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Fuel Hedging 101

Happy New Year! It’s been a while since my last post, as January was a busy month for me. I started this post in December, but wasn’t able to finish it until now. Given the rapid developments in oil prices, I’ve tried to update all the references to reflect current market conditions. Please let me know if you find any remaining inconsistencies!

Last semester, I took a statistics course called STAT435: Forecasting Methods for Management, which essentially covered the fundamentals of time series analysis. This was a good, challenging course that allowed me to apply statistical methods to many of the other quantitative and qualitative concepts from my finance/management education, such as looking at the effect of advertising on sales and analyzing corporate and DJIA returns. The class also allowed me to apply statistics to my passion for aviation. I’ve always held that two of the biggest forces affecting airline profitability are a) passenger capacity and b) fuel costs. To address the first point, I analyzed different forecasts of international airline passenger data, looking specifically for the calendar cycle within airline passenger volumes (i.e. identifying the trend for higher and lower-than-average passenger volumes in a given year). This is intrinsically linked to passenger demand for travel, which is in turn spurred by consumer demand (for holidaymakers) and the state of the global economy (for business travelers). The next logical area of study would look at how airlines forecast passenger volumes and use this data in their operations throughout the year – such as adding or removing certain destinations, and purchasing newer, higher-capacity and more fuel-efficient planes.

The second factor (fuel costs) piqued my interest a bit more, in part due to its relevance to recent events in the global markets. I analyzed the monthly average retail price of unleaded regular gasoline, averaged across U.S. cities, for the period January 1976 through February 2008. My overall conclusion was that unleaded regular gasoline prices lack strong seasonality when compared to other energy products such as natural gas, which is “strong cyclic in nature over a year due to seasonal variation in supply and demand.” A product such as natural gas, which is a main source of heating for homes, has a consumer demand that varies by season and thus “has a general upward price movement in the winter and downward movement in the summer.” Furthermore, the seasonality effects in natural gas prices “can be seen not only through historical spot prices, but also through futures and forward prices.” The product I looked at, unleaded regular gasoline, has a use that is not as greatly affected by seasonality than natural gas. Consumers will tend to drive more or less consistently throughout the year – although they might substitute driving in place of walking short distances in the winter – whereas they will significantly upsize their natural gas and heating demand in certain seasons. Combined with the knowledge that past gasoline prices influence future prices, I concluded that gasoline prices follow a stochastic or random process in the long run, as seen by classic “stochastic drift” in the upwards-trending average value of gasoline prices over the 32-year data range.

Too much statistical analysis for you? Don’t worry, I felt the same way last semester. The point I’m trying to get to is: my analysis of unleaded regular gasoline prices came at a very appropriate time – the day after I submitted (right before Thanksgiving 2014), OPEC announced that it would not cut its oil output, sending crude oil prices downwards (WTI trading near a 5-year low of $55.26 when I started writing this post in December) and generating a knock-on effect in the Russian Ruble currency. Ali al-Naimi, the Saudi oil minister and de-facto head of OPEC, has reaffirmed the cartel’s firm stance against cutting production, which “[spells] out a dramatic policy shift that will have far-reaching implications for the global energy industry.”

I am keenly following the oil markets and the repercussions for the global economy, and it certainly seems to have aligned perfectly with my classwork. The biggest question on my mind, however, is what impact the dramatic oil shifts will have on the airline industry. If I were to continue with my statistical analysis, the next step would be analyze the time series for aviation fuel (designated Jet A, Jet A-1, and Jet B), and pay attention to any stochastic trend in this data. It would be great to apply forecasting methods to aviation fuel prices, to gain a better understanding of how airlines hedge against these volatile indices in order to stay alive. It’s certainly a larger undertaking, one that I might consider doing in the future. For now, I want to look at the practice of so-called “fuel hedging” that many airlines use in their strategic and financial planning.

What is Fuel Hedging?

At its heart, fuel hedging is relatively simple and works pretty much like any standard financial option instrument. Airlines enter into contracts with their fuel suppliers to lock in a set price today for fuel bought in the future. For instance, if an airline enters into a hedging contract at a price of $X per gallon of aviation fuel, it will pay that price in the future regardless of what happens to the market price of the fuel. What this means is that if the market price rises above $X/gallon, let’s say to $Y/gallon, the airline will purchase its fuel at $X/gallon and save the difference between $Y/gallon and $X/gallon. And if the market price declines below $X/gallon, let’s say to $W/gallon, the airline will still purchase its fuel at $X/gallon and will be overpaying for its fuel by the difference between $X/gallon and $W/gallon. Furthermore, an airline may enter into a fuel hedge contract linked to the price of jet fuel or the price of crude oil (per barrel). Since jet fuel is a derivative of crude oil, the prices of the two commodities are fundamentally correlated, but can also diverge due to idiosyncratic factors in the refining and production process. Based on this knowledge, we can already see the implication that recent oil trends have had on airline profitability.

The truth of the matter is that airlines engage in more complex hedging strategies to protect themselves against market volatility. Like a standard options contract, a fuel hedge will cover an airline’s fuel needs for a defined period, and the physical hedging contracts may specify various maturity dates that overlap. Thus, at any given time, the percentage of fuel needs that are covered by hedging contracts varies, with the airline attempting to maintain a target percentage over time. One statistic claims that from 2009 to 2010, the average hedging ratio in the airline industry was approximately 64%.

Regarding the decision to hedge versus not hedge, a 2008 report by Mercatus Energy states:

“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 to fuel if, in fact, our analysis proves to be incorrect.”

So there’s fuel hedging in a nutshell. The real question on everyone’s minds is: what’s the real impact of lowered oil prices on the airline industry? It certainly appears that there are two contrary forces affecting airlines in the current market. The positive (direct) impact: diminished oil prices lead to lower fuel costs, boosting quarterly profits. The negative (indirect) impact: airlines that hedged their fuel costs in the $100/barrel area get hit by volatility and post quarterly losses. To put it simply: much like traders of any other financial instrument, the airlines with the greatest return this year will be the ones that accurately predicted lower oil prices and imputed these expectations into their hedging strategies. Southwest Airlines (NYSE: LUV) – a pioneer in fuel hedging – is up 16.34% in the three months to February 6, 2015. Compare that to a 1.19% increase in the S&P500 (^GSPC) and an 8.34% increase in the NYSE Arca Airline Index (^XAL) over the same period. And Delta Airlines (NYSE: DAL) is up 6.08% even after announcing losses of $1.2 billion on its fuel hedges – because the portion of its fuel that remains unhedged will now be purchased at the significantly lower market price, giving the company a net $0.5 billion benefit from the fall in oil prices. Some more information from Reuters and The Economist on the fuel hedging strategies of various international airlines:

“In Europe, airlines such as Aer Lingus and Ryanair are aiming to take advantage of the low oil prices to lock in fuel costs into 2016 and beyond. Thai Airways plans to hedge 100 percent of its fuel purchases this year… U.S. airlines that hedged based on higher oil prices, such as United Airlines, have had to dump losing bets and are now reviewing their strategies for protecting themselves from oil market volatility… At least one Asian carrier, South Korea’s Asiana Airlines, has stopped hedging since November due to recent price volatility, while Germany’s Air Berlin has said it is considering reducing its hedging rate.”

The articles explain that American Airlines (NYSE: AAL) has “[benefited] disproportionately from the fall in prices,” having not signed a hedging contract since 2013. The same goes for Air India (AIN.UL) and whose finance director “projected it could shave as much as $375 million off its annual fuel costs of about $1.5 billion based on savings made since prices started to fall in June 2014.” Those airlines might certainly consider entering into various fuel hedging strategies this year, while prices remain low. At the same time, these airlines will hedge cautiously, knowing that the oil markets remain uncertain and thus taking a risk-averse outlook to their fuel needs.

The moral of the story is: hedge intelligently, or look for companies that do. An airline that hedges too much or too little of its fuel needs can be exposed to either the severe upsides or downsides that the oil market is increasingly prone to. The trick is to hedge just the right amount of fuel, and the airlines that do this will come out on top. One can look towards the practice of fuel hedging as an indicator of market sentiment, as well as a measure of price volatility. An airline’s hedging strategy is also indicative of its operational flexibility – its ability to foresee and react to the market environment – and this is one of the many factors that airline investors will look for in 2015.