J&l Railroad

Case #4: J&L RAILROAD

Case Summary

J&L Railroad ("J&L" or "Company") formed one of the largest railroads in the country by combining the Jackson and Lawrence rail lines. Considered a Class I railroad, J&L operated approximately 2,500 miles of line throughout the West and the Midwest. Also, due to an unique characteristics of railroad industry, J&L's profitability is dependent upon the price of diesel fuel. In this regard, the company should hedge some of its exposures to diesel fuel and must decide how much of next year's expected fuel demand should be hedged and how it should be hedged.

J&L's exposure to diesel fuel prices during the next 12 months would be substantial. This exposure could be offset with the use of heating oil futures and option contracts that were traded on the New York Mercantile Exchange ("NYMEX"). For hedging alternatives, other than this exchange-traded futures and options, there are several financial instruments available for J&L to hedge against the risk of rising diesel fuel prices: commodity swaps, caps, floors, and collars offered by Kansas City National Bank ("KCNB")'s Risk Management Group.

However, these instruments still have their own downsides and possibly their own risks. In case of hedging by using exchange-traded contracts, the future contracts from NYMEX seems like an effective hedging strategy for J&L, such as good liquidity and possibility of minimizing basis risk, but there are some difficulties in terms of using futures from NYMEX to hedge against the diesel prices. NYMEX did not trade contracts on diesel fuel, so it was not possible to hedge diesel fuel directly. Also, the company needs to post a margin for their future contracts at NYMEX. However, heating oil and diesel fuel are highly correlated with 0.99 of correlation, according to the exhibit 5 of this case, thus, heating-oil futures were considered an excellent hedging instrument for diesel fuel.

As to the products offered by KCNB would charge a nominal up-front fee as compensation for accepting J&L's credit risk, and illiquid compared with NYMEX. However, KCNB would not require J&L to post a margin at the beginning of the contract, and the use of the average price of heating oil during the contract period for hedge would be an advantage to J&L.

Additional Explanation/Insights

In order to construct a future hedge with an estimated amount of 17.5 million gallons of diesel fuel per month, J&L should long a future contract on heating oil, in order to gain from the price increase, based on the current market conditions assuming the futures market was expecting price to trend up for the next 12 months.

However, in this case, J&L should also take into account this situation that if the