Knowing our options

Some council members looked confused at Monday night’s meeting when Council Member Matt Czajkowski asked Brian Litchfield, assistant transit director, about the cost of the forward contract to supply diesel fuel for town buses and service vehicles in the 2010-11 fiscal year. This was an item on the consent agenda that would have been approved by rote had Czajkowski not asked a prudent question: What is the cost of the option?

Buying a forward contract is kind of like buying insurance. The town pays a fee to a dealer that allows the town to buy a certain amount of fuel for a set price during the timeframe specified in the contract. The town is under no obligation to buy the fuel at that contract price, and certainly won’t if the spot market price (the price on the open market, which changes daily) is lower than the contract price. But, if the town doesn’t exercise the option, the town has lost the money it spent on the option fee that guarantees the price in the contract.

In buying a forward contract, the town is betting that the market price will rise significantly higher than the contract price. The dealer is betting the market price will drop. One side wins; the other loses. Czajkowski essentially asked, If we lose, how much do we lose? And if we win, how much do we have to win to make it worth the cost of the option?

Last year, the Transit Department bought two forward contracts, spending $1.866 million for 1.2 million gallons, which was $135,000 less than what was budgeted. (I’m awaiting a response from council members to learn whether that savings remained with the Transit Department to be spent at its discretion or how the town manager spent it.)

At Monday night’s meeting, the town manager wanted approval to buy more forward contracts for fuel, but he had not yet negotiated a price and thus did not know the cost of the option fee. He was essentially asking council for a blank check. That’s no way to balance a budget.

Because of Czajkowski’s probing, Litchfield agreed to send an e-mail to council before any forward contract is signed, letting them know the negotiated price per gallon and the cost of the option. Council members can weigh in on whether that seems like a good deal before the town involves itself in yet another contractual obligation.

Speaking of which, we’re still waiting to hear from the town manager, town attorney or mayor about what it would cost the town to walk away from the 140 West Franklin contract. We’re beginning to think that no one in town government had thought about it until we asked.

— Nancy Oates

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  1. Bob

     /  February 11, 2010

    From the description, it isn’t clear whether this is a forward contract on fuel or an option contract. Typically, a forward contract sets a price at which a transaction will take place in the future. There is no uncertainty about the price or delivery. If the future price of fuel turns out to be higher than the price in the forward contract, the town wins. If the future price is lower, the town loses.

    An option contract gives the holder of the option the right (but not obligation) to buy at the prespecified price. In this case, if the future price turns out to be lower than the price in the option contract, the town abandons the option to buy at the higher price. It loses only the price it paid up front for the option to buy. Of course, if the future price turns out to be higher than the price in the option contract, the town exercises its right to buy fuel at the price in the option contract.

    Both are recognized ways to hedge uncertainty about the cost of fuel in the future. If the town was buying the contract on an open market where forward and option contracts were traded regularly, it could rely on market processes to deliver a competitive price. In this case, I suspect that this forward or option contract under discussion is being offered by a fuel provider. There is no, repeat no, reason to believe that the town is going to get a good price. All the usual factors that would deliver a good price are absent.

    Council Member Matt Czajkowski is asking the right question. Let me add another question: what skill and expertise in financial derivatives exists in the town government? Is there any reason to believe an assistant director on the transit staff could assess whether the price of this contract is fair and reasonable? The finance director for Orange County, CA thought he understood derivative contracts about 20 years ago. Google that debacle if you want to see what can happen.

    Yikes…….this is a mess waiting to happen.

  2. Ned

     /  February 11, 2010

    Glad to see Matt C. bring a level of fiscal responsibility to Chapel Hill. It is long overdue!

  3. j s

     /  February 12, 2010

    I’ve never been to a town council meeting, but when I read this, it just makes Sense to me to question the break-even math on these types of contracts. When you say ‘would have been approved by rote’ does that mean nobody’s looked at the math in the past to see if it’s a good deal or not?

  4. Nancy Oates

     /  February 12, 2010

    By “approved by rote” I meant that it was a consent agenda item. The mayor puts certain matters that come before council on the consent agenda — he’s looked at it and thinks the council should approve it. The council votes on the items as a package, unless any council member wants to separate it from the package to either be discussed or voted on separately. That was what sparked the outrage when former Mayor Kevin Foy put the matter of council members receiving health benefits for life on the consent agenda. Matt Czajkowski pulled that out for a separate vote and initially was the only one who voted against it. I don’t know what happened the last time the Transit Dept. wanted approval for forward contracts, but presumably the council approved it. This time, Czajkowski wanted to know what it would cost. He made it clear he wasn’t planning on quashing the idea; he just wanted the facts.