With more than 80% of shippers paying fuel surcharges across all modes, and fuel prices showing no sign of significant decline, shippers are starting to question the fairness of the current system. Canadian Industrial Transportation Association chairman Graham Allen officially got the debate started with a column directed to all modes of transport in the association’s Shipper ADVOCATE publication. We’ve repeated his comments here along with a rebuttal from the Canadian Trucking Alliance (fuel surcharges are most prevalent in trucking) and an industry supplier that offers an alternative.

Fuel Surcharges – Is there a better way?

Graham Allen, chairman, CITA

One issue that shippers continue to speak out about is the calculation and application of fuel surcharges. Shippers recognize that carriers need to be compensated for changing fuel prices but it is the manner in which they are calculated and applied that causes concern.

The term fuel surcharge implies that the charge only goes one way – up. What happens if the price of fuel drops? While recent experience and market forecasts indicate continuing high – if not higher – prices, shippers should be able to benefit from lower prices. Therefore the concept of a fuel surcharge needs to change from revenue enhancement to risk management.

Most fuel surcharges are calculated as a percentage of the freight rate. Therefore, shippers with higher rates pay more in fuel surcharges than shippers with lower rates. For example, shipper A is paying CDN$1,200 and shipper B $1,500 to the same carrier using the same equipment to travel the same distance with the same amount of freight. Based on a 10% fuel surcharge shipper B will pay $30 more in fuel surcharge for the same move. Does it cost the carrier $30 more to move the same amount of cargo? In addition to the inequity, the carrier may be over-recovering its fuel expense for that particular move. Further, the fuel surcharge is calculated on the entire freight rate, which consists of fixed and variable costs and profit rather than the portion of the rate directly attributable to fuel.

A percentage-based fuel surcharge also compounds any rate increase. Using the same 10% fuel surcharge, a 4% annual rate increase translates into a 4.4% rate increase. This implies the amount of fuel used to transport freight has risen too. This is not correct.

Another concern is the mismatch between the underlying index used to calculate the fuel surcharge and the actual fuel consumed in the movement of the freight. An example is West Texas Intermediate Crude, commonly referred to as WTI, which is the basis for many fuel surcharges versus diesel fuel (which is the fuel actually consumed in the movement of the freight). Different indexes can have different price volatility, which can lead to over- or understating the actual fuel surcharge.

One way to improve the application of a fuel surcharge is to change from a percentage-based formula to a distance-based formula. Under this approach shippers A and B who are paying $1,200 and $1,500 to the same carrier for the same 1,000-kilometre trip would pay a flat fuel surcharge of, for example, $0.10 per kilometre. The result is that each shipper will pay the same fuel surcharge of $100. The surcharge is equitable as it does not penalize the shipper with the higher rate and does not compound any rate changes. Similar to the percentage formula, the distance-based formula would be based on a carrier’s actual cost of fuel and further refined by equipment type. The advantage of these changes would be to increase the transparency of the fuel surcharge and remove a shipper/carrier irritant.

Some carriers have recognized the issues with a percentage-based fuel surcharge and have amended their formulas. These changes are welcome and include adjusting the formula monthly instead of quarterly, changing the underlying basis to reflect the actual fuel consumed and shifting to a distance-based formula.

Shippers and carriers must consider the above discussion points and understand each others’ point of view.

Fuel surcharges may not be perfect, but they are working

David H. Bradley

CEO, Canadian Trucking Alliance

Is there is a better way to calculate fuel surcharges? As CITA chairman Graham Allen states, “shippers recognize that carriers need to be compensated for changing fuel prices, but it is the manner in which they are calculated and applied that causes them concern.”

From the outset, I think it is important to remind ourselves that the reason fuel surcharges evolved the way they did – as a percentage of the rate – was because that was how shippers said they wanted it. It was easy to understand and to calculate. The reality of the market over the past decade or more is that shippers on the whole have been unwilling or resistant to paying higher freight rates. In order to remain viable, to stay safe and to attract drivers, carriers have been forced to use a combination of fuel surcharges, border crossing charges, detention fees, etc., in order to earn a modest return on investment and improve driver pay packages.

CITA says that “the term fuel surcharge implies that the charge only goes one way – up. What happens if fuel goes down?” Well, the answer to that is the fuel surcharge goes down. It’s not the trucking industry’s fault that fuel prices have been skyrocketing on an upward trajectory and show little sign of abating.

CITA also takes issue with the fact that most fuel surcharges are calculated as a percentage of the freight rate. “Therefore, shippers with higher rates pay more in fuel surcharges than shippers with lower rates… (and) a percentage based fuel surcharge also compounds any rate increase,” CITA says.

That may be true to a point, but one needs to consider the reasons why some shippers pay higher rates in the first place. Shippers in a head haul market pay more than those in a backhaul or in a depressed market. The fuel surcharge in a back haul market usually falls well short of compensating the carrier for fuel cost increases. Rates in those markets often do not cover basic costs, let alone fuel or a profit. The shortfall is made up in the head haul lane – it has always been this way, and it will likely always be. Market demand, capacity and type of load all drive the prevailing rates in each lane.

Finally, CITA says that there is a “mismatch between the underlying index used to calculate the fuel surcharge and the actual fuel consumed in the movement of the freight.” This is a bit of a red herring. Work with your carrier to come up with whatever index you want. But, stick with it. If the formula is fair, things should all work out to about the same in the end.

What is the CITA article solution to these “concerns”? The one way it suggests is to change from a percentage-based formula to a distance-based formula. This, it says, would equalize the amount of fuel surcharge any shippers whose goods travel the same distance would pay. A “distance-based formula would be based on a carrier’s actual cost of fuel and further refined by equipment type.”

But, would things change all that much if the industry moved to a distance-based formula? Regardless of the formula you favour, they are both simply benchmarks after all. To a degree everything is distance-based already. However, moving to a wholly distance-based approach would be complex. There are a number of complicating factors – topography, load weights and equipment types would all have to be considered. The surcharge for pulling a load with a GVW of 135,000 lbs would be significantly different than for a load with a GVW of 80,000 lbs. Freight rates vary by weight and distance. This is equitable. More fuel is consumed with increased weight and distance. Furthermore, carriers pay for every drop of fuel they consume on (a) every mile they run; and (b) every hour they sit at a border waiting to cross, or are delayed in loading/unloading, or are stuck in traffic congestion.
What about empty miles? What about summer versus winter fuel? Invariably, carriers see what is happening and start pushing up base rates or increasing fuel surcharges to compensate. The carrier has got to be paid one way or another, at least until we find a way to run our trucks without the need for fuel. In the end, the debate over a percentage-based versus a distance-based formula is a bit like splitting hairs.

CITA says that some carriers “have recognized the issues with a percentage based fuel surcharge and have amended their formulas … (including) adjusting the formula monthly instead of quarterly…”

The reality is that carriers do tweak their fuel surcharges to reflect the reality of the cost of fuel. Furthermore, in general it is not many carriers that would find themselves on a quarterly fuel surcharge formula. Many carriers already adjust their fuel surcharges weekly and others would prefer to do so. We all know the price of fuel rises faster than it falls. There is little prospect of much correction off recent peaks.

Something upon which more carriers might be likely to agree is a recalculation of the underlying base rate used to calculate the fuel surcharge. Does it really make sense to have surcharges in the 20%-30% range? At what point does the base rate become rather meaningless and we are really just working for fuel? Resolving this, however, would require true partnership between shippers and carriers and I am not sure the level of trust is there in all cases yet.

In the end, it is concerning that some shippers are still resistant to fuel surcharges. They are a fact of life in the trucking industry and in virtually all other transportation sectors. Formulas can be tweaked. The base can be changed to whatever you want. In the end, the shippers’ problem is the same as the carriers’. Both need to deal with their customers in order to be appropriately compensated.

Finally, many shippers use the services of 3PL’s/load brokers these days. It is important that the shippers also understand and help to remedy the all-too-often occurrence of their intermediaries using the fuel surcharges as a profit centre by “sharing” in the fuel surcharge revenue instead of passing it all along to the carrier. 3PL’s do not buy fuel. This is something that falls directly under the responsibility of the shipper.

An evolving solution to volatile fuel prices

Richard Thomas, vice president of product development and marketing & communications, Markel Insurance

Over the past several years, trucking carriers have made a valid case for issuing fuel surcharges: shippers must compensate carriers for rising fuel prices if they expect carriers to remain in business.

Today, most shippers and trucking carriers accept this basic fact of life. With the exception of the chronic rate-cutting carrier, there probably isn’t a credible trucking operation today that doesn’t issue a fuel surcharge. Nor is there a credible shipper that doesn’t expect to pay one.

However, over time, fuel surcharges may not be the best solution to fuel price volatility.

The current era of fuel surcharges

After a decade of low and stable fuel costs, diesel prices began to rise in the spring of 1999 – as they did during the 1970s oil embargo, and as they did again in the late 1980s.

To address what was assumed to be a temporary problem, some carriers began to issue a “temporary” fuel surcharge. Soon, more and more carriers were forced to face the black and white reality of running in the red and decided that they too had to pass on these rising costs in order to stay in business.

Thanks to an ongoing capacity shortage, shippers weren’t given much choice but to pay the new surcharge. Without it, shippers risked losing dedicated carriers to the rate cutters – a mistake that many shippers learned the hard way.

However, as each month brought ever-higher fuel costs, years later those temporary fuel surcharges have now become a sizeable part of a carrier’s overall invoice and an increasing part of a shipper’s budget.

This by itself is not the problem. The problem is that fuel surcharges merely pass that unpredictable – and increasingly large – volatility on to the shipper.

The current solution can’t continue

Many carriers and shippers now feel we’re nearing a point where this model cannot continue. Shippers are managing their budgets with greater scrutiny in the face of new competitive and economic challenges. As a result, many shippers are beginning to look harder for cost stability and price breaks wherever they can be found.

Some carriers might be tempted to lower their fuel surcharges under pressure from shippers. However, that simply won’t solve the problem. By doing so, carriers would simply find themselves right back where they started – exposing their businesses to fuel price volatility and asking shippers for a fuel surcharge yet again.

A better way is needed

We all know that shipper-carrier relationships have fundamentally changed when we now find ourselves tracking Middle East geopolitics and US Gulf Coast weather patters as a normal part of running our businesses. Fuel price volatility is getting wilder with each passing year. A better solution to volatile fuel costs is needed.

And that solution may be a financial tool called fuel hedging.

Fuel hedging is a financial tool that’s been used successfully for several years by the airline, rail, shipping and agricultural industries. One particular type of hedging solution – called a call option – seems to be particularly effective for these industries.

A call option caps fuel prices over a set period of time – say, six months or a year. When fuel prices exceed that cap, a reimbursement is issued for the difference. A call option therefore has the effect of stabilizing fuel costs over a set period of time, which can be passed on to shippers in the form of stable rates.

What happens when fuel prices fall? Hedging fuel costs with a call option does not require a carrier to pay a set price for fuel and therefore the carrier will still benefit from falling fuel prices at the pump.

Carriers pay a fee to hedge against rising fuel prices, and in this way, hedging fuel costs is like having a “protection plan” against rising prices. But just like a carrier’s insurance, the costs of a call option should be seen – and managed – as an operating expense. And at a cost of less than a nickel per mile – versus fuel surcharge increases that have risen by more than 20 cents per mile in 2005 – that’s a lot of protection for a modest price. A price for certainty and cost stability that many shippers are likely to be interested in.

Of course, hedging fuel costs wouldn’t be necessary if you knew for certain that fuel prices will remain constant or even drop over the next year. However, given every factor that influences the price of fuel in North America and around the world, you need to ask yourself whether this is indeed a likely scenario. And, if not, whether never-ending increases in fuel surcharges are sustainable in the face of new competitive and economic challenges.

In 2005, Markel launched FUELogic, the first fuel hedge program designed specifically for the Canadian trucking industry. For more information, visit www.markel.ca/fuelogic.