Is Fuel Price Hedging Profitable for Airline Industries - Article Example

1 Introduction & Reasons for Hedging: Airlines indulge in a practice industry calls ‘hedging’ to protect fuel costs. Hedging basically fastens airlines cost of future fuel purchases. Locking in fuel prices also prevents sudden profits from decreasing fuel prices. (Morell & Swan) Other costs are less unstable than fuel prices, so hedging fuel stabilizes overall airline costs. More constant costs also mean more stable profits and higher equity values for shareholders The theory behind airline fuel hedges is to lessen a major swing in profit, and thus better returns for the airline scripts. Most airlines today hedge fuel costs. This has not always been the scenario. As recently as 15 years ago, fuel hedging was rare. European flag carriers used currency hedges previously to dilute their risk in fuel volatility In the last 12 years (From 9/11 particularly), unstable oil prices have caused a huge panic situation in the airline industry, a trend which will probably continue for some time. Crude price level rose to nearly $150 per barrel approx, later collapsing to below $40, and recently recovering back to $122 (Wyman) (Oilnergy). The past five years have been very intriguing for global airline industry. The state of the capital markets has not been too rosy itself leaving many corporations without much access to capital let alone cheaper rates In these times of significant modification and instability, it is a need that these airlines employ a feasible risk management program, allowing not only confronting the most challenging of times, but should also lead them to prosper in face of adversities. The question we will try to answer through this case study is that is it worth it in terms of profitability for airline Industry? 1.2 Types of Fuel Hedging: Previously all airlines hedged their exposure with respect of an oil future. Future implies paying a decided price for an amount of oil on a stated date(s). Consider a company buying a this future of jet fuel at $10 per barrel and jet fuel rises to $18, that commitment protects $10 worth of jet fuel underlying from the consequent 80% increase in price. Airlines typically hedge between 30 to 70% of their expected fuel costs. The recent survey of 24 anonymous international carriers reveals a very important snippet of data (Mercatus Energy) Hedging instruments as we assumed initially only involved fuel hedging used futures contracts. Nowadays, the exposure can be hedged in considerable ways which includes the good old futures, comparatively newer forwards and the latest ones namely options with the limits like covered call and protective put Another snippet from Mercatus Energy advisors report in 2012 revealed a recent trend in fuel hedging practices. As we can see the futures have lost their charm when it comes to hedging exposure (Mercatus Energy) In forwards there is commitment between two parties whereby one party normally buys a decided amount of underlying from the other at a predetermined price on future day. Corporations supplying oil to airlines tend to enter into such agreements, but their tailor-made nature (one size fits all strategy) is not a suitable instrument for third parties or speculators. The purchaser also has a considerable default risk when the transaction is conducted On the other end futures better conform to hedging and trading needs of counterparty, since they are traded on designated exchanges on homogenous contracts. One party agrees to deliver to another corresponding party certain quantity of oil at designated price on predetermined date in the future. No physical delivery of the underlying needs to take place. Less than 1% of trades actually result in the delivery of the underlying commodity (Cme Group). The main players dealing in these markets are the International Petroleum Exchange (IPE) in London and NYMEX in New York. The quantity of underlying is guaranteed and contracts can be fixed for 1-24 months in advance. The liquidity for contracts beyond one year forward declines significantly. A Clearing House is involved and monitors such commitments hence the risk at hand is also negligible. Options are the third of such instruments and deal in several contacts but Brent gas oil and crude are the most popular ones. There no obligation to exercise and if for instance they are not exercised the final position would be that of a futures. Options offer choice and thus flexibility over futures safeguarding against negative movements in price and on the same moment selling an opportunity to come in markets if there are positions which airlines desire of. Options are mostly taken with other parties (e.g. banks like SCB or City Bank). Jet fuel is very seldom traded on any market and thus the transactions are Over the Counter. These involve default risk on both sides, and thus smaller airlines/groups would find it hard to find others willing to take this risk or may charge a much higher premium which will reduce the motive of this strategy altogether. As seen before the current trend in market involves airlines moving towards utilising combinations of a call, put options known a collar. The covered call safeguards the holders from unfavourable price increases above its strike price but it comes at a cost of the option premium that has to be paid no matter the party having the right to exercise gains or lose. The holder of this call also writes a protective put option that to certain degree limits advantage it can take of price reductions below its strike price. It may seem stupid at first but it does bring something all the corporations’ desire. An upper and lower bound in which the price will fluctuates gives them a good idea of their margins and help them budgeting in final accounts. The total figure of both options is the call option premium paid less the put option premium received (can be negative based on market scenarios). Swaps are tailor-made futures contracts where both the parties exchange the cash differentials based on spot price of fuel or oil price on the date when commitment matures or expires. If it exceeds the strike price the counter-party would give the airline the difference times the amount of fuel booked on the initial agreement. However, if it were lower, then the airline would to pay to the counter party. The price is locked as with forward contracts. It is important to realize that hedging oil on exchanges that monitor homogenous commitments eliminate default risk. These also are more readily convertible to cash and allow airline to make a settlement. For longer periods into the future has good liquidity but on the other hand Jet fuel contracts provide liquidity for shorter periods. 2.1 Typical ways of how airlines hedge their fuel price: Before proceeding further it’s important to note that a minuscule fact about fuel hedging. A heavy amount of risk is involved in these transactions namely basis risk. This risk derives from situation where speculator or in our case airlines must use futures contracts on a different underlying to hedge risk on asset they originally want to reduce exposure on. Example, airlines often wish to hedge their jet fuel costs. They sell tickets some time advance mostly months before the flight but the true cost of delivering the flight will reflected hugely by price of fuel on the date of the travel. Airlines can eliminate this risk by using derivatives market but face a problem in hedging jet fuel (Haushalter & David) As discussed before no futures agreements are traded on jet fuel. The closest alternative is heating fuel oil. Thus airline has no option but to hedge their cost exposure using Heating Oil futures contracts. But there is a risk in that practice as well. Heating Oil futures contracts will not exactly reflect the change price of Jet Fuel. This difference in the price of Jet Fuel and the price of heating Oil futures is referred to as basis risk. (University of Virginia) As far as typical ways and approaches are concerned these will be described in this section in detail. Real world practice shows several different approaches to fuel hedging. By differentiating dimensions of markets and amount and instruments we can get a first overview of those approaches. First Approach: As crude oil is also the chemical basis it can serve as an alternative underlying to jet fuel. Several airline carriers place their hedges against the movement of the crude oil price. Both prices are normally highly correlated, yet, this differential can show its very own dynamic mostly driven by refining capacities. The market for financial instruments on jet fuel is mostly not liquid enough to hedge against the full consumption– however carriers can be categorized by whether they also hedge the differential between crude and jet fuel – the crack spread or they focus on the crude market. Second Approach: The amount of consumption coverage allows putting carriers into contingency framework depending on what percentage of their consumption is hedged how far into the future. The currently most successful hedging carriers use a rolling hedging strategy -where consumption on closer dates is hedged to a higher degree than consumption in future times. Generally the hedging policy of an airline will set the rules which instruments to use). By taking into account the derivative instruments available on the market discussed in the last section airline can determine as willing to take more or less price risk, and to participate or not to participate in market shifts. (Karls Rusher Transfer) 2.1 Airlines Involved in Hedging of Fuel (U.S Perspective) The table below will cover all major Air Carriers in U.S.A that hedge or do not hedge their fuel. It can be viewed below Airlines That Hedge their fuel (U.S) Airlines that do not hedge their fuel (U.S) Airtran Holdings Alaska Air Group American West Holding AMR Corp Amtran Atlantic Coast Airline Continental Airlines Delta Air Lines Hawaiian Airlines Midwest Express Holdings Northwest Airlines Southwest Airlines Tower Air Trans world Airlines UAL Group US Airways Group CC AIR Comair Holdings Frontier Airlines Great Lakes Aviation Messa Air Group Messaba Holdings Midway Airlines SkyWest Vanguard Airlines Western Pacific Airlines World Airways Note: These airlines have been known to hedge or not hedge the fuel risk. A failure of any airline to hedge their fuel risk in any financial year does not imply that they have not hedged the fuel in previous years. 3.0 Impact of Fuel Hedging (Local and International Perspective): Most major passenger airlines now hedge at least part of their future fuel needs. A survey of treasurers from 25 of the world’s largest airlines in 1991 revealed that 13 engaged in fuel futures transactions, managing exposures six months to two years into the future. Some state owned airlines such as Air India were only given permission by their central bank to hedge more recently in 2003. (IATA) Three of the eight largest US majors were not hedged for 2004, and one was only hedged for six months of that year .All the major European network airlines had hedged a significant part of their 2005/05 fuel needs at the date of publication of their latest annual report. British Airways were somewhat under-covered, but subsequently increased their hedging activity .Less information was available from the annual reports of Asian airlines. However, in general, less hedging seems to have been undertaken by the still predominately state owned airlines. (Cobbs & Wolf, Spring 2004) Korean Airlines reported a gain of Won 282 million from a forward fuel contract in FY2003, reducing their average fuel price paid by 34%. Qantas offset 73% of their 2003/04 increased fuel price paid through various unspecified hedging activities. Singapore Airlines were able to offset almost all the price element of their 2002/03 increase in fuel costs by hedging, and in the following financial year a S$135m fuel cost increase from higher prices was made S$1m worse by hedging losses. (Morell & Swan) The major Chinese airlines (e.g. China Southern, China Eastern and Air China) were obliged to purchase their domestic fuel needs from the state oil company at PRC spot prices. Southwest Airlines, who are internationally considered to be a benchmark when it comes to fuel hedges, are reported to have gained more than 3 billion US$ just from smart (or lucky) hedging activities since this timeframe however coincides with an era of rising crude oil prices where hedging was favoured by market conditions (Phillips, April 2003) These examples emphasize that hedging is beneficial in smoothening out cost structure over time, where overall price volatility will decrease but temporary gains will be evened out by similar losses as most airline trading policies explicitly recognize. The ultimate question for carriers that follow the classical hedge-to-minimize-risk approach must therefore be if the minimized volatility is really rewarded by the stock market as an increase of company value. (Morell & Swan) By not hedging, airlines are taking on the risk of rising commodity prices into their business model. Some airline executives claim that this risk is present regardless of whether they hedge or not. Airline executives often comment that hedging is not a core competency, and that as long as competitors are not hedged, it will be a level playing field.” However CNN Money further states that unfortunately, when fuel prices rise dramatically; airlines cannot pass all of the cost on to their customers. Other fuel-dependant companies, such as FedEx, are able to force their customers to accept fuel surcharges; however, in the airline industry the success of such programs is very unpredictable. (CNN, 2004) A study from the Wharton School of Business notes that the current spike in jet fuel prices will add an extra $2.5 billion in additional expenses, according to the Air Transport Association. In response, several companies tried to attach a fuel surcharge, but with continued weak demand and fierce competition, the increases didn’t stick. (Wharton School of Business, 2004) Making the case against hedging, Rod Eddington, the CEO of British Airways, commented: ‘’a lot is said about hedging strategy, most of it is well wide of the mark. I don’t think any sensible airline believes that by hedging it saves on its fuel bills. You just flatten out the bumps and remove the spikes.” He went on to say that there is a case for not doing any hedging at all. “When you hedge all you do is bet against the experts of the oil market and pay the middle man, so you can’t save yourself any money long term. You can run from high fuel prices briefly through hedging but you can’t run for very long. (AFX, 2004) On the other hand notion that remaining exposed to fuel prices is the norm of the airline industry and therefore acceptable is questionable at best. The variety and effectiveness of hedging strategies employed by airlines is also evident in their actual jet fuel costs per gallon. During 2003, the largest fuel hedgers (Southwest, JetBlue, and Delta) achieved actual fuel costs that were in-line or below the average New York and U.S. Gulf Coast jet fuel spot prices for the year; whereas, those airlines that do not have a track record of effectively hedging fuel costs incurred actual fuel costs that were at or above the average spot price for the year. Diagram compares the actual average airline fuel cost to the average New York and U.S. Gulf Coast jet fuel spot prices for 2003. In the first quarter of 2004, according to CEO Jim Parker, Southwest’s profit of $26 million would have been a loss of $8 million had they not been hedged against rising fuel prices. (Reflector, 2004) Southwest airlines and Delta Air have stated that fuel hedging is a key component of their low-cost strategy and believe this strategy represents a competitive advantage. In 2001-2003, Southwest reduced its annual fuel expense by $171 million, $45 million, and $80 million, respectively, through its fuel hedging operations 4.0 Conclusions and future trends: Most of the major airlines are hedging fuel using jet fuel, gas oil and crude derivatives. Few cover more than 12 months’ expected consumption, and it is rare to find more than 80% of future needs hedged beyond three months ahead. Crude oil provides more liquidity and flexibility for hedging, but the spread between crude and jet aviation fuel had tended to widen at times of market instability. Not many airlines report gains and losses from fuel hedging activity. That said Airlines will have to keep investing in fuel hedging to mitigate instability in oil prices. Several references of people in our case arguing that fuel hedging is a zero sum game applied in the scenario where the world had not seen such volatility in oil prices where the cost fluctuated wildly between $40-$150. Some airlines may lose a hefty deal on derivative instruments but the scenario of what could have been must always be kept in mind. Over exposure to such risk is not a good idea when prices move in such drastic fashion along with the idea that due to cut throat competition these prices could not be passed onto consumers so easily. Some airlines do recognize developing a more sophisticated fuel hedging can be a competitive advantage .One airline built up a substantial energy trading team and invested in its fuel storage (Wyman). By doing so airline gains visibility in what fuel may cost in future. The critical first step to steady its fuel hedge positions is to develop a set of analytics that make regularly evaluating fuel hedging recommendation manageable. Such tools may rapidly process data to analyse the current dynamics and show thousands of different possibilities in which the airline may profit or loss and may help make a feasible decision. A proper infrastructure is also needed so these decisions can be made quickly in reflection of the gains airline may get by such decisions. Coping with volatile prices will continue to be a challenge for these airlines. Major airlines lost 8 Billion dollars last year in fuel hedges alone and this is due to falling crude prices. Therefore to avoid these losses proper analytics will need to be in place. Other factors that may reduce the hedging is putting upper and lower bounds by a higher air travel authorities like IATA which may limit the volatility of the crude oil to let’s say + 5 % of the spot price at the end of the year. This way the companies will be obligated to be charged 5% above the spot price on normal days but if the prices increases beyond 5% they will be sold at the same price they were previously sold on. That way the airlines can be sure of the maximum impact volatility of oil prices can have on their profitability. The amount of hedging also depends on expected volatility and GDP growth rates/trends throughout the world. In the times like current scenario hedging of oil is not that beneficial as the volatility is low and the scenario is stable oil prices. This may change in future but it depends on different time frames in consideration. There is hence no black or white answer in such situations. It again signifies the need of proper analytical systems that we discussed prior which fortunately are being worked upon by majority of airlines now. Bibliography AFX. (2004, May 17). BA says fuel requirement 45% hedging in current year. AFX News article . AFX. Cme Group. (n.d.). Nymex. Retrieved from Nymex: www.cmegroup.com CNN. (2004, May 26). United raises surcharge. Retrieved from CNN Money: www.money.cnn.com Cobbs, R., & Wolf, A. ( Spring 2004). Cobbs, R. and Wolf, A.: Jet Fuel Hedging Strategies: Options Available for Airlines and a Survey of Industry Practices. In: Finance 467 . Haushalter, & David, G. (n.d.). Financing policy,Basis Risk and Corporate Hedging: Evidence from oil and gas producers. Journal of Finance 55 , 107-152. IATA. (n.d.). Iata. Retrieved from 1991 Statistics: (http://www.iata.org/whatwedo/economics/Pages/index.asp/1991 Karls Rusher Transfer. (n.d.). Fuel Hedging. Retrieved from http://www.karlsruher-transfer.de/fileadmin/download/transfer/kt38/KT_38_FuelHedging.pdf Mercatus Energy. (n.d.). Mercarus Energy. Retrieved from http://www.mercatusenergy.com/Portals/80554/docs/the-state-of-airline-fuel-hedging-and-risk-management.pdf Morell, P., & Swan, W. (n.d.). Oilnergy. (n.d.). Retrieved from Oilnergy: www.oilnergy.com/1onymex.htm Phillips, E. ( April 2003). Southwest Stays in Black. Aviation Week & Space Technologyol.158, No.17 . Reflector. (2004, May 7). Southwest Air Hedges Bet on Oil Prices. Retrieved from Reflector.com . University of Virginia. (n.d.). Darden Faculty of Virginia. 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