Fuel hedging for airlines has never been as widely talked about as it is in these times of record oil prices. But what is the best strategy, and to what extent is hedging a gamble?
Hedging is the mot du jour in the airline industry at the moment and with good reason. With the price of fuel having skyrocketed beyond the worst nightmares of most airline executives, those carriers that were forward-thinking enough to implement fuel hedging strategies back when oil prices were at a level that can only be dreamed about today have every reason to be smug. Meanwhile, those airlines that took a gamble that oil prices would not surpass the $100-a-barrel level and decided not to hedge are attempting to play catch-up.
A large part of deciding whether or not to hedge comes down to the way in which airlines view hedging. Those that see it as an insurance policy which enables them to foresee exactly what they will be paying for fuel, therefore avoiding any nasty shocks, are the most likely to implement long-term fuel hedging strategies.
"Airlines should look at hedging as a strategic device that keeps them on an even keel and avoids extremes," says Leo Drollas, deputy executive director and chief economist at the London-based Centre for Global Energy Studies. But he adds that there is a tendency for airlines to hedge tactically rather than strategically, meaning they are "either too heavily hedged or too light on hedging, so they lurch from one situation to another".
"Airlines that have been hedging heavily in the last few years have done well. But if the price dives some time this year or early next year, they will get a caning," says Drollas. An airline that follows a strategic approach to hedging will "look at what's a good price in, say, a three-year period and whether there's a strategic need to hedge", according to Jon Bell, relationship director for airports and airlines at London-based Barclays. Tactical hedging, on the other hand, is "shorter-term and done on the basis of volatility", says Bell.
One airline that follows a strategic approach to fuel hedging and has done so since 1990 is Lufthansa. "Our hedging programme is designed to shield the airline from the adverse impact of the market," says Lufthansa vice-president corporate fuel management Helmut Fredrich. "Our strategy is that we are not speculating if there is a low [fuel] price environment. The aim is to mitigate the effects of changing oil prices to give Lufthansa time to adjust to different levels. We start 24 months out, building up our hedges by 5% a month so that after 18 months up to 85-90% of demand is hedged." This means 90% of Lufthansa's fuel is hedged for the coming six months, while 54% is so far hedged for 2009.
However, because the carrier hedges using options which follow the forward curve set by the market oil price, it is not possible to give a price per barrel at which it is hedged. "We always know for the next six months that our hedge ratio is full but we don't know exactly what we'll pay - that depends on where the market goes," says Fredrich. "We hardly ever use swaps because when prices drop you have very large payouts."
He adds that for Lufthansa to start losing money on its fuel hedges in the second half of 2008, the market price for a barrel of crude would have to drop below $60. "In 2009 the chart looks a little different but the payout period would start at a higher price."
Air France-KLM hedges its fuel even further in advance than Lufthansa, but shares the view that hedging is a strategic tool to protect against market shocks. The Franco-Dutch carrier hedges four years in advance and primarily uses swaps and collars. "We decided a long time ago, back in 1999, to maintain a hedging policy," says Air France-KLM president Jean-Cyril Spinetta. "Normally our target is to be 80% hedged in the first year, 60% in the second year, 40% in the third and 20% in the fourth year. We hedge to avoid too much volatility, but we are taking the risk of paying more than the market price. Since 1999 the market price has always increased so it has always been profitable for us, but this is not the target. The target is to have fewer shocks. In the current circumstances it's a strong asset for us."
With oil at $120 a barrel, the economic value of Air France-KLM's hedging policy is about $9 billion, says Spinetta, "but this is changing every day, every week, every hour". Whereas Lufthansa would lose money on its hedges if the price of oil fell below $60 a barrel this year, the level for Air France-KLM would be $79 a barrel, says Spinetta: "At $79 we will pay exactly the market price - below that we will pay more. If the fuel price drops it will improve our economic result but the efficiency of our hedging would be less."
The main difference between Lufthansa and Air France-KLM's fuel hedging strategies, says Spinetta, is that "Lufthansa is hedging for the current year and partially for the next year, whereas ours is four years rolling, so we are systematically hedging for the next four years". This means that if the oil price remains high next year, "the hedging position [Air France-KLM] built two to three years ago will be a very strong asset to us". Air France-KLM expects its hedges to save it up to €2 billion ($3.1 billion) this fiscal year. "Last year, for 2007/08, the total impact of our hedging was €1.1 billion. This year, for 2008/09, with fuel at $126 a barrel, it could be more than that at €2 billion," says Spinetta.
Abu Dhabi's Etihad Airways also hedges well ahead of time, a policy it adopted soon after chief executive James Hogan took the helm. "We embarked on a policy to hedge on a rolling basis over three years," says Etihad executive vice-president finance James Rigney, adding that the carrier hedges mostly on jet fuel, as opposed to crude oil, using caps and three-way collars.
"We don't get any free kicks, no free oil. We have to work the open market like everyone else"
Fuel hedging is all about "risk mitigation", according to Rigney, and mitigating those risks is all the more important with oil prices being so high. "Fuel is the largest expense and it's the most volatile," he explains. "Fuel represented 20% of our cost base in 2005. Today it's just over 40%. We'll see what happens going forward. The price of oil has been trending down so we're watching very carefully to see what happens."
British Airways expects to receive considerable protection from hedging in the foreseeable future, but it believes the scenario will change for the industry as existing hedges begin to run their course. "We have significant [hedging] cover for the rest of the year. On a calendar basis, 80% this year and 50% for 2009," BA chief financial officer Keith Jones told analysts recently. "On a financial year basis we're 78% covered this year at prices between $91 and $95."
But BA chief executive Willie Walsh added the following note of caution: "Hedging has given us a cushion - we see that as having given us time to adjust and reshape the business to cope with a high oil environment. Ultimately hedging within the industry will unwind. We've got good hedging this year, we're 35% hedged for next financial year, but as those hedges unwind we're going to have to reflect the reality of the oil price in our business in exactly the same way as other airlines are going to have to do."
Hedging has become more expensive than it was in the past due to the volatility of the market, says Bell of Barclays. Singapore Airlines, which hedges about 45% of its fuel requirements, plus or minus 15%, up to 18 months out, agrees: "In sustained high fuel price times, hedging will be of more marginal benefit than in the past, as even the hedges available will be at higher prices." However, Bell says hedging is "probably being done more now than it ever was" because "carriers are trying to buy disaster protection".
This is the position that Ryanair has found itself in. The Irish carrier took a gamble that oil would not go beyond $100 a barrel and allowed its hedges to run out at the end of March. "A lot of airlines have gone into hedging and then stopped because the price is too high, for example Ryanair," says Lufthansa's Fredrich. Adds Bell: "Ryanair has free-floated and has now caught a cold." Faced with massive fuel bills and the prospect of full-year losses, Ryanair chief executive Michael O'Leary said in late July that the carrier had bitten the bullet and "taken advantage of the recent weakness in oil prices" to hedge 90% of its fuel in September at $129 per barrel and 80% for the third quarter at $124 per barrel.
The carrier remains unhedged for the fourth quarter and is predicting that it will break-even at best for the full-year, but could go into the red to the tune of €60 million. Nevertheless, O'Leary remains bullish, pointing out that the carrier "continues to believe that oil prices remain subject to irrational exuberance", and insisting that Ryanair will not introduce fuel surcharges and instead "will continue to absorb higher oil costs, even if it means short-term losses".
Low-cost rival easyJet is following a strategy of building up its fuel hedging position incrementally using straight swaps at a fixed price, and expects about half of its fuel to be hedged this winter. "Again we will continue to hedge portions on a monthly basis that will build up on a rolling average in terms of the price that we'll be exposed to, and I would expect by the time we get into the winter we'll be around sort of within the 50% area in terms of the volumes that we'll have hedged," easyJet group finance director Jeff Carr told analysts recently.
Ryanair took a gamble and lost, whereas Fredrich says that in Lufthansa's case "there is no gambling involved - we look at the risks on both sides and we're doing it constantly". And it is not just full-service airlines that have adopted Lufthansa's stance. In the US, low-cost carrier Southwest Airlines has long been renowned for its successful fuel hedging strategy, which has helped it to consistently remain one of the few profitable US airlines.
However, even Southwest, which is 80% hedged for the third quarter at an enviable $61 a barrel, will see less benefit from its hedges going forward. In 2009 the carrier is 70% hedged at $66 a barrel, going down to 40% at $81 in 2010 and 20% in 2010 and 2011 at $77 and $76, respectively.
Getting the right balance on how much fuel to hedge is a question of risk management, according to Bell of Barclays. "We argue that you should never be completely hedged - this is prudent risk management. It is also unwise to be unhedged," he says. "There should be a treasury policy within an airline, and within this there will be parameters on the level and over what period hedging should be conducted, and what tools can be used to implement it."
Lufthansa's Fredrich says airlines need to carefully balance the pros and cons of hedging: "The whole risk management is the balance between what you pay out when you enter hedging, the risk on the downside and the risk on the upside. You have to look at what risk you can take, what the competition is doing and what compensation you can get from fuel surcharges."
FUEL HEDGING MADE SIMPLE
Airlines have various options available to them when it comes to hedging their fuel, but there are three main instruments that can be used: the swap, the cap and the collar.
The most popular tool for airlines is the collar, according to Jon Bell, relationship director for airports and airlines at Barclays. The collar works by allowing the airline to purchase put and call options based on a set range of oil prices. The airline trades off some of the upside "cap" by agreeing to a "floor" rate, below which the airline will not benefit.
"This allows us to create a zero premium solution," says Bell. "Collars are becoming more popular because there's no upfront premium, and premiums are getting expensive because of volatility, credit rating and expected rates of default."
Under the swap method an airline signs a contract to purchase its fuel for a given volume at a fixed price on a set date, effectively swapping a variable price for a fixed price. This gives the airline the assurance of knowing exactly how much it will be paying for its fuel ahead of time. Before signing up for a swap, an airline must look at its fuel consumption and cash outgoings month by month and then decide what percentage of its fuel it wants to hedge.
Air France-KLM uses mainly swaps, but the carrier's president Jean-Cyril Spinetta says it switches to collars when the oil price skyrockets. "We use simple hedging tools - we use swap contracts so there's nothing to pay," says Spinetta. "But recently when the price has been very high and the forward prices have been very high we have utilised, for example, collar tools, where we're protected against an increase in prices."
If an airline opts for the cap tool it pays a premium to buy an option to cap the maximum amount it will pay for its fuel in the future. If the market price for a barrel of oil goes up, the carrier pays no more than the capped level. "This method is driven by profit margin and credit risk, so it's better for good credit risk airlines than fringe carriers that have a high credit risk," says Bell. The percentage of fuel to be hedged varies from airline to airline, but Bell cautions against hedging the total consumption.