Airline Jet Fuel Hedging: Theory and Practice

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Airline Jet Fuel Hedging: Theory and practice

PETER MORRELL and WILLIAM SWAN

Department of Air Transport, Cranfield University, Bedford, UK

ABSTRACT Hedging fuel costs is widely practiced by most international airlines

but its theoretical justification is weak. This paper explores the nature and extent of

airline fuel hedging and asks why airlines hedge. A policy of permanent hedging of

fuel costs should leave expected long-run profits unchanged. If it damps out profit

volatility, it should do so in a way that the market would not value. However, it may

not damp out volatility, after all. Oil prices and air travel demand cycles are linked

when oil supply reductions drive GDP declines. But oil and travel are negatively

correlated when GDP demand surges drive oil price increases. So oil prices can

either increase or decrease airline profit cycles, depending on the time period

sampled. A fuel price hedge would create exceptional value when an airline is on the

edge of bankruptcy. However, when on the verge of bankruptcy, an airline does not

have the liquidity to buy oil futures. And variable levels of hedging can be useful in

transferring profits from one quarter to another. Finally, hedging may be a zero-cost

signal to investors that management is technically alert. Perhaps this is the most

compelling argument for airline hedging. However, it lies more in the realm of the

psychology of markets than the mathematics.

Correspondence Address: Peter Morrell, Department of Air Transport, Cranfield University, MK43

0AL, UK. E-mail: p.s.morrell@cranfield.ac.uk

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Introduction

Airlines do something the industry calls 'hedging' to protect fuel costs. Hedging

broadly means locking in the cost of future fuel purchases. This protects against

sudden losses from rising fuel prices. Locking in fuel prices also prevents sudden

gains from decreasing fuel prices. So airlines hedge fuel to stabilize fuel costs. Fuel

is about 15% of the airlines' costs. Other costs are less volatile than fuel prices, so

hedging fuel stabilizes overall airline costs. More stable costs also mean more stable

profits.

Conceptual hedge transaction

Most fuel hedges are purchases of an oil future. A future is a contract to pay a stated

price for an amount of oil on a particular date. If the airline buys a future at $22 per

barrel and oil goes up to $33, that contract protects $22 worth of jet fuel purchases

from the expected 50% increase in price. Section 3 examines futures and derivative

instruments in some detail. Airlines typically hedge between one and two thirds of

their expected fuel costs. Most airlines look forward six months in their hedging.

Few hedges are forward more that a year out.

What hedging does

Why airlines hedge is the topic of this paper. The commonly stated reason is that

hedging stabilize fuel prices and therefore overall costs, cash flows, and profits. The

implication is that the market will respond to reduced volatility in profits with a

higher price for the airline's stock. This implication is deduced from the correct

observation that risk has a cost in the investment marketplace.

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Airline profits are volatile for two reasons. First, travel demand is sensitive to

consumer confidence, which itself is correlated with stock market performance. And

second, airlines themselves are highly leveraged, in the sense that the total value of

outstanding stock is a small fraction of annual incomes. Small changes in profits as a

fraction of revenues make for large changes in the return to stock shares.

The theory behind airline fuel hedges is to reduce a major source of swings in profits,

and thus higher prices for the airlines' stocks. This theory is confirmed by analysts

who forecast airline stock prices. They observe and comment on the degree to which

an airline might be hedged, whenever fuel prices themselves are uncertain.

Most traded airlines today hedge fuel costs. This has not always been the case. As

recently as 15 years ago, fuel hedging was rare. European flag carriers used currency

hedges long before fuel price hedges became common.

Logic of hedging

The theoretical justification for hedging fuel costs is weak. Classical investment

theory holds that investors reward stocks for their performance as part of a larger

portfolio. And portfolio investors can hedge oil to balance their returns at their own

discretion. As we shall see later, there are conditions where hedging does help.

However, the baseline case of using hedging to reduce airline profit swings is weak.

There are even market reasons to avoid hedging.

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