ANALYSIS: Should airlines hedge their bets on fuel?
Published: July 25, 2012
Volatile oil prices bring into focus airline strategies for protecting themselves from spiralling fuel costs and whether they can avoid taking too much of a gamble
When Delta Air Lines announced its intention to acquire an oil refinery earlier this year, the unusual move drew a mixed response from analysts. Some praised its innovation, arguing that its daily consumption of 210,000 barrels of jet fuel justified cutting out the middle man. Others questioned whether airlines should be in the business of refining crude oil.
But one thing no one disputed was the urgent need to offset fuel price volatility. According to IATA’s latest forecast, Brent crude, the main European benchmark, is likely to average $ 110 a barrel this year – but in just six months spot prices have ricocheted wildly between $ 128 and $ 88.
For airlines that rely on stable ticket pricing to deliver profitability, such swings have brought fuel hedging firmly back into vogue during the post-2008 recovery. In its simplest form, hedging allows fuel prices to be fixed or capped for future expenditure, smoothing out unforeseen spikes in the oil price and bringing some certainty to margins.
But as Delta has experienced, this can be a double-edged sword. The airline wrote down fuel hedging losses of $ 155 million in the second quarter of 2012, alongside mark-to-market paper losses of $ 800 million for future hedges. It took the hit after West Texas Intermediate (WTI) crude, the main US benchmark, slumped from $ 110 a barrel in February to $ 78 in June, making spot prices much cheaper than the futures contracts Delta was locked into.
The spread between WTI and Brent reflects differing stockpiles on either side of the Atlantic, as well as variations in demand and transportation costs. Both benchmarks feed into secondary jet fuel prices – which, as of 6 July, have fallen by 10.9% year on year to an average of $ 117.40 a barrel, according to Platts.
Delta will not be the only carrier to record hedging losses in Q2 2012, but its results are the first worrying sign that the industry has repeated the mistakes of 2008, when airlines locked in sky-high hedges only to see Brent crash from $ 147 a barrel in July to $ 36 in December.
“There was a fear that oil prices were going to go to $ 200 or $ 300 a barrel,” says Mike Corley, president of hedging consultancy Mercatus Energy Advisors. “The fear of being exposed to $ 200 a barrel was so great that a lot of people convinced themselves prices could not decline. Prices were rising so fast that many airlines started hedging without even really thinking about it.”
When oil then collapsed along with most other asset classes, the opportunity cost of hedging above $ 100 a barrel took a heavy toll. In the 2008/09 fiscal year, Cathay Pacific recorded mark-to-market hedging losses of HK$ 7.6 billion ($ 974 million); Air China booked 6.8 billion yuan ($ 994 million) in losses; and Emirates lost 1.57 billion dirham ($ 428 million). Even Southwest, once the pin-up for fuel hedging, lost $ 117 million on its Q4 positions.
These losses prompted a seismic shift in attitudes to hedging. Stalwart practitioners such as Air France-KLM , British Airways and EasyJet all scaled back their programmes, while China’s risk-averse government took the extraordinary step of banning airlines from buying oil futures.
Memories of 2008 will be keenest in Asia because of the widely held perception that western banks had mis-sold hedging instruments. Little wonder, then, that Japan Airlines, All Nippon Airways, Cathay Pacific and Singapore Airlines have all moved to reduce fuel surcharges in recent weeks – no doubt relishing their higher exposure to spot prices.
Helane Becke, analyst at Dahlman Rose and Company, says: “We expect airlines that do not hedge jet fuel to say they are managing their businesses better, because they will not report hedge losses in this declining jet fuel environment.”
However, although sceptics are now singing the praises of risk aversion, out-performance in a bear market is just one side of the coin. Macroeconomic fundamentals continue to exert upward pressure on oil, which makes heavy exposure to spot prices just as risky as light exposure. “If you are not hedging, you are speculating,” says Mercatus’s Corley.
Fuel-consuming companies that choose not to hedge generally believe one or both of the following: that they have the ability to pass on fuel-driven inflation to customers, and/or they are confident that oil prices will fall.
For airlines, both viewpoints are dubious. Even carriers tightly managing capacity have limited control on price elasticity, which is dictated more by the competition and demand, while predicting price movements is essentially a gamble. As Ryanair deputy chief executive Michael Cawley once observed: “You can’t anticipate fuel prices. If we could, we wouldn’t be running an airline.”
Instead of trying to out-manoeuvre the market, prudent hedges aim to smooth volatility. By acquiring positions that partly negate real-world exposure, airlines can use financial derivatives to mitigate price shocks.
“It’s really about quantifying your fuel costs and then taking action to limit your exposure to volatility,” Corley says.
“Hedging reduces exposure to price risk by shifting that risk to companies that have opposite risk profiles, or to investors who are willing to accept the risk in exchange for a potential profit opportunity,” he adds.
To do this, carriers can choose from an array of financial tools. The simplest are fixed price swaps, which lock in future prices and tend to be favoured in periods of low volatility. Many of the airlines that got burnt in 2008 had taken out $ 120-plus swaps, turning a blind eye to the huge downside risk.
Call options are typically better suited to periods of high volatility because they give the opportunity, but not the obligation, to buy fuel at an agreed future price. By exposing a company to downside cost savings while capping upside risk, call options offer the greatest flexibility – but that comes with a hefty price-tag.
Corley admits premiums for call options have risen in recent years, with greater volatility raising the level of risk shouldered by counterparties. “But put yourself in an airline’s shoes,” he says. “Would you rather pay a little more for something that allows you to benefit from a $ 30 price decline, or would you rather have not paid that premium and now be locked into $ 125 Brent?”
As a compromise, collars provide limited upside and downside protection by putting ceilings and floors on prices. Although typically favouring collars in periods of moderate volatility, airlines are increasingly combining them with the more conservative call options.
Air New Zealand , for example, has hedged 48% of its estimated fuel expenditure for the first quarter of the 2012/13 fiscal year, making provision for 910,000 barrels. Most of this is achieved through call options on 740,000 barrels at a WTI strike price of $ 116.80. But a further 170,000 barrels are locked into a ceiling price of $ 106.40 and a floor price of $ 82.26. So the carrier’s hedges are positioned defensively against higher prices while retaining some exposure to lower prices.
Although Air New Zealand’s collar will be loss-making if WTI slips below $ 82.26 a barrel, this will be vastly outweighed by savings elsewhere. Not only will its call options expire unused, but the airline’s 52% unhedged position will see it enjoy lower spot prices on most of its fuel burn.
“The key to a successful hedging programme is developing and implementing strategies that perform as intended in both high- and low-price environments as well as in between,” says Corley. “You can start combining all these tools, and there really are some great hedging strategies.”
Critics of hedging argue that counterparties have a financial incentive to sell under-performing hedges, with the airline’s loss becoming the bank’s gain, but Corley says the responsibility lies with management.
“One of the problems is that airlines generally don’t construct their own hedging strategies,” he says. “They rely on the derivative marketers at the bank to make suggestions, and often those suggestions are not necessarily in the airlines’ best interest.
“I would say 90% of the industry’s hedging-related problems are a result of executives not having an in-depth understanding of hedging. The chief financial officer arguably should have the best understanding, but he has to wear 17 other hats. And often the board has an even lower level of understanding, yet it is the board that has to give approval.”
Without in-house expertise, finance directors often fall into the trap of speculation. Recalling the media frenzy about oil reaching $ 200 a barrel in 2008, Corley says many airlines started to treat hedging as “an emotional rather than an analytical decision”.
He contrasts that with the “highly quantitative and mathematical” strategy adopted by the Lufthansa Group, which in its 2011 annual report calculated that a 10% rise in fuel prices this year would increase costs by €372 million ($ 456 million) without protective hedges. The group reduces this risk every month by hedging about 5% of its predicted fuel burn over the next two years. This rolling strategy has been in force since 1990 and persists in all market conditions.
Ultimately, such emotional detachment from price action underpins the most reliable strategies. “You need to have a rigid hedging plan,” says Corley. “Current prices dictate what instruments you should use, not whether you should hedge.”
“Prices dictate what instruments you should use, not whether you should hedge”
A guide to hedging instruments
- Swap: If an airline takes out a $ 120 swap and spot prices rise to $ 135 at the strike date, it will receive a $ 15-a-barrel payment from the bank. But if prices fall to $ 90, it must pay the bank the $ 30 difference.
- Swap with put option: By adding a put option of $ 85 to the previous swap, the airline’s downside risk is capped at $ 35. If spot prices fall to $ 70, its fuel costs are $ 105 net.
- Call option: If an airline takes out a $ 110 call option and prices rise to $ 130, it can exercise the option to receive a $ 20 payment. If prices fall to $ 100, the option is ‘out of the money’ and expires unused.
- Call option spread: By selling a $ 135 call option on top of the previous example, the airline will receive a maximum payment of $ 25 a barrel. If prices rise to $ 140, its fuel costs are $ 115 net.
- Costless collar: Buying a $ 120 call option means an airline will not pay more than $ 120 a barrel for its fuel, whereas while simultaneously selling a $ 90 put option means it will not pay less than $ 90.
- Three-way collar: By selling a $ 135 call option on top of the previous collar, the airline’s maximum gain is capped at $ 15. If prices rise to $ 145, its fuel costs are $ 130 net.
- Four-way collar: Buying a $ 70 put option alongside the $ 90 floor in the three-way collar means the airline’s maximum loss is capped at $ 20. If prices fall to $ 55, its fuel costs are $ 75 net.
Read more about how airlines work to counter the impact of high fuel prices at: flightglobal.com/FuelPain