Fuel hedging: What is it?
Airlines use fuel hedging contracts to stabilise the price they pay for the purchase of jet fuel. A fuel hedge is an agreement to purchase jet fuel at a predetermined price for a specified future time period. Generally, an airline will hedge only a certain portion of fuel requirements for a specific period with multiple contracts overlapping as different hedging agreements expire over time (Wikipedia, 2008 7).
Fuel hedging is a gamble against the future price of jet fuel as despite the seemingly consistent belief that fuel prices go up, they also come down unexpectedly. If an airline predicts that the cost of fuel is going to increase in the future, the airline can sign a fuel hedging contract to purchase fuel at the current price for months or years ahead of time. If fuel prices double in a year then the airline is able purchase fuel at the previous year's "locked in" lower rate as per the fuel hedging agreement resulting in a saving for the airline (Grabianowski, 2009 2). However, if the price of jet fuel falls below what an airline hedged to buy it at, the airline will be contractually forced to pay a higher than market price for jet fuel thereby losing money. Consequently, the cost of fuel hedging is dependent on the predicted future fuel price (Wikipedia, 2008 7).
To Hedge or Not to Hedge
Why do Airlines enter into Fuel Hedging contracts?
- To reduce or save costs based on a bet that future jet fuel prices will be higher than current prices (or the price that an airline has agreed to purchase jet fuel under a fuel hedge contract) (Wikipedia, 2008 7). Fuel makes up a large proportion of an airline's operating costs. A fuel hedge is a form of insurance policy, protecting an airline's cost structure from potentially catastrophic increases or spikes in jet fuel prices due to external factors/events outside airline control.
- To remove the future uncertainty of volatile jet fuel prices so that the airline can build a business plan knowing fixed or "locked" fuel costs over a prescribed period (Wikipedia, 2008 7). In other words, protect an airline's cost structure from fuel price market volatility.
Why do Airlines refuse to enter into Fuel Hedging contracts?
- The airline believes that increases in fuel prices can be passed onto customers without any negative impact on profit margins (Wikipedia, 2008 7).
- The airline is confident that fuel prices will fall and is satisfied paying a higher fuel price to attain benefits of falling fuel prices in the future (Wikipedia, 2008 7).
Volatile Fuel Prices
Airlines place hedges based on the predicted future prices of jet fuel or crude oil which are extremely changeable as shown by Figure 1. Volatility of fuel and oil prices makes fuel hedging an extremely risky business practice.
|Figure 1 (image embedded from IATA on 06 Aug 2009)|
For example, Figure 1 shows that 2008 was an extremely volatile year with the price of crude oil fluctuating from $90 to $145 to $40 per barrel. Figure 1 also shows that jet fuel reached a record high in 2008 before collapsing. US Airways reported that fuel price volatility led to a 2008 fourth quarter loss of $220 million compared to a loss of $42 million in the fourth quarter 2007 (Reed, 2009 5).
Figure 1 portrays that the prices of crude oil and jet fuel are normally correlated. This is because jet fuel is sourced from crude oil. However, other factors (such as refinery capacity issues) can cause divergence in crude oil and jet fuel price trends (Wikipedia, 2008 7).
Exchange rate movements also impact the volatility of jet fuel prices and crude oil prices as indicated by Figure 2.
|Figure 2: Impact of Euro/US dollar exchange rate movement (image embedded from IATA on 06 Aug 2009)|
Exchange rates can compound the volatility of fuel prices particularly if the currency of the home base airline must be converted to buy jet fuel in a different currency (Schelling, 2008 6). Similarly, jet fuel price in US dollars can differ from country to country and from region to region depending on transportation costs and insurance (Schelling, 2008 6).
The Southwest Lesson: A Double-Edged Sword
In the past Southwest Airlines has been less conservative than other US domestic carriers by hedging a greater percentage of fuel requirements than the Airline's direct competitors. Southwest's aggressive fuel hedging has helped the airline remain profitable despite airline industry downturns resulting from high fuel costs (Wikipedia, 2008 7).
Southwest saved approximately $3.5 billion by engaging in fuel hedging agreements between 1998 and 2008 (Reed, 2008 4). In other words, Southwest would have paid $3.5 billion more if it had not entered into fuel hedging contracts and had instead paid the industry average price for jet fuel between 1998 and 2008. These fuel hedging contracts served as a cost control mechanism for Southwest, protecting the airline from rises in crude oil prices and dramatically reducing fuel expenses. Furthermore, when fuel prices are high hedged airlines tend to have more cash flow as a result of fuel hedging that provides these airlines with the flexibility to make investments and enhance profitability (Reed, 2008 4).
Southwest's aggressive fuel hedging started in the 1990s when the airline locked in prices for 20 to 30 percent of total fuel requirements three to six months in advance (Reed, 2008 4). At the time, low jet fuel prices made hedging seem unimportant to many airlines (Reed, 2008 4). However this view began to change in 1998 following the Asian market meltdown. Southwest hedged fuel at $12.50 per barrel in 1999 and not long after fuel prices rose to $26.10 and then to $34.00 per barrel (Reed, 2008 4). As a result, between 1999 and 2003 Southwest paid between 25% and 40% less for jet fuel than the Airline's competitors who had smaller or nil fuel hedging contracts in place (Reed, 2008 4).
Backed by cost-saving fuel hedging contracts, Southwest Airlines remained profitable throughout the aviation industry downturn 2001-2005 when the airline industry as a whole lost more than $35 billion (Reed, 2008 4).
On the other hand, aggressive fuel hedging can leave an airline open to the negative impact of a sharp decline in fuel and oil prices. Southwest hedged more than 70 percent of the Airline's 2008 fuel requirements at $51.00 per barrel (Hannon, 2009 3). This fuel hedge looked positive in the first quarter of 2008 when crude oil was priced above $125.00 per barrel but prices plummeted in the second half of 2008. The long-successfully hedged and profitable Southwest Airlines reported a 2008 fourth quarter net loss after incurring fuel hedging losses of $117 million (Dunn, 2009 1). The loss was the result of a rapid fall in fuel and oil prices to a level below what the airline had hedged to buy it at.
The Southwest Lesson suggests that even airlines with a history of profitable fuel hedging practices can be vulnerable to the volatility of fuel and oil prices.
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