Fuel Hedging a Strategy for Air Carriers to Combat Fuel Hike Essays

Fuel Hedging a Strategy for Air Carriers to Combat Fuel Hike Essays Fuel Hedging a Strategy for Air Carriers to Combat Fuel Hike Essay Fuel Hedging a Strategy for Air Carriers to Combat Fuel Hike Essay Fuel Hedging A Strategy for Air Carriers to Combat Fuel Hike Index Jet Fuel – The Nemesis of Airlines In the year 2008, the growth of global aviation industry received a major bolt from the fear of global economic slowdown and the rise in crude oil prices. Though the global economic uncertainties impacted the business of airlines, but the steep surge in crude prices has changed the financial equations of the airline across the world, with India being no exception. In fact over the previous ten months crude prices have increased over 80 percent, from nearly $80 per barrel in October, 2007 to $147 per barrel in June, 2008. A similar increase was seen in the case of Arabian Gulf Jet prices. As per the figures released by IATA (International Air Transport Association), fig. 1, the price of Jet Fuel, as on 1st Aug’07, has increased by 314. 5% since 2000, and almost 70% since August last year. IATA has forecast the loss in aviation sector to be nearly USD 2. 3 billion (more than 9500 crores) in 2008. |1-Aug-08 | Fig. 1 Aviation Turbine Fuel more popularly known as ATF or Jet Fuel, continues to be the single largest cost factor for airlines constituting nearly 40 per cent of the total operating costs. Hence as ATF prices start to increase, airlines typically respond by raising fuel surcharges. Only Rs. 225 of the surcharge is payable to AAI (Airports Authority of India); the balance goes to the airlines. In the past six months alone, fuel surcharge has increased from nearly Rs 950 to Rs 2,350. That’s nearly an increase of 150%. Considering a basic fare of Rs 1,000(say) and other charges being constant, cost of flying has nearly doubled. : That is deterring the low and middle income group travelers who were beginning to switch to air travel mode from traveling by railways. The rise in crude prices is hurting both high end carriers and low cost carriers as the decline in the number of passengers has affected the load factor. The load factor for Indian carriers has come down during June-July period. Further increase in ticket prices, which is inevitable if the fuel prices rise further, can devastate the future plans of airlines. Reasons for Rise in Fuel Prices Demand Outstrips Supply According to the experts, the demand for crude oil is directly related to the world GDP growth. During the last few years, the developing countries like India and China have seen tremendous growth, and hence accelerated the demand for crude oil. Though the developed countries have also seen growth, but the increase in the buying power of people is higher in developing countries. Although the demand has surged but the supply side has not seen much change. The oil reserves are more or less same and producing same amount of oil. This mismatch in demand and supply has been the most prominent factor behind the crude prices rally. OPEC Control The Organization of Petroleum Exporting Countries (OPEC) is an organization of eleven developing countries that are the major exporter of crude oil across the globe. OPEC controls almost 40% of the world’s crude oil. It accounts for almost 75% of the world proven oil reserves. OPEC yields power to disturb the supply-demand equation by squeezing the supply side, and it has even been observed in the past that OPEC countries have reduced the supply of oil to increase the prices. Speculative Buying and Selling A lot has been debated over the trading of oil futures in the commodity exchanges around the world. The OPEC countries, to shift the blame, criticize that speculation causes the prices of commodities like fuel to rise beyond expectation. Cartelization and hoarding of oil are said to be responsible for such irrational increase in the crude prices. Possible Measures The factors that control the prices of crude oil are all external to aviation industry. The airlines can’t just wait and watch their profits dwindling. They need to pull out some strategy to safeguard itself against the nemesis. Globally the strategists in aviation are evaluating two options: Alternate Fuel – With the surge in fuel prices, the demand for an alternate fuel is all time high. Airlines and aero plane manufactures like Boeing and Airbus are spending millions on the research of technologies and alternatives to jet fuel. Recently Virgin Atlantic’s Richard Branson has allocated 3 Billion dollars to Virgin Green Fund to be spent on alternative fuel and solar technologies over the next decade. In the recent past several test flights have been made using the alternatives like bio fuel. Virgin Atlantic flew an experimental flight on a Boeing 747 using a blend babassu palm oil and coconut oil. The thrust is on the research of fuel which is environmentally safe and can be produced without putting stress on arable land. The aircraft manufactures are promoting research on fuel which can be drop-in replacement which should not require change in air frame, air engine as very expensive investment would be required then. Fuel Hedging Fuel hedging is the practice, often employed by airline companies, of making advance purchases of fuel at a fixed price for future delivery to protect against the shock of anticipated rises in price. Fuel hedging is a risk mitigating strategy. It doesn’t add to the profits but protects against any future losses due to rise in fuel prices beyond the expectations. Hedging is a popular tool used by the airlines globally to insure themselves during the fuel crisis situations. Fuel hedging is done in the commodities market either directly using the ATF/Jet Fuel futures or by surrogate means using crude oil futures or heating oil futures due to a very high degree of correlation between the prices of ATF and crude/heating oil. Since fuel has become the major component of expenses of airlines, many airlines like Lufthansa have created a separate department to devise strategies on oil. It has been observed that the strategies of such airlines have been predominated by fuel hedging. Hedging- A Lone Rescuer With relentless oil price fluctuations, and uncertainty of the results of bio fuel, the only answer for Indian Airline companies is to take a leaf out of the book of their global counterparts and incorporate a sustained hedging programme to maintain fuel cost as a percentage of total expenditure. Fuel Hedging and Global Carriers Fuel hedging is best exemplified by Southwest Airlines, a low cost American carrier, whose hedging against rising fuel costs has helped the discount carrier soar high above its competitors. Southwest treasurer Scott Topping mentioned in an interview that with their hedging advantage, they have enjoyed more flexibility in managing revenues. Southwest locked in oil at $51 a barrel prior to crudes yearlong run-up in the year 2007. For the first nine months of 07, the Dallas-based carrier realized gains of $427 million. Those hedging profits, a result of a shrewd call by Southwest CEO Gary Kelly, have kept costs down. To have a better understanding of the standing of airlines in term of hedging, let’s look at the Air Fuel Expense and hedging Summary for major airlines of US for the year 2003-04. Fig. 3 summarizes the fuel expense and hedging strategies for the 13 US airlines included in this analysis. [pic] Fig. 3 It can be seen in the figure the low cost carriers like Southwest and JetBlue are the major hedging airlines. Because of its hedging strategy, Southwest Airlines is termed as a hedging firm instead of an airline. However, the financial results of these airlines show that hedging has helped them to sail across in trouble water. Further, In addition to the obvious importance of controlling such a significant operating expense for an airline, numerous academic studies have demonstrated that measurable fuel hedging can increase the value of the firm. While there are a number of factors that influence an airlines valuation, the valuations of the airlines (as measured by the firm’s price to revenue ratio) do have a positive correlation coefficient with the airlines level of fuel hedging, as shown in Fig. 4. Price/revenue ratio is presented rather than price to earnings because many of the airlines have negative earnings. [pic]LUV – Southwest, JBLU- JetBlue, AMR- American, AAI – Airtran Holdings, FRNT – Frontier, MEH – Midwest Air, NWAC – Northwest, CAL – Continental, DAL – Delta, UALAQ- United, ATAH – ATA, UAIR – US Airways Fig. 4 Fig. 4 clearly shows that Southwest Airlines, and JetBlue, the airlines which hedge most, are valued proportionately higher than other airlines. The confidence of investors is higher in these airlines because their hedging strategies cover them against any fluctuation in fuel prices. Hedging is not only common among US carriers, the European carriers like Lufthansa and Air France-KLM have also shielded themselves from fuel fluctuations by locking into fuel hedging. Lufthansa hedge almost 85% of its fuel consumption and has increased its operating profit by 63% for fiscal year 2007-08. Airlines from Asia Pacific region such as Malaysian Airlines and Singapore Airlines have also used hedging during the fuel fluctuation. Fuel Hedging and Indian Carriers While aviation firms around the world have taken to hedging to insulate themselves from the high oil prices, Indian carriers have generally shied away from it. In 2007 when the government allowed hedging, Air India was the first airline in the county to hedge but soon backed out after it saw losses. Air India did hedging of 10% of its fuel consumption on NYMEX. A senior Air India executive told that the airline initially made money through hedging. But after a round of losses when oil came below the hedged prices, it discontinued the practice as no one wanted to take the risk. Unfortunately, such past experiences are still discouraging airlines from adopting a hedging strategy. Hedging is also considered to be a specialist domain which has resulted in some airlines staying away from it. A Raghunathan, CFO, Kingfisher Airlines, in his interview to DNA Money said, Because it was not allowed in India earlier, the expertise required for it is not available. However, airlines are waking up to the profits of hedging. â€Å"Hedging has not been traditionally done in India. In hindsight, it sounds wise today to have done that,† GoAir spokesperson Neeraj Kapoor quoted in a DNA Money. The company is evaluating the process of hedging. Fuel hedging is only allowed in India in 2007 by RBI. Earlier if an airline wanted to mitigate the risk of fuel prices; it could only hedge in foreign markets. This has also discouraged carriers as trading in foreign markets expose them to the problem of currency fluctuation. It’s like evading one problem to accept other. As an effect of RBI orders, MCX (Multi-Commodity Exchange of India Limited) has introduced ATF futures and crude oil futures. Fuel Hedging – Available Hedging Options in India ATF Futures Airlines in India can do hedging in both domestic and international markets. MCX has been given nod by the Forward Market Commission, the commodity markets regulator, in April to offer ATF futures. ATF futures are now available in futures market for trading. Appendix 1 details the different ATF futures contracts available for trading on MCX. Appendix 2 shows the month wise turnover for ATF futures as compared to other commodities futures on MCX. Since the trading of ATF futures has only started in July, figures are only available for the month of July. ATF futures can also be traded on JPTC. Airlines are a little suspicious of the hedging of ATF futures because the volume available for hedging is small and lack of availability of past trends. Crude Oil Futures ATF is only traded on only two commodity exchanges around the world – MCX and JPTC. So, airlines around the world, especially American and European carriers use surrogate hedging which basically means use of alternate commodity which has a high degree of price correlation with the original commodity. In the case of ATF, Crude oil and heating oil are the alternatives for ATF. As can be seen the figure below, there is a high degree of correlation between the price of Brent crude oil and Jet fuel. In the surrogate trading the actual transfer of commodity doesn’t take place. If the prices go up then profit earned in futures market can be used to buy Jet fuel in the spot market. [pic] Same holds true for heating oil (refer figure below) which is the main commodity of hedging by the airlines. In the US primarily airlines prefer heating oil for hedging. The number of contracts purchased depends on the correlation between the prices of the commodities. pic] Preferred Option in India – Brent Crude Oil Hedging For the quarter ending June’08, ATF futures were not available for trading. First future contract on MCX has expiry of July’08. So, Brent Crude oil (BRCRUDEOIL) futures traded over MCX are preferred to construct the model. Moreover, the ATF futures contracts volume is low which is deterring investors from investing. It has also be en noticed that ATF futures are 6 months contracts while the Brent Crude oil contracts are 3 months contract, so in the scenario like present days the short duration derivatives are preferred. In addition, the movement of the prices of both commodities is similar (refer Appendix 3). Hedging for Jet Airways Jet Airways along with Jet Lite is the largest carrier in India. It has the fleet of more than 100 aircrafts used for both domestic and international operations. For the two consecutive years, it has generated significant operating profit, but for the quarter ending June’08, it suffered an operational loss of Rs. 3950 millions (refer Appendix 4). The Fuel expenses, which used to constitute 25-30% of total expenses, were Rs. 3040 millions; approximately 40% of Jet Airways’ total expenses (refer Appendix 4) because of soaring Jet fuel prices. Jet Airways had hedged once on foreign bourses when fuel hedging was not allowed in India. However, due to the impact of currency fluctuation on the returns from hedging, the experience wasn’t satisfactory. Based on this experience, it didn’t opt for hedging during the recent times. But, according to Jet Ai rways’ Saroj Dutta, Jet Airways is now contemplating to enter into hedging and is evaluating various options. It would be prudent to use Jet Airways example to understand the intricacies of Fuel hedging. The analysis of the quarterly results, for the quarter ending June’08, shows that the operating losses that Jet Airways incur were almost 30% of the total fuel expenses. If we assume that the quantity of fuel required for the entire quarter was constant, then the 30% reduction in fuel expenses can flatten the operating losses to zero. Let’s use hedging to analyze the scenario. The prices of crude oil have seen unexpected surge in the first of quarter of the year2008-09, so the importance of hedging can be best demonstrated for the data pertaining to this quarter. Since surrogate hedging is done, Jet Airways will take only position, and will not take actual delivery of the Brent Crude. The futures contracts available on MCX have a period of 3 months. To hedge for the month of April, the airline can start hedging in Jan. It is assumed Recommendations The analysis of the contemporary position of airlines with respect to surge in fuel prices suggests fuel hedging is the call of the situation and air carriers should start evaluating it as a potential strategy against the fuel spikes. Hedging can help airlines generate stable cash flows. In an uncertain environment hedging airlines are able to predict future cash flows and earnings and make investment during the high stages of the price cycle; such a strategy is valued higher by the investors. Secondly, hedging allows airlines to take advantage of investment opportunities in times of high commodity prices. It is more likely that airlines will go bankrupt when fuel prices are very high, and in such cases they are often forced to sell planes and other assets at substantially below-market prices. Airlines that are hedged against higher prices will have more resources available to invest and are therefore the only ones able to purchase these discounted assets, thus strengthening their competitive position and growing value. Hedging is not believed to be a long term solution to the fear of fuel hike. It flattens the spikes for a small duration. The airlines should really start looking for alternate fuel for sustainability in the future. A few millions spend now on technology upgradation and on research of alternatives can earn billions for the industry in the future. The aircraft manufactures should be encouraged to innovate to decrease the dependency on the nemesis. Airlines also need to evaluate other options to reduce the expenses. The complete operational model should be reviewed to take care of different scenarios. Airlines should look for lighter aircrafts as the fuel consumption is directly proportional to the weight of an aircraft. Other methods like revision of wage structure, scrutinization of non-profitable routes and optimum utilization of aircrafts should be incorporated by carriers. Hedging, however, comes with a word of precaution. Airlines in the wake of saving themselves from future crisis after seeing the sudden surge of crude in the recent past, should not indulge themselves in over-hedging, hedging more than expected to be consumed. Fuel hedging can also result in losses if the prediction goes wrong and prices come down. If, for example, an airline forecasts that it will burn 100,000 gallons of jet fuel in a given month, hedges 100% of this usage, and then uses only 80,000 gallons, it calls into question the company’s ability to hedge. Therefore, it should be a common practice for firms to hedge up to the level they are certain to use, and remain unhedged for any additional consumption. Airlines should always devise a strategy by understanding the recent trends how much short and how much long it should go. Hedging with an Example Over hedging should be avoided Other alternatives should be analyzed at regular interval Other startegies like reduction in the weight of an aircraft Wage structure should be revised Portfolio should be preapred for hedging pic] Source: www. iata. org Fig. 2 What is more disturbing to the airlines than the rise in fuel prices is the drop in Consumer Confidence Index as can be seen in, Fig. 2 which is released IATA in financial forecast statement, June’08. The figure is depiction of Confidence Index of US consumers. The 2. 5x rise in fuel prices from 2003 to 2007 was survived by the industry because during that same period consumer confidence rose, the world economy experienced exce ptionally strong growth, and airline revenues boomed.