Essay About Airline Jet Fuel Hedging And Airlines Hedge

Airline Jet Fuel Hedging: Theory and Practice
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Airline Jet Fuel Hedging: Theory and practice
PETER MORRELL and WILLIAM SWAN
Department of Air Transport, Cranfield University, Bedford, UK
ABSTRACT Hedging fuel costs is widely practiced by most international airlines
but its theoretical justification is weak. This paper explores the nature and extent of
airline fuel hedging and asks why airlines hedge. A policy of permanent hedging of
fuel costs should leave expected long-run profits unchanged. If it damps out profit
volatility, it should do so in a way that the market would not value. However, it may
not damp out volatility, after all. Oil prices and air travel demand cycles are linked
when oil supply reductions drive GDP declines. But oil and travel are negatively
correlated when GDP demand surges drive oil price increases. So oil prices can
either increase or decrease airline profit cycles, depending on the time period
sampled. A fuel price hedge would create exceptional value when an airline is on the
edge of bankruptcy. However, when on the verge of bankruptcy, an airline does not
have the liquidity to buy oil futures. And variable levels of hedging can be useful in
transferring profits from one quarter to another. Finally, hedging may be a zero-cost
signal to investors that management is technically alert. Perhaps this is the most
compelling argument for airline hedging. However, it lies more in the realm of the
psychology of markets than the mathematics.
Correspondence Address: Peter Morrell, Department of Air Transport, Cranfield University, MK43
0AL, UK. E-mail: [email protected]
Introduction
Airlines do something the industry calls hedging to protect fuel costs. Hedging
broadly means locking in the cost of future fuel purchases. This protects against
sudden losses from rising fuel prices. Locking in fuel prices also prevents sudden
gains from decreasing fuel prices. So airlines hedge fuel to stabilize fuel costs. Fuel
is about 15% of the airlines costs. Other costs are less volatile than fuel prices, so
hedging fuel stabilizes overall airline costs. More stable costs also mean more stable
profits.
Conceptual hedge transaction
Most fuel hedges are purchases of an oil future. A future is a contract to pay a stated
price for an amount of oil on a particular date. If the airline buys a future at $22 per
barrel and oil goes up to $33, that contract protects $22 worth of jet fuel purchases
from the expected 50% increase in price. Section 3 examines futures and derivative
instruments in some detail. Airlines typically hedge between one and two thirds of
their expected fuel costs. Most airlines look forward six months in their hedging.
Few hedges are forward more that a year out.
What hedging does
Why airlines hedge is the topic of this paper. The commonly stated reason is that
hedging stabilize fuel prices and therefore overall costs, cash flows, and profits. The
implication is that the market will respond to reduced volatility in profits with a
higher price for the airlines stock. This implication is deduced from the correct
observation that risk has a cost in the investment marketplace.
Airline profits are volatile for two reasons. First, travel demand is sensitive to
consumer confidence, which itself is correlated with stock market performance. And
second, airlines themselves are highly leveraged, in the sense that the total value of
outstanding stock is a small fraction of annual incomes. Small changes in profits as a
fraction of revenues make for large changes in the return to stock shares.
The theory behind airline fuel hedges is to reduce a major source of swings in profits,
and thus higher prices for the airlines stocks. This theory is confirmed by analysts
who forecast airline stock prices. They observe and comment on the degree to which
an airline might be hedged, whenever fuel prices themselves are uncertain.
Most traded airlines today hedge fuel costs. This has not always been the case. As
recently as 15 years ago, fuel hedging was rare. European flag carriers used currency
hedges long before fuel price hedges became common.
Logic of hedging
The theoretical justification for hedging fuel costs is weak. Classical investment
theory holds that investors reward stocks for their performance as part of a larger
portfolio. And portfolio investors can hedge oil to balance their returns at their own
discretion. As we shall see later, there are conditions where hedging does help.
However, the baseline case of using hedging to reduce airline profit swings is weak.
There are even market reasons to avoid hedging.