Hedging Commodity Price Risk - Essay Example

Introduction Firms are exposed to several great risks in the of their business operations. These risks have a significant impact on these firms' earnings and cash flows. Airlines are typically exposed to commodity price risk in the form of fluctuations in the price of fuel oil. Because of the fact that fuel price cost constitutes a major part of any airline's total expenditure, hedging becomes very crucial for these firms. There are several strategies that are used by airlines for the purpose of managing the commodity price risk. These strategies are forward contracts, futures contracts, swaps, call options, collars etc. All these strategies have significant strengths and weaknesses, which needs to be efficiently balanced by firms. This paper illuminates the impact of commodity price risk on the firms as well the significance of hedging such risk. It also analyzes different hedging strategies used by companies and their strengths and weaknesses. Hedging Commodity Price Risk Hedging constitutes one of the most important financial decisions of any firm. It refers to different ways through which a company can minimize its exposure to various kinds of risks. Fuel represents a crucial cost in the total airline expenditure and thus fuel price risk has a great impact on the earnings and cash flows of airlines. Any drastic increase in oil prices can adversely affect cash flows. Effective hedging strategies are imperative for airlines to minimize the variability of cash flows due to volatility in oil price (Carter, Rogers. and Simkins, 2003). This is why almost firms use various hedging strategies to protect their cash flow from variations resulting out of oil price fluctuations. Froot, Scharfstein and Stein propound that "if a firm does not hedge, there will be some variability in the cash flows generated by assets in place." (1993, p. 1630) A non-hedging airline is also likely to be greatly vulnerable to any change in fuel market price. Because of effectiveness of hedging in commodity price risk management, firms are not adversely affected by sudden rise in oil prices. Any adverse fluctuation in oil price can greatly affect a firm's earnings and its ability to pay off its debt obligations. Froot, Scharfstein and Stein suggest that "for a given level of debt, hedging can reduce the probability that a firm will find itself in a situation where it is unable to repay that debt." (1993, p. 1632) This is one of the greatest benefits of using hedging strategies to manage commodity price risk. These strategies assure management that even if the commodity price moves in the unfavourable direction, it will not have a great impact of firm's earnings and cash flows. Forward contracts are the most common hedging strategies used by firms. Southwest airlines managed its exposure to oil price risk in the year 2005 with the help of forward contracts and successfully enhanced its earnings. On the contrary, in the same year other airlines like Delta and United Airlines faced great difficulties. However, there is high credit risk involved in hedging strategy using forward contracts. Froot, Scharfstein and Stein elaborate that "because they are not settled until maturity, forwards can involve substantially more credit risk than futures." (1993, p. 1649) Forwards have a distinctive feature as compared to the futures contract that they cannot be settled before maturity date. Hence, on one hand forwards strategy helps firms to considerably minimize their exposure to commodity price risk, it also leads to significant credit risk. Futures contract is another most commonly used strategy that firms can use to hedge against the commodity price risk. Veld-Merkoulova and de Roon (2003) illuminate a 'nave' strategy which relies on short term futures contracts for the purpose of hedging long term position in the spot market when the size of both the positions are the same. Under this hedging strategy, the futures contract is closed on the same date as that of the spot contract if futures contract has a maturity date following the spot contract. In an opposite situation, this strategy requires a firm to constantly rebalance the hedging portfolio as the futures contract matures. It thus requires a firm to keep a short term futures contract for every single spot contract. However, such a strategy leads to significant cash flow problems in an effort to continuously rebalance the portfolio in long-term hedging. Using futures contracts for the purpose of hedging commodity price risk, liquidity constraint is an important issue (Wong, 2004). This is another risk involved in hedging using futures contracts. A firm's decision to use short or long term futures contract has a considerable impact on its cash flows, which enhances the liquidity constraints it is exposed to. Veld-Merkoulova and de Roon also assert that "successful hedging strategies should be based on using short-term futures contract in order to minimize market impact costs" (2003, p. 129). Long term futures contracts are riskier than the short term futures. This is the reason not every airline can opt for long-term futures contracts. When a firm uses futures contracts, it minimizes its exposure to commodity price fluctuations and confronts with less liquidity constraints. Other strategies that could be used for commodity price risk management are price swaps and price collars etc (Jin and Jorion, 2006). Call options are also used by firms to formulate a hedging strategy against commodity price risk. These refer to a right to buy an asset at an already fixed price at some specified time in future until the date of maturity. The major benefit of using options is that they enable firms to hedge cross-market risks. For example, airlines can use one commodity as a cross-market hedge against another commodity. However, these options are highly expensive in case of energy commodities because of high volatility of price (Carter, Rogers and Simkins, 2004). These options are useful for airlines that deal in various fuel oils other than jet fuels such as crude oil, heating oil etc. Airlines can use various fuel oils at different prices for cross-market hedging using call options so as to keep down the cost of hedging. However, it is not always possible because of high unanticipated fluctuations in the energy prices. Airlines also utilize various derivative instruments to hedge against fluctuations in oil price on the basis of jet fuels as well as commodities other than jet fuels i.e. crude oil, heating oil, diesel fuel and jet kerosene. Airlines, on a major part, also rely on plain vanilla instruments like swaps, call options and collars to manage this risk and avoid the adverse effect of fluctuations in oil price on cash flow. Firms use different fuels apart from jet fuel because the prices of these commodities are highly correlated. Liquidity is another issue in using fuels other than the jet fuel because of the fact that jet fuel does not endorse a futures contract due to lack of enough liquidity. On the other hand, fuel oils such as crude oil and heating oil offer high liquidity and minimum credit risk (Carter, Rogers and Simkins, 2004). Swaps, collars and call options enable firms to avoid liquidity risk involved in other hedging strategies. However a major weakness of these strategies is that they are highly expensive because of risky nature of oil commodities. There are other risks in using derivative contracts. The major risk involved with hedging using derivative contracts is the basis risk. This risk arises out of the fear that oil price would not change in line with the value of derivative contracts used. When airlines hedge using crude oil, heating oil and jet fuel, it is assumed that the prices of these commodities are highly correlated and thus, there arises huge basis risk as this relationship collapses. Basis risk is greatly involved in futures market as the value difference between the oil price and the futures contract for oil. Basis risk is mainly of three types i.e. product basis risk, time basis risk and locational basis risk. All of these risks bear great potential in adversely affecting the hedging strategy of airlines. In order to minimize its exposure to basis risk, firms can use differential swaps (Carter, Rogers and Simkins, 2004). There always remain great probability that price of oil fuels might not change in the same manner as the value of futures. In such a case firms are likely to be affected with basis risk if they use derivative contracts. Conclusion This paper discusses the impact of commodity price risk on the vulnerability of a firm's cash flows and earnings. Airlines use several strategies to hedge against the risk of fluctuations in the price of fuel oil depending on their financial position. There are certain risks that are further associated with these strategies such as liquidity constraints, credit risk and basis risk. Hedging strategies using forwards contracts generally enhance credit risk because of the fact that these contracts cannot be settled off before the maturity date. Liquidity constraints are usually associated with futures contracts due to the market impact costs. Derivative contracts such as swaps, collars and call options expose a firm to basis risk because of the fact that there remains a probability that fuel price might not change in the same line as changes in the value of the respective derivative contract. The use of a particular hedging strategy thus depends on a firm's financial position and capacity to bear risks. References Carter, D., Rogers, D. and Simkins, B. (July, 2004). Fuel Hedging in the Airline Industry: The Case of Southwest Airlines. Available at http://207.36.165.114/NewOrleans/Papers/8302208.pdf Carter, D.A., Rogers, D.A. and Simkins, B.J. (May, 2003). Does Fuel Hedging Make Economic Sense The Case of the US Airline Industry". AFA 2004 San Diego Meetings. Available at http://neumann.hec.ca/cref/sem/documents/030923.pdf Froot, K.A., Scharfstein, D.S., and Stein J.C. (1993). Risk Management: Coordinating Corporate Investment and Financing Policies. The Journal of Finance, 48(5), pp. 1629-1658 Jin, Y. and Jorion, P. (2006). Firm Value and Hedging: Evidence from U.S. Oil and Gas Producers. Journal of Finance, 61(2), pp. 893-919 Veld-Merkoulova, Y.V. and de Roon, F.A. (Feb 2003). Hedging Long-Term Commodity Risk. The Journal of Futures Markets; 23(2), pp. 109-133 Wong, K.P. (October, 2004). Liquidity Constraints and the Hedging Role of Futures Spreads. Journal of Futures Markets, 24(10), pp. 909-921 Read More