FUEL HEDGING What is fuel hedging
Many factors shake fuel prices. Nevertheless, economic circumstances, storage inventories and weather, as well as the market’s awareness of these issues, are the primary aspects that drive fuel prices. Most airline companies can moderate their exposure to potentially rising fuel costs, as well as natural gas and electricity costs, through hedging. Hedging allows market members to lock in prices and margins in advance, while reducing the potential impact of high fuel prices. Thus, fuel Hedging is a contractual means that some large fuel consuming companies, such as airlines, cruise lines and trucking companies, use to reduce their exposure to potentially rising fuel costs. In turn, this allows a fuel-consuming company to establish a fixed or capped cost, via a commodity swap or option. (Corley,2008)
Why do most airlines use fuel hedging
Fuel Hedging Mitigates Risk
Hedging reduces exposure to price risk by shifting that risk to companies that have differing risk profiles or to investors who are willing to accept the risk in exchange for profit opportunity. Fuel hedging involves establishing a position in a financial instrument that is equal and opposite of the company’s exposure in the physical fuel market.
Airlines use hedging because the cash prices and financial prices of fuel tend to have a strong correlation to their respective counterparts. Even though the difference between the cash and financial prices may rise or decline, the risk of a contrary change happening in this relationship is generally much less than the risk presented by not hedging. Again, the purpose of fuel hedging is to mitigate the company’s exposure to volatile and potentially rising fuel prices, thus stabilizing its fuel expenses. (Corley, 2008)
Fuel Hedging Strategies
Domestic airlines have a variety of hedging strategies available to them. These include using both over-the-counter and exchange-traded derivatives and remaining unhedged. 2
used by airlines. Many, including Southwest, have stated that they prefer over-the-counter derivatives to exchange traded futures because they are more customizable. OTC derivatives are
traded directly between the airlines and investment banks, and as such have counterparty risk that must be considered. Therefore, most airlines prefer to trade with three or four different banks to diversify this risk and also to get the best pricing possible. (Wolf, Cobbs,2004) Mr.
Corley points out that, “ A company that is not hedging its fuel costs is saying one of two things: 1. Our Company has the ability to pass on any and all increases in fuel prices to our customers, without a negative impact on our profit margins. 2. Our company is confident that fuel prices are going to fall. We are comfortable paying a higher price for fuel if, in fact, our analysis proves to be incorrect.” (Corley, 2008
Nevertheless, the truth to the matter is that you need to analyze your historical and future anticipated fuel-consumption volumes if you do decide to develop a fuel hedging strategy. Is your business growing? Will you soon be buying new equipment or airplanes? These types of questions need serious attention.
There are many ways to reduce your collective operation’s exposure to high fuel prices,
including futures, swaps and options. By creating and applying a fuel-hedging program, you will not only be able to alleviate your risk, you also will be able to correctly forecast your future fuel costs and (possibly) provide your corporation with a competitive advantage.
Foreign Versus Domestic Carriers on Fuel Hedging
In the airline industry, survival through the unpredictability in the market is dependent on where
makes up at least 30% of most airlines' overall operating costs and an effective hedging strategy is crucial as heightened competition forces carriers to cut fares and operate on thin margins”
(Reuters 2014). Fuel hedging is a major business strategy in keeping airlines afloat in the industry. As oil is a commodity that is needed worldwide and especially in the airline industry, airlines are competitive when it comes to finding the best price. Finding the best price on fuel
can ultimately be the determining factor in whether they stay in business or not. As oil has a higher production rate in other countries, it may seem as if the airline of the same or nearby an
oil producing company has an advantage to oil prices and hedging. In the articles to be presented we will see if that is true.
Do foreign carriers have an advantage in fuel hedging versus domestic carriers?
Well, James Hogan of Abu Dhabi’s Etihad Airways points this out, an article interviewing him said, “Hogan is keen to point out that Etihad does not receive any benefits from being based in an oil-producing country. We don't get any free kicks, no free oil. We have to work the open
market like everyone else," (Ezard 2008). In this section, we will look closer into why this is the case and if foreign airliners use any other fuel hedging strategies to survive in the static market.
When it comes to fuel hedging, most airlines, globally are on a fairly level playing field for some obvious reasons. The first being the airline industry is not related to the fuel industry in terms of
production. The relationship directly varies as producer to consumer. So it would essentially not benefit the oil companies to give any airline a discount beyond what is agreed under fuel hedging
director for airports and airlines at Barclays. The collar works by allowing the airline to purchase put and call options based on a set range of oil prices. “The airline trades off some of the upside
"cap" by agreeing to a "floor" rate, below which the airline will not benefit” (Ezard 2008). Collars are a popular method because they eliminate the need to pay a premium cost. Most of the successful airlines across the globe seek their advantage through hedging methods by
meticulously calculating their costs up to 4 years in advance. These costs are recalculated with the trend of oil prices in order to ensure the best price per barrel of oil. Naturally, as the
calculations for price vary over time, the calculations become less accurate so percentages of how much fuel an airline will hedge become less and less. Because of this, some airliners choose not to hedge for as long, but that is a risk they take. There are always major winners and losers in
the bets against fuel hedging. “The main difference between Lufthansa and Air France-KLM's fuel hedging strategies, says Spinetta, is that "Lufthansa is hedging for the current year and
partially for the next year, whereas ours is four years rolling... This means that if the oil price remains high next year, "the hedging position [Air France-KLM] built two to three years ago will be a very strong asset to us". Air France-KLM expects its hedges to save it up to €2 billion ($3.1
billion) this fiscal year. "Last year, for 2007/08, the total impact of our hedging was €1.1 billion.” (Ezard 2008) In the case of losers, but only currently, Ryanair hedged too high and
locked in a rate at almost $17 over the current barrel prices at the time. When airlines use
millions of barrels, these costs quickly add up. “Ryanair also has been using an ad-hoc approach to hedging. That means that for the third quarter it is stuck with 80% of its anticipated fuel bill
hedged at $124 per barrel, far above market rates. On the other hand, Ryanair gambled by leaving the fourth quarter unhedged, a bet that is now paying off. But there are hurdles. Ryanair
approximately $17-per-barrel difference is too great, he says” (Flottau & Wall 2008). In this quote from Flottau and Wall’s article it shows that the extended period of time by which Ryanair
locked in its rate, they received a temporary loss, for about a year, but now that prices of oil are starting to rise again they are now on the winning end.
In the case of domestic airlines Southwest has been the frontrunner in fuel hedging successes. The risk in domestic airliner hedging is very high, but insurances are still provided such as
declaring bankruptcy. The ability to hedge is limited by how much collateral a company has. “In addition to problems of raising money to buy hedge investments or finding assets that can serve as collateral for hedge investments, there is the issue of counterparty risk for those airlines who
choose and who are able to afford hedging. Every hedge investment is defined by a contract or a collection of contracts” (Simmons 2015). Every hedge investment contract for a domestic airline
could literally be the deciding fat on whether they stay in business or not. Risk mitigation is the key and airlines spend a great deal of money to hire financial experts to calculate these high risk costs. It is worth it to save the costs and sustainability of multi-billion dollar companies in an
Works Cited
Cobbs, R., & Wolf, A. (2004, Spring). Jet Fuel Hedging Strategies: Options Available for
Airlines and a Survey of Industry Practices. Retrieved April/May, 2016, from http://www.citationmachine.net/apa/cite-a-website/manual
Corley, M. (2008, November). Know When to Hold'Em. Retrieved April/May, 2016,
from https://www.mercatusenergy.com/hs-fs/hub/80554/file-15739403-pdf/docs/ rockproducts.pdf
Simmons, G. (2015). DOES HEDGING REDUCE RISK? ANALYSIS OF LARGE DOMESTIC AIRLINES. Journal Of Business Strategies, 32(1), 1-20
Flottau, J., & Wall, R. (2008). Bad Bet. Aviation Week & Space Technology, 169(20),
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