While news organizations often announce airlines’ financial results, it quickly becomes difficult to further dissect and understand the major cost drivers, particularly related to fuel. This is the first part of a two-part series explaining the basics of fuel hedging and how it impacts airlines around the world. The first part will focus on an introduction to the concept, while the second part will focus on real world examples of fuel hedging done right and wrong.
One of the largest costs every airline faces is fuel. As we have seen time and time again, the price of fuel is often not stable, and can fluctuate greatly based on varying market forces.
This poses a major problem for airlines: how does an airline control its fuel costs when the price of fuel changes so much? Fuel could be cheap one quarter and the airline can profit greatly, and can be expensive the next, causing massive losses.
The answer is fuel hedging, a contractual tool that airlines use to reduce their exposure to the volatility of fuel prices. This tool kit often gives the airline a bit of control when it comes to forecasting their expenses, but it can also create greater financial issues if not forecasted correctly.
Ultimately, there are four main ways that an airline can hedge fuel: current oil contracts, call options, collar hedges, and fuel swaps.
Current Oil Contracts
When an airline believes that fuel prices will rise in the future, it can purchase large amounts of current oil contracts for future use. Essentially the airline is buying the rights to purchase gas in the future at a set price which they believe will be less than the future market price.
For example, an airline forecasts that it will need a certain amount fuel over the next six months. Instead of buying fuel as needed, the airline will buy all the fuel they need at the current price, hoping that at the end of six months it will come out ahead.
A call option is a type of agreement that gives one party the right, but not the obligation, to buy something at a certain price within an agreed upon period of time.
In a situation where an airline believes the price of fuel will increase, it can purchase a call option for a set amount over a set period of time, for example, $5 in a 180-day period. If the current price per barrel is $60, the airline will have the right to purchase a barrel of oil for $70 within the 180-day period.
The price difference between the current and call price is the option premium. This is essentially the cost having the option. If the price of the barrel increases to more than $75, the airline will end up saving money since it is paying the agreed upon rate of $70 per barrel instead of the market rate of $75.
The next method of fuel hedging involves a collar hedge, which requires the airline to purchase both the call option mentioned above and a put option. Essentially the opposite of a call option, a put option allows the airline to sell at a future date for a price agreed upon now.
The call protects the airline from price increases above the agreed upon price at a cost of the option premium. The put option limits the loss from price reductions below another agreed upon price. This method is becoming popular since it locks in the price paid for fuel between two known values limiting risk.
A collar hedge protects the airline from a decline in the price of fuel. So while the call option provides the airline with a hedge against higher fuel prices, the put option covers the cost of the call option. In theory this would cost the airline nothing at the end of the day, but nothing is free of course.
A simple collar hedge is the best way to introduce the concept, but it gets considerably more complicated with strategies such as three and four-way collars to hedge fuel. This is one particular strategy that requires heavy but informative reading to understand the process and various options available.
The final method that will be discussed is the swap contract. This plan allows the airline to put in place a swap strategy to protect against the possibility of rising fuel costs. A swap is similar to a call option, but there is one key difference.
While a call option gives you the right to purchase fuel in the future at a certain price, a swap locks in the purchase at a future date. The obvious downside is that if the price drops, the airlines is stuck paying much more than the market price for fuel.
While these are just a few of the various methods that airlines use to mitigate risk when it comes to fuel costs, there are also several variations of these strategies that airlines across the globe utilize each year. With that being said, there are some companies that choose not to hedge fuel whatsoever.
Companies that don’t hedge fuel believe that they will be able to directly pass on any and all fuel increase to customers without hurting the bottom line, or that fuel prices will drop in the future and they are comfortable paying a higher price now.
In part two of the story, we’ll analyze different strategies that airlines have taken to hedge fuel, as while some have used fuel hedging to their great benefit, some have ended up losing billions through poor hedging decisions.