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Aviation Fuel Hedging Research Paper

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Updated: Mar 20th, 2022

Introduction

According to the “Travel Dictionary” (2010), fuel hedging is defined as “the practice, often employed by airline companies, of making advance purchase of fuel at a fixed price for future delivery to protect against the shock of anticipated rises in prices” (Para 1). Fuel hedging is among the strategies that are employed by airline companies for them to protect themselves from the anticipation of an increase in the price of ‘jet fuel”. According to Anonymous (Fuel hedging, 2008), “hedging has been described as everything from gambling to buying insurance” (Paragraph 2).

A large number of “International air carriers”, just in the same manner as the rest of the members in the transport sector, engage in fuel hedging with the main reason of insulating themselves against the prices which are often unpredictable. In this paper, there is going to be gaining fundamental insight into the “significance of fuel costs” for the airline companies and the reasons why companies engage in fuel hedging and what motives they have for hedging and why some companies benefit from hedging while others make losses.

Aviation Fuel Hedging

Among the main “cost drivers” in the aviation industry is the “purchased jet fuel” that is required for the operations of the airlines. AS Kling (2008) points out “the contribution to the operation cost of airlines varies widely with market prices for fuel and other influences, but is quoted mostly between 20% and 40% and thus a considerable share of total operating costs”. Regarding overall costs for the entire company, Morrell and Swan (2006) point out that “fuel costs are about 15% of the total costs when oil is near $25/barrel” (Page 723). Philips (2003) points out that in 2003, Southwest had oil accounting for 15% of the overall “airline cost of the US carrier”.

As on one hand consideration is made of the operating costs of the airlines as being the main part, on the other hand, it is pointed out by Kling (2008) that “the greatest lever for reducing cost lies within operations itself by measurements of reducing consumption and only to a very small extend within market instruments: (Page 16). There is a limitation in the efforts that are carried out to engage in passing on of varying degrees of the costs of fuel to the clients as surcharges because of the “price elasticity of demand” and also due to the legal precincts.

Having engaged in exploring to establish that there is an importance of the fuel costs to the airline companies, there comes up a question as to whether or not fuel hedging is of any benefit in whatever way. An emphasis is put by Morrell and Swann (2006) that bringing down the level of unpredictability in prices translates to bring down the level of the “risk exposure” and this results in ‘the higher estimation of the airline’s value as a reward to investors” (Page 724).

Morrell and Swann (2006) as well point out that there can not be having the aim of bringing down the level of the costs of fuel in the long run by hedging. In practice, it is indicated that among the airline companies, some tend to follow this objective by way of a more aggressive “fuel trading policy” resulting in a higher chance of acquiring benefits but not bringing down the level of “risk exposure” that is the major aim of hedging.

In practice, there is an indication of various approaches. An initial overview of these approaches can be obtained through carrying out the differentiation of 3 market dimensions as well as the quantity and instruments. Since crude oil is as well the “chemical basis” and can act as basic to the “jet fuel”, most of the hedging carriers put the hedges they have against “the movement of the crude oil price” (Kling, 2008). The financial instruments market on the fuel is greatly not liquid to a level to “hedge against the full consumption” (Kling 2008). Yet there can be classified of the carriers in terms of whether or not they engage in hedging “the differential between crude and jet fuel” or whether or not these carriers concentrate on the “crude market” (Kling, 2008).

The “consumption coverage level” gives room for placing carriers into a “contingency context” and this is dependent on the level of the consumption they have that is hedged for which time period into the future. In the current days, the hedging airlines that have achieved success to a great level employ what is referred to as “rolling hedging strategy”. In this strategy, the consumption in the near future is hedged to a greater level in comparison with the future dates that are far. In general terms, there will be putting in place the “hedging policy” by an airline company in regard to the rules that have to be followed to make a choice of which instruments to be employed.

In relative terms, the concept of fuel hedging is not an old concept. This concept started in the course of the 1990s. According to Kling (2008) “instruments can be divided into options which grant the rights to buy or sell at a specified time without obligation to draw the fight to buy futures that lock in the price of a future trade” (Page 17). Employing futures in hedging can bring about direct losses if the level of prices goes down and at the same time a “call option” will prevent losses resulting from the decreasing prices at the time there is no execution of the option. Therefore, Kling (2008) concludes that “options are traded at a sometimes considerable premium the counterparty charges for taking over the full price risk” (Page 17). This implies that an airline company engages in “betting on the price” to remain in this band.

According to Anonymous (United may not be alone with fuel hedge losses, 2008) “Southwest Airlines” who are regarded on an international level as being a benchmark in regard to “fuel hedges” was reported to have derived a gain of over three billion US dollars resulting from hedging beginning from the year 1999 to the year 2008. In the course of the same period, there was an increase in the “crude oil prices” and at this time, hedging was enhanced by the “market conditions”. Anonymous (Fuel hedging, 2008) reports that not in a similar manner as Southwest, other local airlines have not been very much “aggressive at hedging” and as a result of this, these companies are paying prices that are higher.

Anonymous (Fuel hedging, 2008) further reports that “Delta only hedged 27% of its first-quarter fuel consumption, while United hedged 30%, and continental hedged just 22%, leaving them particularly exposed to the higher prices of jet fuel” (Para 4). Consequently, Southwest paid 1.98 US dollars/gallon at still at the same period United was paying almost double the amount (3.02 US dollars/gallon). United Airlines is said to have made losses of more than a half a billion US dollars in the year 2008 alone. Another company that is reported to have made losses is Delta. This company made a loss of 108 million US dollars in the year 2007. More so, Continental was also reported to have lost over 18 million in the first quarter of 2007 from hedging (Anonymous: Hedging, 2008).

The benefits and losses that result as indicated above imply that hedging can be of benefit just for “smoothening out the cost structure in the time, where there will be an overall reduction in the unpredictability of the price but temporary gains will be evened out by similar losses as most airline trading policies explicitly recognize” (Kling, 2008, Pg 17). The critical question that comes up for airline companies which follow the “classical hedge-to-minimize-risk” approach is thus supposed to be whether or not bringing down the level of volatility is given a reward by the “stock market as an increase of the company value” (Kling, 2008).

Since exposure to oil prices unpredictability is not a risk that is specific to any company, it is assumed that the investors would be in a position to obtain a portfolio that is efficient by themselves through the development of “counterpositions” to that particular risk. They can carry out this, for example as pointed out by Morrell and Swan (2006) by “buying positions of refineries or oil-producing companies or by accumulating adequate hedging instruments themselves” (Page 725). Morrell and Swann further point out that, to this point, there is no need, in theoretical terms, for an airline company that has enough liquidity to engage in hedging.

Kling (2008) observes that the opposing position arising with a “reality check” is that “the underlying theory behind this hypothesis – the CAPM – is not very strong in the real world due to the costs of information gathering and the economies of scale connected with hedging operations” (Page 17). A point is added by Morrell and Swan (2006) by putting “oils prices movements” into two classes. These classes are “demand drive price movements” and “supply-driven price movements”. They put forth a strong position that “hedging will smooth out only supply-driven oil price changes while turning demand-driven changes even higher” (Page 725)

Conclusion

The objective of the airline companies engaging in hedging is to them to protect themselves from the anticipation of an increase in the price of ‘jet fuel”. Some of the companies such as Southwest airlines have been successful in hedging and they have been able to derive benefits from this. On the other hand, some companies in the industry have not been successful in fuel hedging and they have ended up making losses. Such companies include Delta and United among others.

At the present, the airline companies which engage in hedging that have been successful to a higher level are the ones that use a strategy in which the consumption on the days that are not far in the future is hedged to a level that is higher as compared to the level of hedging to the days that are far in the future. These companies engage in hedging using a more aggressive “fuel trading policy” and this enables them to have higher chances of getting benefits.

References

Anonymous, (2008). Fuel Hedging. Web.

Anonymous, (2008). United may not be alone with fuel hedge losses. Associated Press. Web.

Kling, M. V. (2008). Fuel hedging in the airline sector. Transfer, No. 38.

Morrell, P. and Swan, W. (2006). Airline fuel hedging: Theory and Practice. Transport Reviews, Vol. 26 No. 6.

Phillips, E. H. (2003). Southwest stays in black. Aviation Week & Space Technology, Vol. 158, No. 17.

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