Airlines & Fuel Hedging:
industry plays an important role in economic growth of world by providing means
of transport, either passenger transport or cargo. Moreover, airline is one of
the safest and easy means of transport and according to the annual review of
IATA 2013 half of the world tourists travel through. Besides this airline
industry also provides cushion to the other industries, for example tourism industry
or other events like football world cup which is important for most of the
existing countries in the world (IATA, 2013).
size of airline industry in it self is massive and it can be seen through the
stats which is provided by the report of IATA 2013. In the year 2012 the use of
the air transport was gigantic around 3 billion people and 47 million metric
tons of the cargo were transported by air. Because of the huge size which
airline industry owns, in parallel it also hugely takes a part in the activity
of providing jobs, 57million job were provided by airline industry in 2012.
Furthermore, it also plays very important role in the economy of world,
2.2trillion of economic activity which is about 3.5% of global GDP (IATA, 2013).
airline industry is highly competitive in nature and unlike other industry it
also possesses the systematic and unsystematic risk. In the competitive
business environment several factors exist which affects airline business like
Global GDP, economic crisis, terrorism etc., but the factor which hits the core
of the airline business is, the fluctuation of fuel prices. The oil accounts
33% of the total operating cost (IATA, 2013) minor change in the price of oil leads towards greater change
in the operating cost.
AFFECTS OF HEDGING ON CASH FLOW:
hedging not only effects the profitability of business, but it also has an
impact on other financial areas. The effect of hedging can also be clearly seen
on the cash flow of the firm in a negative aspect or a positive aspect. Hedging
could be favourable for an airline if they find a suitable investment
opportunity, so when the internal cashflow is low and oil prices are high it provides
a cushion for the business and helps to maintain cashflow (pg9)
FUEL AS EXTERNAL FACTOR:
are several external factors exist in every business environment which cannot
be controllable or avoidable. To deal with this kind of factors a business must
have design a strategy which can help to find a way out or tackle the
Fuel price is one of the
uncontrollable external factor which is un avoidable because of its volatile
nature. Other transportation business like railroad and trucking
companies can deal with it because of their contracts which they have with
their corporate customers. Industries like railroad and trucking have a
leverage to charge more fee in form of a surcharge from their corporate
customers, if the fuel price are high in the market. Moreover, airline industry
which is highly fuel dependent had tried the strategy of transferring burden of
rising fuel cost on their customers, but it has a little success due to the
highly competitive business environment. (Carter, 2006).
FUEL HEDGING OR GAMBLING:
the month of January 2005 till September 2005 fuel was the biggest cost of
airline, more than passenger, maintenance and cost of labour. In mid of July
fuel price reached to its peak of U.S $147 per barrel and later it fell to U.S
$60 per barrel and further it went towards more fall and reached to U.S $35. These
fluctuation in the prices of a jet fuel often shows impact on the decision of
airlines CFO regarding fuel hedging strategies. Fuel hedging is kind of gamble
where one can bet on future or in other words it’s a prediction for future oil
prices. The rise of oil prices in late 2004 originated a need for airlines to
start hedging expertly in order to avoid unforeseen circumstances in the price
of oil. Airlines often announce publicly about the fuel consumption and the
amount of fuel which is hedged for the coming year, and it also provide the
rates on which airline is buying or hedging fuel for future consumption. In
2008-2010 most of the CFOs who made decision of hedging again rising fuel
prices were wrong. In the same year the companies with good financial
performance and good credit line who were involve in intensive hedging lost
huge amount of money. In parallel the small size companies who were unable to
afford hedging won the situation because of 70% fall in oil price. The big
airlines lost the money in the game of hedging and faced the deduction in
profit, while on other hand small airline won the situation and it also gives
the boost in their profitability (Batt).
EXISTING RISK IN HEDGING:
every aspect of business there is an element of risk, and the most common rule
is that one should take more risk for more gain. Hedging also include basic
risk, for instance if there is no element of risk in hedging then airline can
hedge in a huge quantity for crude oil. Due to the existence of risk in hedging
crude oil, airlines always limit the amount of hedge crude oil quantity. Furthermore,
the smaller the size of crude oil hedge less the volatility of cash flow
statement, larger the size of crude oil hedge larger the volatility in cash
flow. This shows that there is no established formula to mitigate the risk
associated with the volatility in crude oil prices. (from the paper Jet fuel
and basic risk)
SFAS NO:133 ACCOUNTING FOR DERIVATIVES:
standard of accounting gives a uniform approach for the treatment of Accounting
Derivative Instrument and Hedging Activities. The standard was issued on June
1998 and was affected from June 15, 1999. This standard recognizes the position
of derivatives in the statement of financial position as asset or liability at
a fair value. To apply this standard certain criterion must meet. Following are
the criterion which must meet in order to apply this standard.
Fair value hedge
Cash flow hedge
Hedge of a net investment in a foreign operation
value hedge is used by the company to mitigate the risk associated with the
volatility in the value of the recognize assets and liabilities. A firm should
determine the fair value of hedged item and hedging instrument at the date of
reporting. The change in the fair value of hedging instrument can lead to
profit or loss so the company must recognize this change (Drakopoulou, 2014).
hedge gives exposure to the variability in cash flows for future transaction.
If a company is concerned that the commodity or any other asset which it has to
buy next year will appreciate its value, company can designate this as hedged
item. To compete this transaction process company, enter into derivative.
hedge of a foreign currency exposure is a technique to eliminate risk which
could arise from foreign transaction in foreign currency. If a company is doing
business with other foreign company, where they have transaction in foreign
currencies in exchange of home currency for payables and receivables. These
kind of transaction carries risk of foreign currency exchange rate, which might
year 2017 consumer benefits are high and 1% of world GDP was spend on air
travel. The equity owners of the airline industry also enjoyed the gains in the
year 2017. The airline industry of America performed better in comparison of
other countries. The prediction of net post-tax profit margin for U.S airline
industry is 7.2% (IATA,
INFLUENCE OF AIRLINE INDUSTRY ON CONSUMER
just not only facilitate people around the world but also plays a vital role in
economic development. Through airline industry the flow of goods, services,
people, ideas and technology increases, which provide ease for any economy
which is looking forward towards expansion. If we compare todays airline
industry with the industry twenty years ago we can clearly see the huge
difference. The unique number of city-pair connection are forecasted to extend
19000 in 2017. Furthermore, the falling prices of airline fairs is not only
encouraging consumers to fly frequent but also giving boom in trade activities (IATA, Outlook, 2017).
section will focus on the ongoing hedging trends and available hedging
instruments and contracts which are available in the market currently.
are different financial instruments which is accessible in the financial market
and each of them has different features. Following are the three types of
financial instruments which is being commonly used by airlines for fuel price
hedging (MORRELL & SWAN, 2006).
Options, Collars, Swaps
FORWARD: Forward contracts are the
consent between two parties. In this consent one party purchases the fixed
amount of the fuel at a fix price from the other party. The delivery of fuel
will occur at some future date, which is fixed by the both parties at the time
of transaction or agreement (MORRELL & SWAN, 2006).
FUTURES: Futures contracts allowed one
party to deliver standardized product at an agreed price which is (strike price)
at specified future date. These contracts are easily reversible before the
agreed date of contracts so that no physical delivery takes place. The
standards of these contracts are set by the International Petroleum Exchange
(IPE) London and by (NYMEX) in New York. The quality of the product (oil) is
assured in this contract so that the other party gets the desire product.
Future contracts can be fix each month up to two years ahead and it can also be
fixed half yearly to the three years out (MORRELL & SWAN, 2006).
OPTIONS: These are available in both
Brent gas oil and crude at IPE. Options gives its holder a facility to have a
safe standing in future against adverse price movements, and also provide an opportunity
to participate in favourable moments. Options are based on underlying futures
and its not obligatory to exercise options (MORRELL & SWAN, 2006).
options can be divided into types.
option gives an airline a right to buy a fuel at a specified exercise price on
or before exercise date.
put option gives a right to seller to sell its asset at an specified price on
or before the exercise date.
SWAPS: Swaps are the tailor made future
contacts where the airline exchanges payments at a future
date based on the fuel or oil price. These arrangements can be done with a
supplier and then airline can buy a swap for a certain period of time at a
strike price specified amount of jet fuel per month (MORRELL & SWAN, 2006).
During this time period of SWAP
contract, airline can buy a fuel with the supplier at any airport. If the Swap
contract between the airline and broker (bank) is settled at the price of U.S
$150 and if the airline is getting fuel at higher price form suppliers, due to
any reason so the difference will be paid by broker (bank). On other hand, if
the airline line is getting oil in less price than the price of SWAP then the
difference will be paid by airline to the broker (bank). Initiating a SWAP
contract and fixing the price is heavily dependent on the dynamics and the
condition of the market. These floating rates of fuel are based on global oil
market benchmark for example Platts Jet Fuel Rotterdam.
COLLARS: Collars are based on the combination of
put and call option. In the process of buying a airline fuel, a collar is
created by selling a put option with a strike price lower than market on going
fuel price. Furthermore, same treatment is done by purchasing a call option
with a strike price which is higher than current fuel price.
The procurement of call option provides
a security during the life of option against high jet fuel price movements.
Moreover, on the other side the premium which is received by selling put option
settle the loss of call option. (ACL JET FUEL HEDGING PAPER)