What is Fuel Hedging ?
Fuel Hedging a Financial Risk Management Tool (contractual in nature between Airlines and Oil companies) for some giant fuel consuming industries, such as airlines industry, to save their business from or to take the advantage by striking the correct deal with the oil companies against the abrupt rise or fall in the price of fuel in the international market.
The companies enter into hedging contracts to mitigate their exposure to future fuel prices that may be higher than current prices and/or to establish a known fuel cost for budgeting purposes.
For an example if an airline company enters into the contract by fixing the fuel price for a certain period in future and the fuel price in the market declines then the company will eventually be forced to pay an above-market rate for fuel converting the deal into a loss for them but a benefactor for the oil Company. So, the Vice-versa may help airline to reduce on their operating cost significantly.
Logic Behind Hedging !
Since airline operates on a very tight RASK (revenue available per seat kilometer) so it becomes necessary for it to apply some financial tactics to squeeze out all possible gains from the current market.
The cost of fuel hedging depends on the correct speculation of the future price of fuel in the market. Airlines may place hedges either based on future prices of jet fuel or on future prices of crude oil.
Companies which consume large volumes of fuel and do not hedge their fuel costs generally believes one, if not both, of the following:
- The company has the ability to pass on any and all increases in fuel prices to their customers, without a negative impact on their profit margins.
- The company is confident that fuel prices are going to fall and is comfortable paying a higher price for fuel if, in fact, their analysis proves to be incorrect.
Note: Typically, airlines will hedge only a certain portion of their fuel requirements for a certain period, though market research and great efforts are applied but still it is a big gamble. Often, contracts for portions of an airline’s jet fuel needs will overlap, with different levels of hedging expiring over time.
During the 2009-2010 period, the studies for the airline industry have shown the average hedging ratio to be 64%. Especially during the peak stress periods, the ratio tends to increase.
Example of ULCC (ultra low cost carrier)
Southwest Airlines tends to hedge a greater portion of its fuel needs as compared to other major U.S. domestic carriers. Southwest’s aggressive fuel hedging has helped the airline partially avoid financial consequences caused by airline industry downturns (e.g., the downturn caused by the 2000s energy crisis). Between 1999 and 2008, Southwest saved more than $4 billion through fuel hedging under the strategic leadership of former CFO Kelly (who became CEO in 2004, and President and Chairman in 2008).
Crude Oil Example
As one can figure out the unexpected fall in the crude oil price in the year 2020 (Q2), at dollars 40 per barrel was really a “Boon” for airlines which had not opted for the strategy of fuel hedging before quarter 2 of 2020 taking into account the decreasing slope of fuel prices, but the airlines which had opted for this strategy during Q2 or after it for year 2020 considering the increasing fuel prices thereafter benefitted greatly from the strategy.
So, how do you find this financial risk management tool – Fuel Hedging please comment below and share your ideas.