The airline industry is cyclical in nature and sensitive to a number of key drivers, the most prominent being the global price of crude oil. It is a well-known fact that movements in oil prices have a significant impact on the well-being of companies in the airline space.
Fuel costs account for a significant chunk of an airline company’s operating expenses. Consequently, lower the oil prices, the merrier for airline stocks. This has been the trend for the last year or so. The persistent fall in oil prices has tremendously boosted the bottom lines of most airline stocks. Major companies like Delta Air Lines DAL, American Airlines Group AAL and United Continental Holdings, Inc. UAL posted better-than-expected earnings in the second quarter of 2015, aided by low fuel costs.
Oil Price Fluctuations Put Carriers’ Hedging Strategies in Focus
Oil prices have fluctuated wildly over the past few months. Early last week, WTI crude dipped below $39 per barrel for the first time in more than six years. However, oil prices have rebounded over the last couple of days and ended last week at $45.22 a barrel. The wild fluctuations is the price of this key commodity for airlines has obviously put the hedging tools used by carriers to cope with rising oil prices back in spotlight. The carriers use a combination of calls, swaps and collars at varying WTI crude-equivalent price levels to hedge.
We note that despite the substantial rise in oil prices over the last couple of days, airline stocks have held their own. The NYSE ARCA Airline index has gained 1.6% over the last couple of days despite the strong rise in oil prices. Stocks like Delta Air Lines and United Continental which resort to hedging as a protection against the surge in oil prices, have gained over the period despite the inverse relation between oil prices and the value of aviation stocks.
Fuel Hedging Strategies
By definition Hedging in the world of Finance indicates a risk management strategy which is used to mitigate or offset the probability of suffering losses due to fluctuations in the prices of commodities, currencies, or securities. To achieve the objective the tool, which basically lends protection against unforeseen events, mostly involves the purchase of securities that move in the opposite direction than the asset being protected.
Hedging strategies are widely used by airline companies as a profit protection tool to cope with the rising fuel prices. According to a report appearing in the Conversion hedging is most prevalent among low-cost carriers like Southwest Airlines LUV and JetBlue Airways JBLU. They are highly exposed to the swings in fuel prices as all other expenses are reduced to the minimum level by these carriers.
One of the most prevalent derivatives to hedge risk are futures contracts. The contract takes place between the buyer and the seller and basically obligates both parties to buy or sell an asset at the price agreed upon at the time the transaction. Delivery and payment take place at a future specified date. The contracts between the parties, used to mitigate their risk exposures to potentially rising oil prices, are negotiated on a futures exchange, such as CME/NYMEX or ICE.
Moreover, airline companies also make use of a fuel swap to hedge their exposure to the fluctuations in fuel prices. A jet fuel swap refers to an agreement between two parties which ensures that a floating (market) price is exchanged for a fixed price over a specific time period. Moreover, options, costless collars and call option spreads are other hedging strategies utilized by carriers to protect themselves from volatile fuel prices.
Different Approaches
The approaches of different carriers vary with respect to hedging. While some carriers hedge aggressively almost their entire fuel requirements others like American Airlines do not resort to hedging. With oil prices way below the highs reached in mid 2014, Delta, which hedges aggressively has recorded hedging related losses to the tune of $313 million in the first half of 2015.
Delta modified its hedging portfolio earlier this year. The Atlanta-based carrier resorted to the early settlement of certain 2015 hedges and deferred the same of a portion of the remaining positions. The carrier recorded fuel hedging gains of $98 million in the second quarter of 2015.
Delta is not the sole carrier to restructure its fuel hedge portfolio in the wake of the soft fuel price environment. United Continental too has walked the same path. The California-based carrier, which recorded hedging losses to the tune of $200 million in the second quarter, is hedging 22% of its fuel for the second half of 2015 and only 5% for 2016.
Good Time to Hedge?
With oil prices fluctuating wildly, the hedging schemes adopted by various carriers are in spotlight. Although it is a fact that most carriers hedge at least some of their fuel costs, the majority of them should still continue to benefit considerably from the plunge in oil prices.
Despite the recent rally, crude prices have been hovering around the $40 a barrel mark. This represents a significant decline from the approximately $105 per barrel witnessed in July last year. With oil prices expected to be soft at least in the remainder of 2015, carriers may look at the present time as a favorable one for fresh hedging to lock in future fuel prices.
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