Hedging of jet fuel

04 September 2010

PETALING JAYA: To hedge or not to hedge? The medium-term volatility of oil prices is giving the aviation sector a headache.

While hedging is an instrument that airlines can use to mitigate the impact of rising jet fuel costs, it is becoming increasingly difficult to rationalise the use of such an approach given the downward risk of global crude oil prices.

“The oil price volatility is one, an airline’s limited resources to invest in such an activity is another,” an analyst with a foreign research company said about challenges that airlines face today in getting their hedging position right.

“But if they did not hedge, rising jet fuel could potentially crush their operating margins, and dent their financial positions,” he added.

Crude oil prices, which determine the direction of jet fuel prices, are expected to average at US$79 a barrel by the fourth quarter of this year. As of last week, the International Air Transport Association’s (IATA) forecast of the average jet fuel price for 2010 stands at US$88.30 per barrel.

Industry experts claimed that crude oil prices could rise to an average of US$85 a barrel next year and US$100 a barrel by 2012.

Nevertheless, the trend of these oil prices remained largely unpredictable due to the weakening momentum of the global economic recovery.

As it is, some argued that there were more downward potential to crude oil prices (than there were upside potential) as they saw demand for the commodity softening in line with the trend of a slower economic growth in the next one to two years.

Still, not many airlines can afford to take the risk. This is because jet fuel represents one of the single-largest cost components for most airlines, accounting for up to one-third of their operating costs per passenger.

So, managing the cost element becomes even more significant as failure to do so can be detrimental to the business of the carrier.

A case in point: According to IATA, 25 airlines went bankrupt in the first half of 2008 due mainly to their inability to cope with rising fuel costs.

To recap, crude oil prices then were rising progressively from US$75 per barrel in the middle of 2007 to an all-time high of US$147 in July 2008.

Consequently, jet fuel prices within a span of 12 months also surged more than double to surpass US$170 per barrel in the middle of 2008. (Crude oil prices have since fallen to hover around the US$70 to US$80 per barrel level now, while jet fuel prices are currently hovering around the US$85 to US$95 per barrel level.)

So, to help stabilise their cost structures, airlines would typically hedge a portion of their fuel requirements at a pre-determined price for a specified period, while leaving the remainder to be purchased at spot prices.

Domestically, we see national carrier Malaysian Airline System Bhd (MAS) hedging 60% of its fuel requirement at US$100 per barrel for the rest of 2010, and 40% at US$100 per barrel for 2011, while local low-cost carrier AirAsia Bhd has hedged 26% of its fuel requirement at US$85 per barrel for 2010.

AirAsia has not entered into any hedging yet for 2011.

“Given the downside risks of crude oil prices, no one can be for sure whether it is a right or wrong strategy to hedge.

“As long as the airline hedges its fuel requirements, there will always be the realisation of marked-to-market gains or losses for every quarter of their financial results,” an analyst explained.

It’s a bet, analysts note. If airlines hedged their fuel requirements at a price lower than the market prices, then they would have protected their margins from being crushed by rising fuel prices.

But if market prices of fuel did not rise above the level at which airlines have hedged, then their under-hedged position would cost them extra money, which could probably lead to some booking losses.

For instance, MAS booked a marked-to-market loss of RM217mil from its hedging position for the three months to June 2010, widening its net loss to RM537mil for the period in review.

The average price of jet fuel for the quarter to June was around US$90 per barrel.

Chances of the jet fuel price exceeding US$100 per barrel for the rest of this year are slim, hence it is likely that MAS’ financials would continue to be burdened by its hedging position.

Nevertheless, investors have to take note that marked-to-market gains or losses resulting from hedging positions do not in any way reflect the airlines’ operational efficiency.

“It’s just a tool to mitigate fuel price volatility, and probably help to a certain extent... but ultimately, airlines would have to focus on the structural part such as fleet modernisation and optimal utilisation of resources to improve their operational efficiency and effectiveness, and that’s what gives them the competitive edge over their industry peers,” an analyst explained.

“And as long as the airlines can grow their revenue per available seat kilometre, they will be in a better position to cushion the effects of fuel price hike and enjoy better margins,” he added.

By Cecilia Kok

The Star