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How Do Airlines Hedge Against Rising Fuel Prices?
August 31, 2015, 06:02:00 PM EDT By Zacks Equity Research, Zacks.com
The airline industry is cyclical in nature and sensitive to a number of key drivers, the
most prominent being the global price of crude oil . It is a well-known fact that
movements in oil prices have a significant impact on the well-being of companies in
the airline space.
Fuel costs account for a significant chunk of an airline company's operating expenses.
Consequently, lower the oil prices, the merrier for airline stocks. This has been the
trend for the last year or so. The persistent fall in oil prices has tremendously boosted
the bottom lines of most airline stocks. Major companies like Delta Air Lines, American
Airlines Group and United Continental Holdings, Inc. posted better-than-expected
earnings in the second quarter of 2015, aided by low fuel costs.
Oil Price Fluctuations Put Carriers' Hedging Strategies in Focus
Oil prices have fluctuated wildly over the past few months. Early last week, WTI crude
dipped below $39 per barrel for the first time in more than six years. However, oil prices
have rebounded over the last couple of days and ended last week at $45.22 a barrel.
(and dropped further in 2016 before returning to a similar level…Mr. B) The wild
fluctuations in the price of this key commodity for airlines has obviously put the hedging
tools used by carriers to cope with rising oil prices back in spotlight. The carriers hedge
by using options and swaps of various WTI crude-equivalent price levels to hedge.
We note that despite the substantial rise in oil prices over the last couple of days, airline
stocks have held their own. The NYSE ARCA Airline index has gained 1.6% over the
last couple of days despite the strong rise in oil prices. Stocks like Delta Air Lines and
United Continental which resort to hedging as a protection against the surge in oil prices
have gained over the period despite the inverse relation between oil prices and the
value of unhedged aviation stocks.
Fuel Hedging Strategies
By definition Hedging in the world of Finance indicates a risk management strategy
which is used to mitigate or offset the probability of suffering losses due to fluctuations
in the prices of commodities, currencies, or securities. To achieve the objective the tool,
which basically lends protection against unforeseen events, mostly involves the
purchase of securities that move in the opposite direction than the asset being
protected.
Hedging strategies are widely used by airline companies as a profit protection tool to
cope with the rising fuel prices. According to a report appearing in the Conversion
hedging is most prevalent among low-cost carriers like Southwest Airlines and JetBlue
Airways. They are highly exposed to the swings in fuel prices as all other expenses are
reduced to the minimum level by these carriers.
One of the most prevalent derivatives to hedge risk are futures contracts. The contract
takes place between the buyer and the seller and basically obligates both parties to buy
or sell an asset at the price agreed upon at the time the transaction. Delivery and
payment take place at a future specified date. The contracts between the parties, used
to mitigate their risk exposures to potentially rising oil prices, are negotiated on a futures
exchange, such as CME/NYMEX or ICE.
Moreover, airline companies also make use of a fuel swap to hedge their exposure to
the fluctuations in fuel prices. A jet fuel swap refers to an agreement between two
parties which ensures that a floating (market) price is exchanged for a fixed price over a
specific time period. Moreover, options, costless collars and call option spreads are
other hedging strategies utilized by carriers to protect themselves from volatile fuel
prices.
Different Approaches
The approaches of different carriers vary with respect to hedging. While some carriers
hedge aggressively almost their entire fuel requirements others like American Airlines
do not resort to hedging. With oil prices way below the highs reached in mid 2014,
Delta, which hedges aggressively has recorded hedging related losses to the tune of
$313 million in the first half of 2015.
Delta modified its hedging portfolio earlier this year. The Atlanta-based carrier resorted
to the early settlement of certain 2015 hedges and deferred the same of a portion of the
remaining positions. The carrier recorded fuel hedging gains of $98 million in the
second quarter of 2015.
Delta is not the sole carrier to restructure its fuel hedge portfolio in the wake of the soft
fuel price environment. United Continental too has walked the same path. The
California-based carrier, which recorded hedging losses to the tune of $200 million in
the second quarter, is hedging 22% of its fuel for the second half of 2015 and only 5%
for 2016.
Good Time to Hedge?
With oil prices fluctuating wildly, the hedging schemes adopted by various carriers are in
spotlight. Although it is a fact that most carriers hedge at least some of their fuel costs,
the majority of them should still continue to benefit considerably from the plunge in oil
prices.
Despite the recent rally, crude prices have been hovering around the $40 a barrel mark.
This represents a significant decline from the approximately $105 per barrel witnessed
in July last year. With oil prices expected to be soft at least in the remainder of 2015,
carriers may look at the present time as a favorable one for fresh hedging to lock in
future fuel prices.
http://www.nasdaq.com/article/how-do-airlines-hedge-against-rising-fuel-prices-cm515324
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Questions:
1. Would an airline buy or sell futures to hedge their expected costs?
2. If oil and/or jet fuel prices rise between today and expiration, will their fuel
costs rise?
3. If oil and/or jet fuel prices fall between today and expiration, will their fuel
costs fall?
4. If fuel costs fall, will airlines who do not hedge have a price advantage?
5. If other airlines do not hedge, is there competitive risk in hedging fuel
prices?
6. Do airlines know if competing airlines are hedging?
7. What could airlines do to hedge fuel costs if there were no futures
contracts?
8. What is the advantage of using futures contracts to hedge?
9. What is a disadvantage of using futures contracts to hedge?