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Gambling with a clear game plan

July 2012

Fuel hedging is a common, yet not always successful, way for airlines to mitigate volatile oil prices. But if well constructed, it need not be an unduly risky strategy

by Martin Rivers
[email protected]

In its 2006/07 annual report, Dubai-based Emirates Airline proudly announced that its “fuel risk management programme” – more accurately described as an oil hedging strategy – had delivered savings of $197 million against spot prices for jet fuel. Gary Chapman, president of group services at the carrier, said the programme had saved Emirates $1 billion over eight years.

One year later, on the precipice of the worst financial crisis in living memory, the airline vowed that it would continue to “achieve a level of control over jet fuel costs so that profitability is not adversely affected” by volatile market prices.

It failed to do so. By the time Emirates’ 2008/09 report was being audited by PricewaterhouseCoopers, the company had written down annual fuel hedging losses of Dhs1.57 billion ($428 million). It may have succeeded in positioning itself defensively against higher oil prices, but it did not mitigate the downside risk of a price crash, which inevitably accompanied the global recession. The mistake was repeated in airline boardrooms around the world.

In Dublin, shortly after admitting he had “screwed up” by not hedging when oil was cheap, Ryanair chief executive Michael O'Leary belatedly started locking in $120-plus per barrel prices just as oil began its rapid descent back down to $40. In China, the risk-averse government was so furious about the hedging losses incurred by its airlines that it banned them from buying crude oil futures.

The perceived benefit of hedging in 2007, as in today’s expensive market, was stability. While higher prices are not in themselves an obstacle to profit – provided they can be passed on to passengers through fare increases – rapid spikes and swings in any cost-base inject uncertainty into business models.

Because airlines sell their tickets several months ahead of the date of travel, and because fuel accounts for more than one third of their expenses, there is a pressing need to insulate themselves from unknown future price movements. This is exacerbated by the added risk of buying fuel from refineries, whose jet fuel price may not move in tandem with the underlying price of crude oil.

But mitigating fuel volatility is about more than locking in contracts for fear of even higher prices around the corner. As Mike Corley, president of hedging consultancy Mercatus Energy Advisors, explains, effective strategies should deliver predictable returns in all hypothetical market conditions.

“It’s really about quantifying your fuel costs, and then taking action to limit your exposure to the volatility,” he tells The Gulf. “There’s a perception that fuel hedging is gambling. I would argue that when done properly, it couldn’t be any more opposite.”

When a speculator bets on the future price of oil, or any other commodity or financial derivative, he is gambling on his conviction about which direction price will take. In 2007, Corley posits, such speculation had become rampant. “There was a fear that oil prices were going to go to $200 or $300 a barrel,” he recalls. “The fear of being exposed to $200 a barrel was so great that a lot of people convinced themselves prices could not decline.

“Prices were rising so fast that many airlines started hedging without even really thinking about it. It became an emotional rather than an analytical decision.”

By contrast, Corley says well-constructed hedging strategies are designed to accommodate all eventualities. Rather than trying to profit from being one step ahead of the market, they aim to deliver consistent margins at all times – irrespective of whether costs rise, fall or stay the same.

With Brent crude plummeting from $128 in March 2012 to $89 in mid-June, it is no surprise that airlines are once again scrutinising their hedging positions. “The price decline has definitely caused our phone to ring,” Corley says. Tellingly, he adds that the number of hedged airlines seeking protection from steeper falls is roughly equal to the number of unhedged carriers seeking to benefit from a rebound in prices.

After explaining the folly of speculating, Corley’s next challenge is tailoring strategies to a complex array of determining factors and financial instruments. “We’ve had executives from various airlines call and ask how much they should be hedging,” Corley continues. “Until they give us tonnes of data about their business, we can’t answer that question. There’s no magic number.”

The first question a finance director should ask himself when formulating a hedging strategy is, ‘What are my motives’? Secondly, ‘Which specific risks am I looking to mitigate’? And thirdly, ‘Which tools are best suited to achieving this in my marketplace’?

Hedging, by definition, involves opening a position in a financial derivative that is equal and opposite to your exposure in the physical market. Such a counter-intuitive move requires logical justification. Paranoia or optimism are not valid reasons for negating real-world exposure, as they stake your profitability on a mere hunch.

However, there are many valid justifications. For airlines that have sold a significant proportion of forward bookings, there is a clear need to lock in profit margins on ticket sales. Failure to do so means that a spike in the price of oil will see them operating loss-making flights even when their planes are full.

“If people can only book tickets six months out, you shouldn’t be hedging 18 months out,” Corley acknowledges. “But looking at tickets sold, if you’ve sold 90 per cent of your seats for the next three months, I would argue that you probably ought to have hedged, give or take, 90 per cent of your fuel for those three months, because you’ve already brought in the revenue.”

Another reason is maintaining competitiveness with key rivals. In the Gulf market, Abu Dhabi-based Etihad is well known for hedging aggressively. While Emirates may be unwilling to mirror its strategy, it may want to consider smaller positions that shrink the upside gap between the two rivals. This will reduce Etihad’s ability to price Emirates out of the market should the former’s hedges be ‘in the money’.

Finally, leaving aside the profitability and competitiveness of ticket prices, well-hedged fuel costs lend stability to an airline’s cashflow, and in doing so help keep it afloat.

Turning to the identification of specific risk factors, Corley emphasises that these will vary from company to company. “There’s definitely not a one-size-fits-all approach,” he says. In addition to considering forward sales profiles – whether an airline accepts bookings three, six or 12 months in advance – airlines must factor in the ability of their ticket pricing model to absorb hedging gains or losses. Carriers that impose fuel surcharges will have the greatest flexibility in this regard.

There is also the question of where the fuel is sourced from. Hedging contracts can be signed against various derivative instruments, including futures for Brent crude, West Texas Intermediate or Singapore Jet Fuel. Airlines must decide which regional benchmark reflects their usage through “a correlation analysis of the specific carrier’s destinations”.

After an airline has identified its motivation and requirements, the final stage is execution. There are five key financial instruments – swaps, swaps with put options, call options, costless collars and three-way collars – which can be combined to reflect differing risk appetites.

Speaking to Dow Jones in May, Emirates president Tim Clark left little doubt about his disdain for hedging. “You can’t win [at hedging],” he asserted. “It’s a casino.”

The airline executive has previously spoken of his scepticism about the motives of counterparties, typically banks, in such contracts. To this end Corley has some sympathy, noting: “Airlines generally don’t construct their own hedging strategies. They rely on the derivative marketers at the bank to make suggestions to them, and all too often those suggestions aren’t necessarily in the airlines’ best interests.”

At the same time, though, Clark made it clear that his company still engages in basic hedging. While the fixed-price swaps that hurt airlines so badly in 2008 are unlikely to feature in his portfolio, he admitted that Emirates today holds “insurance” positions – most likely call options that place a ceiling on prices – in case oil exceeds $120 or $130.

Such options are effectively a conservative “win-win” instrument, Corley says, as they allow carriers to benefit from lower prices while capping upside risk. However, the flexibility they afford attracts a hefty premium.

Perhaps mindful of their price tag, Emirates chairman Shaikh Ahmed bin Saeed al Maktoum has hinted that the airline’s risk appetite is returning. Speaking to Reuters in March, before the carrier posted a 72 per cent slump in full-year profits, Shaikh Ahmed said the airline is once again considering sophisticated hedging. Its 2011/12 bottom line was hit by a 44.4 per cent jump in fuel costs – a spike which better-hedged rivals will have mitigated.

Etihad, for example, hedged 80 per cent of its fuel costs last year for an approximate saving of $300 million, according to chief financial officer James Rigney. As of February 2012, the carrier was 77 per cent hedged for this year and 50 per cent hedged for 2013, meaning that while it may have benefited less from the recent downturn, its overall exposure to volatility is reduced. Qatar Airways also hedges its fuel costs, though a spokesperson declined to give details about its positions.

Asked if he believes the recent slump in oil prices is part of a long-term trend, or a short-term pullback, Corley characteristically hedges his bets. “I won’t be surprised to see prices go to $75, and I won’t be surprised to see them go to $125,” he shrugs.

“Actually, I think $25 in either direction is highly probable, and maybe both directions.” For airline executives who have an effective hedging strategy in place, though, neither scenario will be too alarming.

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