To Hedge or Not to Hedge Airline Fuel Costs?

Posted by Sherry Hagerty, June 16, 2016 on Thursday, June 16, 2016

There is no shortage of dialogue on the positives of airlines hedging annual fuel requirements. Most energy trading professionals are astounded that many airlines do not hedge their fuel purchases. What trading desk wouldn't drool at the prospect of billions in easy, repeatable, hedging business annually? In an industry where fuel can comprise upwards of 30% of total annual costs, it would seem at first glance to be short sighted not to hedge. Combined with increasing competition, world globalization, and shrinking margins - it would seem to many to be just plain common sense. A closer look into the airline business quickly reveals a few reasons why airlines may choose to remain unhedged.
  1. Fixed Costs of Participating Deals - airlines don't want the fixed cost associated with a participating deal structure (think option premiums). With tightening margins, many airlines simply cannot (or are unwilling to) sustain the additional cost of a participating deal without additional negative margin impact. 
  2. Avoidance of Fuel Surcharges - many airlines do not want to introduce a fuel surcharge to cover the costs of a hedge. Fuel surcharges are too noticeable in a highly competitive customer service industry. Even if the executive and board were ok with the anticipated negative customer sentiment, introducing a surcharge in a falling price environment is near impossible. A hedge originating in a rising price environment with a term that continues through a falling price environment will find an unforgiving market demanding the elimination of the Fuel Surcharges levied to cover the hedge cost; regardless of the intention and term of the original hedge. 
  3. Not Core Business - energy trading and risk mitigation is not a core function in many airlines. Many airlines prefer to "hedge" using core business lines - flight path optimization, network optimization, aircraft utilization, revenue & price management, and even fleet re-configuration. These more familiar business lines are central to the airline industry - while often energy hedging is not.
  4. Explaining the Hedge and MTM - explaining a hedging program can be complex and difficult even to a seasoned energy executive and board. Adjusting accounting entries for the hedge MTM and explaining these adjustments can be daunting and time-consuming and leave opportunity for confusion, irregularities, and actions that might be considered unnecessary.
  5. Press Coverage and Executive Motivation - When companies hedge they should be looking for certainty, but the press and consumers are relentlessly negative when hedges do not "beat the market". For a publically traded firm - being "wrong" can have a significant risk to executives and share price - and the highly intertwined executive compensation packages.

Oddly enough, many of these issues are not isolated to airlines. The internal struggle with accounting for and communication of hedging programs resonates across many industries. Many producers faced the same scrutiny in past years over hedging programs that do not "beat the market" - including some of the larger and most profitable Alberta-based producers. Costs are near and dear to the heart of any business in the current environment - which could be resolved with lower fixed premium offerings. However with the current capital requirements and optimal use of limits in trading and risk shops this may prove to be prohibitive for the larger desks seeking higher year over year returns.



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