Hedging Fuel Costs Strategies Of Airline Companies

Published Date: 02 Nov 2017

The cost of jet fuel is an important issue for airline companies because it affects the profitability of the firms. This paper explores the hedging fuel costs strategies, implication of accounting rules for driving hedging strategies in United States. Besides, authors also conducted an industry survey to examine current hedging strategies and its benefits in United States business aviation.

Cobbs and Wolf (2004) pointed out that there are three type of contracts utilized for fuel hedging purposes: over-the-counter instruments, exchange-traded-futures, and not hedging. Over-the-counter contracts entered by airlines are swaps, options and combinations of options such as collars structures. Despite of illiquid market and insufficient quantities available to hedge jet fuel consumption, many airlines still prefer over-the-counter instruments because of its customisation feature. Southwest successfully used this hedging strategy to implement its dynamic hedging program. It allow the airlines to lock in prices at a lower point in the oil price cycle assuming that oil price cycle is a mean-reverting process.

For examples, fixed swaps are used at the low point of oil price cycle because of the likelihood of price appreciation than price declines. Then, the airline can use swap contract to lock in at a lower price. Giving up potential savings from price decrease whilst hedging against further increases, airlines use collar to lock in a specified range of prices in the mid-range of the price cycle. Peak prices are more likely to require caps in the form of straight calls to allow company benefit from price depreciation and prevent losses from further appreciation. A substantial amount of monitoring is required for this strategy.

United States do not have exchange-traded derivatives on jet fuel, therefore a similar hedge are set up such as between the price of heating oil and crude oil which highly correlated with jet fuel. These commodity future contracts result basis risk because of imperfectly correlation (contracts are based on an underlying asset other than jet fuel).

Some airline companies employ another strategy- not hedging. There are two conditions should be met for this strategy to work: Firstly, other competitors also do not hedge jet fuel cost. In fact, this condition hardly is met, because hedging airlines have a competitive position (stable cash flow and better cash flow planning) over non-hedging airlines though aviation is not an actively hedging industry. Secondly, increase air fare and pass the change in fuel prices to passengers. It is more difficult for airlines to transfer additional fuel cost in highly competition nature of industry because being competitive on price was the key to any airline’s survival and success. As such, aviation businesses in United States use various hedging strategies ranging from not hedging to fully hedging using a combination of instruments.

Parties involved in hedging need some accounting standards knowledge since it has great implication in adopting hedging instruments and enable the firms to receive preferable accounting treatment.

Industry survey reveals that fuel costs is the second-largest expense for airlines which account for 16% of the carrier's operating costs. To reduce the volatility of operating expenses and maintain bottom line profitability, airlines choose to hedge fuel prices. Study showed that Southwest and JetBlue are the industry leaders. Cobbs and Wolf (2004) indicated that there is a positive relationship between fuel hedging and the value of the firm by illustrating price/revenue ratio and hedging ratio of airlines. This study also suggests that airlines that are hedged have a competitive advantage over the non-hedging airlines.

This paper concluded that a sophisticated hedging program can create a comparative advantage, overweight the costs and enhance firm value.

c)

Industry survey was conducted based on 13 United Stated domestic airlines. Survey shows that hedging jet fuel costs brings benefits to airlines. This result is supported by theory that hedging increases firm value.

Cobbs and Wolf (2004) indicate that fuel costs is the second-largest expenses for airlines which account for about 16% of the carrier's operating expenses after personnel expenses in year 2003. At least 80% of fuel costs were bear by each of the airlines in this industry survey.

Aviation businesses’ average airfare pricing (available seat mile) decrease by 0.1%; airlines faced a compounded annual rise of 25.9% in fuel costs from 2001 to 2003. Few airlines have tried to transfer the rises in fuel costs to passengers by charging surcharges or increase in airfares during the period February to May 2004. However, it was an unsuccessful attempt because rival companies choose to not pass additional costs to their customers.

This paper repeats the Carter et al. (2002) results: fuel hedging airlines trade at a premium. Cobbs and Wolf (2004) also suggest a positive correlation coefficient between fuel hedging and the firms value by illustrating price/revenue ratio and hedging ratio of airlines. EPS

Southwest, JetBlue and Delta were the largest fuel hedgers in United Stated domestic airlines in 2003. Their actual fuel cost were in-line or below the average of jet fuel spot prices. On the other hands, non-hedging airlines’ fuel cost were at or above the average spot fuel price. According to Southwest’s CEO statement, Southwest would face $8million loss due to rising in fuel prices if they not hedged their position.

Southwest uses a combination of call options, collars, and fixed price swap agreements to hedge its jet fuel exposure. Whereas, JetBlue hedge its fuel consumption through swap agreement and crude oil option contracts and outsources its fuel management services. Dynamic hedging strategies enable Southwest and JetBlue- the industry hedging leader to save on fuel expenses and create competitive advantages compared to other carriers.

Besides, many airlines (American, Continental Northwest and United) have to deal with liquidity issues which limit their ability to fully hedge their jet fuel consumption and protect themselves from oil price fluctuations.

d)

Jet fuel prices have been substantially volatile throughout the last decade. It drive airlines to hedge their fuel consumption to protect themselves from fuel price rising. For instance, the impact of fuel price changes drove United Airlines entered into options contracts to protect against increases in jet fuel prices (Carter et al., 2002).

Jet fuel hedging is valuable for airline companies according to previous literature studies: US airlines which engage in fuel hedging activities increase in firms values (Carter et al.,2002; Cobbs and Wolf, 2004; Lin and Chang, 2008); Kvello and Stenvik (2009) study on European airlines hedging also has consistent results with US airlines.

Fuel cost is one of the largest costs for airlines. It is more volatile than other courier expenses (Cobbs and Wolf, 2004). Thus, hedging activities is a tool to stabilize overall costs and reduce the volatility of profitability. For examples, in 2003, Korean Airlines entered into forward fuel contract which reduce their average fuel price paid by 34% and reported a gain of Won 282 million. Through dynamic hedging activities, Qantas offset 73% of their 2003/04 increased fuel price paid (Morrell and Swan, 2006).

Carriers may face threat of bankruptcy if fuel prices keep increasing. For examples, Legend Airlines and National Airlines seek for insolvency protection because of rising fuel cost in 2000 (Cobbs and Wolf, 2004). Hedging aids in reducing the cash flows or accounting profits volatility, minimize risks, diminishing the probability of bankruptcy (Kvello and Stenvik, 2009). In 2003-2005, rise in fuel prices drove several airlines into bankruptcy. However, Southwest was able to weather the changes in fuel prices by using extensive fuel hedging program ( Ingrassia and Fleischer, 2006). Trempski’s (2009) study note that Southwest and JetBlue Airlines- the industry leaders in fuel hedging strategy never has filed for bankruptcy, thus investors perceived them as more stable firm. Hence, fuel hedging would increase investors’ confidence and valuation of firms.

During economic downturn period or fuel prices are very high, financially troubled airlines would sale its assets (e.g. aircrafts) below market prices (Carter et al.,2002). In this context, hedging airlines are allowed to take advantages buy these assets or acquire that carrier at prices below fair value (Pulvino, 1998; Cobbs and Wolf, 2004; Kvello and Stenvik, 2009). Kim and Singal (1993) implies that typically higher fare environments are created upon completion of the acquisition.

By fuel hedging, airlines reduce cash flow volatility, improve its cash position thus enhance its flexibility in investment policies during economic downturns. Froot et al., (1993) analyze that hedged-airlines have sufficient internal funds and rely less on external sources of funds to complete this profitable capital expenditures. For example, American Airlines acquired Trans World Airlines by utilizing its available cash and assumption of Trans World Airlines debt in 2001 (as cited it Carter et al., 2002). Involving in positive net present value investment would strengthen hedged-airlines competitive position.

Rob Fyfe, Air New Zealand chief executive commented that fuel hedging not only trying to remove volatility and also provide airlines ability to compete against its rivals. Fuel hedging makes sure airlines have some parity in fuel costs with competitors and prevent competitors from undercut on prices (in case rivals obtained a lower fuel cost). Fyfe statement is illustrated with a real case scenario. Qantas Airways’ fuel strategy successfully enhanced its competitive advantage and obtained cheaper fuel cost, resulting in captured some market share from rivals (Ballantyne, 2009).