Airlines hedging jet fuel should be evaluating long term hedges NOW!

Victoria
By Victoria April 18, 2013 09:25

Airlines hedging jet fuel should be evaluating long term hedges NOW!

Prudent jet fuel hedgers are actively hedging their forward costs of jet fuel. At the time of this article, jet fuel costs have dropped more than $0.5000 c/gal (= %16.50) and now currently rest within the lower 20% range of the Nov 2012/March 2013 rally. Alternatively, it can be said current fuel prices rest within ten cents of their June 2012 low (on a correlated basis). In this environment, airlines should be combining call spreads, out-of-the-money ceilings and 3-way structures to lock in forward rates and create price ceilings assuring limitations on maximum forward prices should prices return to their two-year highs. This can be done without sacrificing future low-price opportunities.

Airline folklore is created from “out of the box thinking” and “proactive risk management” as displayed by the risk managers of Southwest Airlines (SWA) in the mid-2000’s. Through 2000/2003 SWA executed forward fuel hedges allocating less than $0.05 cents per gallon on their fuel costs to achieve fuel savings of more than $1.00 per gallon during the mid-2000’s. Today, even airlines with challenging cashflow can execute the groundwork to secure similar results.

Now is the time for airlines to evaluate fuel hedges extending three to five years into the future. Several strategies can be utilized to limit the “out of pocket costs” of these hedges. However, the paramount decision needs to be focused towards the airline securing a competitive advantage using 2012 prices versus competing with competitors using spot prices and hedging 10% or less of its volumes.

The process of jet fuel hedging is intended to manage the degree of risk present when engaging in the execution of the forward procurement of fuel. Essentially the structure of the fuel hedge is determined by current market conditions and historical retrospect. This information is used to design the hedging process which attempts to compensate for any shifts in the relative price of fuel from the forward projections of the airline. The expectation (if properly executed) is that by minimizing the airlines exposure to unfavourable shifts in forward fuel prices when compared to budget, a reasonable return will be generated by the airline and assured to the airline’s shareholders, even if the price of jet fuel rises substantially.

This is a two-way risk since fuel prices can move adversely or favourably thereby making the choice of hedging strategy imperative. Our research shows (1) airline management typically hedges for adverse movements only, for example higher fuel costs and then (2) only hedges a portion of their forward fuel exposure (probably because of poor strategy selection).

Airline operations and business plans vary substantially, however we strongly suggest all airlines make it a priority to review their long-term fuel hedging and fuel risk management exposure. Please follow us as we continue this discussion with a thorough analysis in the next Airline Economics Publication.

Peter Bryant, Bryant Capital Partners

Victoria
By Victoria April 18, 2013 09:25
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