J&L RAILROAD

A) 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.

B. Should J&L hedge all of its exposure to diesel fuel for the ensuing year? Why? What

percentage of the 210 million gallons would you hedge?

J&L Rail Road should go for hedging, but it is not necessary to hedge all of its exposure

as for its diesel fuel. It is because of the reason that, 17.5 million gallons are being just an

expected amount of fuel and in future the perfect hedge cannot be achieved. J&L should

accurately estimate the future demand as the demand is decreasing due to the reason that in 2008

there was a recession that affects the fuel prices and it soften the demand. The percentage of the

210 million gallon would be hedged as J&L go for the future contracts with the suppliers at the

fixed rate and the percentage they should hedge for the fuel prices should be around 25% it is

because of the reason that for the first quarter of the year they should store the inventory for the

future demand. This percentage is lower because of the lower demand.

C. Discuss the railroad industry and the J&L Company in particular.

Many railroad firms within the United States has begun to experience profits that are not

at a point of maximization because of the increase fuel costs they must incur. With severe prices
competition firms are not able to increase prices in response to increased costs because of

consumers changing behavior in direct response to prices changes. Although some firms have

discussed adjusting prices in response to fuel costs, they have not taken this action. In result of

this decrease in potential profit, firms are beginning to explore potential ways to decrease the risk

associated with the volatility of fuel costs, so they can increase and maximize the profit. J&L

Railroad in particular is exploring the avenue of hedging. CFO, Jeannine Mathews has been

researching potential hedging alternatives to present to the Board of J&L Railroads. Mathews

and J&L Railroad must decide is hedging is the best option for the company and its shareholders,

and if so, how much they should hedge, and in what manner should implement the hedging.

J&L Railroad was founded in 1928 and although publically owned, is one of only a few

Class I railroads still manger by the original founding families. Along with many other firms

within the industry, J&L has invested large amounts of capital in order to increase efficiency

within the company. This has included, replacing equipment, repairing railways and building

lighter railroad cars. Although these contributions have helped decrease prices in the long run,

the firm still has seen lowering of potential profit due solely to the increasing fuel costs and the

inability to increase prices. In 2001, total fuel costs were 6.7% of revenues. This cost has

increased constantly since then, accounting for 16.3% of revenues in 2008. Focusing on 2008,

the company saw an increase in rail revenues of $154 million, but operating margin had

decreased by $114 million. The firm experienced a decrease in operating profit of 11% 2008 –

which followed an increase of 9% the year prior. Faced with these financial issues, the firm

began to thoroughly examine the opportunity of hedging.

D. What are the pros and cons of using NYMEX contracts versus using the risk-

management products offered by KCNB?

NYMEX

PROS

The benefit of the NYMEX contract was that, it provides the mark to the market transaction

facility in which J&L’s position was settled daily and this market to market restricted towards

lower exposure of risks as 5% margin was required for the contract from both the parties and any

increase and decrease in the position of the buyer and seller were deducted on a daily basis.

CONS

For J&L Rail Road cannot use the hedging on diesel fuel because of the reason that NYMEX did

not deal with the fuel hedging contracts and for that reason J&L firstly has to use the heating oil

contracts in order to hedge the diesel fuel exposure and there would be lower exposure which is

affected by the different prices of these two commodity instruments. Another problem of the

NYMEX contracts was the standardized contract structure with respect to the time to maturity

and the size of the contract.

KCNB:

PROS

KCNB provide the products to J&L Rail Road for the hedging of the diesel fuel such as Cap,

Floor, Collar, and Commodity Swaps. Within these products the Cap is the call option, Floor is
the Put option and Collar is the combination of the Cap as Call option and Floor as the Put

option. KCNB was providing the commodity SWAP in which KCNB was agreed on paying the

amount on the settlement date if there was any incremental changes in the heating oil prices for

the year.

CONS

KCNB offers option on cap and call that gives the holder of option a right to purchase or sell the

certain number of contract of the underlying assets, meanwhile, its drawback is that it requires an

upfront premium to be paid on the number of contract purchased

E. What types of hedging strategies do you recommend that Matthews should employ?

After both conceptual and financial observation, I recommend that J&L does indeed

partake in hedging actions. Options contracts have helped many corporations reduce exchange

rate risk, which not only benefits the firm but the shareholders. I believe that with the correct

actions, J&L will be able to hedge successfully, increasing profits and increasing the return to

shareholders. I think that the best way to do this is to enter into a relationship with KCNB. The

NYMEX comes with too many risks and challenges. These include, not being knowledgeable in

the field, which comes hand in hand with potential to enter into contracts without the accurate

prior information. Additionally, NYMEX future contracts are set at 42,000 gallons per month;

J&L is unlikely to always need a multiple of 42,000 gallons. Utilizing KCNB will enable J&L to

focus their attention on the field they are knowledgeable and professionals in, leaving the

investment strategies up to investment professionals. Although there are upfront fees to use
KCNB, the products offered will provide J&L many ways to hedge their diesel-fuel cost risks. I

think that during the first year of hedging, J&L should hedge 60% of their costs. This will enable

to the firm to experience the potential benefits of hedging, without putting themselves at too

much of risk.