount is only approximately 100,000 to 200,000 gallons. RTD’s supplier has honored the locked-in price for these small volumes above the planned amount in the closing weeks of the year; however the supplier is not required to do so by its contract. Consider Other Influences That Affect Pricing RTD’s contracts with its contracted services providers state that the agency will reimburse them for fuel only up to the RTD locked-in fuel price. This approach eliminates the extra expense RTD experienced from the contracted services providers, including higher fuels prices in their bids to RTD to cover their increased risk from volatile fuel prices.

Abbreviations and acronyms used without definitions in TRB publications: AAAE American Association of Airport Executives AASHO American Association of State Highway Officials AASHTO American Association of State Highway and Transportation Officials ACI–NA Airports Council International–North America ACRP Airport Cooperative Research Program ADA Americans with Disabilities Act APTA American Public Transportation Association ASCE American Society of Civil Engineers ASME American Society of Mechanical Engineers ASTM American Society for Testing and Materials ATA American Trucking Associations CTAA Community Transportation Association of America CTBSSP Commercial Truck and Bus Safety Synthesis Program DHS Department of Homeland Security DOE Department of Energy EPA Environmental Protection Agency FAA Federal Aviation Administration FHWA Federal Highway Administration FMCSA Federal Motor Carrier Safety Administration FRA Federal Railroad Administration FTA Federal Transit Administration HMCRP Hazardous Materials Cooperative Research Program IEEE Institute of Electrical and Electronics Engineers ISTEA Intermodal Surface Transportation Efficiency Act of 1991 ITE Institute of Transportation Engineers NASA National Aeronautics and Space Administration NASAO National Association of State Aviation Officials NCFRP National Cooperative Freight Research Program NCHRP National Cooperative Highway Research Program NHTSA National Highway Traffic Safety Administration NTSB National Transportation Safety Board PHMSA Pipeline and Hazardous Materials Safety Administration RITA Research and Innovative Technology Administration SAE Society of Automotive Engineers SAFETEA-LU Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users (2005) TCRP Transit Cooperative Research Program TEA-21 Transportation Equity Act for the 21st Century (1998) TRB Transportation Research Board TSA Transportation Security Administration U.S.DOT United States Department of Transportation