Explainer: fuel hedging and its impact on airlines and airfares

When airlines fill up, it’s not always easy to work out the cost. Patrick Lauke/Flickr, CC BY-NC-ND

With oil prices on the decline, and analysts predicting record profits for the 2014/15 financial year, Qantas and Virgin Australia are under increasing pressure to abolish fuel surcharges and lower their fares.

The Australian Competition & Consumer Commission is investigating whether Qantas has been misleading with its surcharges, amid a growing perception airlines are pocketing all the fuel savings without passing any of the benefits on to their loyal customers.

Virgin Australia moved first by reintegrating the fuel surcharges on the Sydney to Los Angeles route, the only Virgin route to which the surcharge applied. Qantas followed this week by lowering the fuel surcharge for frequent flyer point redemption tickets on some routes, including to the US and Asia, but not Europe. Qantas will absorb all fuel surcharges into the base fares as soon as hedge contracts allow it and/or competition forces it to do so. As consumers are traditionally less price sensitive to the fuel surcharge compared to the base fare, unbundling both has been beneficial to airlines. The question is not if but when fuel surcharges, which only apply on international flights, will be reintegrated into the ticket price. All fares (including domestic) are also expected to come down further.

Over the past decade fares and cargo rates have fallen globally by around 60% after adjusting for CPI inflation, according to the International Air Transport Association. Qantas’ international airfares, including the fuel surcharge, have never been lower than today. Consumers have therefore enjoyed lower fares while jet fuel prices went up, which is not something other transport modes can claim.

In theory, airlines should be among the top beneficiaries of the oil price slump as fuel costs have become the largest cost category for airlines in the last decade, often representing 30-40% of total operating expenses.

Low-cost carriers are particularly exposed to fuel price changes, as they have reduced all other costs (such as staff costs) to a minimum. For example, Air Asia’s aircraft fuel expenses are around 47%. This means nearly all low cost carriers hedge, with the most famous and successful example being Southwest Airlines.

The impact of hedging

While it is a no brainer that airlines will benefit from the recent sharp decline in oil prices (more than 50% since last year’s peak) in the long run, in the short to medium term hedging contracts and foreign exchange rate risks can make things a lot more complex.

The International Air Transport Association expects airlines to post a collective global net profit of some US$25 billion in 2015 with lower oil prices being one of the main drivers behind the improved profitability. Given that the 40 year average net post-tax profit margin of global airlines is around 0.1%, the soon to be materialised profits are important for much needed capital and debt management as well as fleet modernisation and product improvements.

That said, despite all the excitement about the massive profits the hedged airlines will soon be making, IATA expects the return on invested capital (ROIC) is to grow to 7.0% only. While this is a significant improvement on the 6.1% 2014 ROIC it is still 0.8 percentage points below the 7.8% expected weighted average cost of capital (WACC), so most airlines will still destroy shareholder value. For Australian airlines the recent 20% depreciation of the Australian dollar means that some of the fuel price gains will be diminished as most of the jet fuel (and many other airline expenses) is traded in US dollars.

What is more, most airlines (and their customers) need to be patient as lower fuel prices will be realised with a time lag, due to forward fuel-buying practices that are aimed at protecting both airlines and their consumers. Qantas is no different, with the airline expecting only a A$30 million benefit from lower fuel prices in the first half of FY 2015, which is in the context of an annual fuel bill of around A$4.5 billion. Not exactly a huge cost saving (yet) that could translate into profits or eventually lower fares.

Fuel hedging is just one example of the risk mitigation strategies taken by airlines. The exposure to risk relating to the volatility of fuel prices, currency fluctuations and interest rates are widely hedged by airlines using different types of financial instruments.

How different airlines approach hedging varies (e.g. disciplined Lufthansa versus Ryanair, which tries to out-manoeuvre the market). Some will hedge almost all of their fuel requirements, currency and interest rate exposures, some do not hedge at all.

Virgin founder Richard Branson: ‘The easiest way to become a millionaire is to start out as a billionaire and then go into the airline business.’ Rebecca Le May/AAP

Hedging doesn’t always work

During the last sharp fall of spot market oil prices (FY 2008/09 and related to the GFC), many airlines reported huge hedging losses (on paper) - for example Cathay Pacific (-$974m), Air China (-$994m) and Emirates (-$428m). More recently Delta Air Lines reported a US$1.2 billion charge for mark-to-market adjustments on its fuel hedges in 2014. As a result many airlines, including British Airways and Air France, scaled back their hedging for a while, and others stopped hedging altogether.

China’s government went one step further by banning all its airlines from fuel hedging. This means they are now in the best position to reduce international fares, but may pay down the track through full and immediate exposure to future fuel price increases.

Other airlines will report similar paper losses but will at the same time benefit from the fuel price drop as not all of their requirements are hedged and those that are hedged are often designed to cap losses both ways.

To determine whether airlines speculate with the fuel price requires in depth analysis on the types of fuel hedge instruments they use.

Transparency of charges

A lack of disclosure requirements makes it almost impossible to establish how exactly or when airlines have hedged. None of them would of course publicly discuss details of their strategies, as successful fuel hedging is a competitive advantage. Most airlines use “costless” collar hedging which is using a call option while at the same time going short with a put option at a lower strike price. By doing so the airlines can cap their losses and pay for it by also limiting the upside benefits, which therefore limits volatility and clearly shows hedging is not a bed of speculation but is purely protection from volatile fuel prices.

Locally, Qantas, Virgin Australia and Air New Zealand are all heavily hedged. Qantas at 94% (1H2015), Virgin Australia at 72% (at A$110/bbl for FY15) and Air New Zealand at 78% of 1H2015 and 56% of their 2H2015 estimated fuel requirement.

Etihad has stopped its fuel hedging recently and Chinese carriers are not hedged at all. This makes them currently more flexible in their pricing strategy, but they can only be so as they are state backed and less concerned with their exposure to future oil price hikes.

Ultimately, large privately run airlines rely on stable ticket pricing and costs for achieving profitability. If they are not hedging, then they are essentially speculating (that oil prices will fall further), don’t engage in hedging because their balance sheet is not strong enough (e.g. American Airlines for many years) or have the ability to immediately pass on fuel-driven inflation to customers (which in Australian is nearly impossible). It is therefore inevitable that there will be a time lag in terms of customers being able to enjoy lower fares as a result of lower jet fuel prices.

Once the airlines are paying fuel prices close to the current low spot market prices, competition will force them to pass on much of those savings to their customers. What will not be passed on will ensure that private investors will see at least some return on their investments in this extremely competitive market.