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Jet Fuel: To hedge or not to hedge, that is the question

16 January 2016

Crude oil prices are hovering just below USD30 per barrel as of 15 January. The black gold has seen a dramatic decline of over 70% since mid-2014 as supply has outstripped demand. At these levels, is it a good idea for airlines to lock in future purchases or could we see a further downside to oil?

Jet fuel typically makes up a third of operating costs of most airlines. In the United States, every extra cent adds up to USD200 million to the fuel bill of U.S. carriers alone. This is derived from the annual jet fuel consumption rate of American airlines (over 20 billion gallons per annum) for both passenger and cargo carriers.

Here in Asia, consumers have not quite seen the ripple effects of weakening oil prices on airfares. Indeed, ticket prices at many full service carriers remain firm and the airlines understandably show little desire to slash fares when demand continues to be strong.

Moreover, some airlines have hedged fuel futures at considerably higher prices than what the market is showing now. Theoretically that could result in sizeable losses at the end of the financial year. Take Cathay Pacific Airways for example. In 2008 Cathay lost almost USD1 billion in wrong-way bets on fuel hedges.

Singapore Airlines, meanwhile, has hedged about 65% of its fuel needs for the period October 2015 to March 2016 at an average price of USD116 per barrel of jet fuel. Budget carrier AirAsia said in August last year (AirAsia fuel) that it had hedged 60% of its jet fuel needs at around USD80 per barrel. As of 8 January 2016 the price of a barrel of jet fuel was slightly above USD44.

What is hedging and what does it do?

Airlines hedge to manage risks. Volatility in crude prices presents a huge financial risk that can impact an airline’s bottomline by up to 40%. In layman’s term, hedging basically is the act of locking in future oil purchases at a certain price, thus protecting the airline from sudden losses. When an airline hedges, this mitigates their exposure from the vagaries of the oil market.

Fuel price hedging can be executed in various ways:

  • Forward contracts;
  • Futures contracts; and
  • Option, swaps

Over-the-counter (OTC) financial instruments include collars, options and swaps. This is a popular technique among many carriers as it provides customisation. One of the world’s most profitable airline, Southwest, is a prolific user of hedging tools. The budget airline has publicly stated its preference for OTC derivatives over say, exchange-traded futures, due to this ability to customise.

In OTC deals, airlines and investment banks do a direct transaction. Thus, they have to take into account a counter-party risk. What Southwest did successfully, was to trade with four or five different banks, which allows the airline to diversify the risk. It also allows Southwest to get the best pricing.

There are many different types of strategies being employed when an airline hedges. It usually involves a complex financial instrument that helps shields from wild swings in currencies and interest rates. Typically for many airlines a basic hedge calls for the carrier to enter into a futures contract to buy oil between three to six months in advance at a fixed price. This gives the airline the advantage of locking in future costs.

There is no guarantee that an airline will save money from hedging, as the example with Cathay Pacific has shown. That said, an airline that hedges will have a better chance (up to 10%) of achieving a better financial performance than those that do not. It’s like buying insurance against oil prices moving drastically up or down as short notice.

It’s a foregone conclusion that many airlines in Asia and indeed, other parts of the world, are going to benefit from this rapid decline in oil prices. But as with many things in life, it’s not always a straightforward win-win game. Forex rate risks and how hedging contracts are structured can make the situation a bit more complicated.

The International Air Transport Association (IATA) recently adjusted its forecasts for airlines worldwide in 2015 to collectively earn a net profit of USD33 billion (4.6% net profit margin) from an earlier USD29.3 billion forecast in June 2015, citing lower oil prices as the main factor. This year IATA sees an average net profit margin of 5.1% with total net profits of USD36.3 billion.

The alternative is not to hedge…

With oil prices currently in a downward spiral, some airlines have chosen to hedge less or not at all (buy at spot prices). Delta Airlines is hedged just 5% in 2016, and expects to save USD3 billion on fuel. The lower oil prices dip, the more money Delta saves. Similarly, United Continental has also been canny with its fuel hedging policy in 2016 and has hedged just 17%. Should oil prices continue to slide, United is looking at savings of around USD2 billion.

In Asia, Chinese carriers appear to be the main beneficiaries in 2016. Flag carrier Air China, China Eastern Airlines and China Southern Airlines all have not hedged on fuel purchases. Air China 1H16 net income is to soar by as much as 743%! Among budget airlines, Cebu Pacific in the Philippines said it has hedged 24% in 2016 and 18% in 2017 at around USD75 per barrel. It conceded though, that the carrier could see “some mark-to-market hedging losses” if oil continues to fall.

At the end of the day – whether it stays up or down – oil prices will pose considerable challenges to airlines. Either an airline is exposed to the vagaries of the marketplace by not hedging or it has hedged at much higher prices using less than ideal financial instruments. There will be carriers who will continue to be conservative and there will be those (especially with a solid cashflow) who will throw caution to the wind and not hedge. What is certain is that oil prices won’t stay low forever.

 

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