Fuel hedges prove costly gamble for Asian airlines

To keep themselves above water, regional airlines must salvage any possible costs or seek to book higher profits by trimming hedges, some analysts say

SINGAPORE: Asia-Pacific airlines have clipped their fuel hedges to save on steep premium costs as oil slid to three-month lows, but they need to keep a consistent ratio to safeguard against volatile price swings.

A likely slowdown in global travel and ballooning fuel costs, which have more than offset a series of fare and fuel tax hikes and led to industry-wide losses in the second-quarter, have forced many airlines to scrap routes.

Some have even been threatened by insolvency.

To keep themselves above water, regional airlines must salvage any possible costs or seek to book higher profits by trimming hedges, betting on sustained price falls rather than a rebound to new highs, some analysts said.

“Hedging gives you the ability to fix costs and/or profit margins, but it typically takes away potential for windfall profits for favourable price movements,” said Gerard Rigby of Fuel First Consulting in Sydney.

US oil futures have deepened their losses to three-month lows below US$120 a barrel this week from a record of US$147.27 last month, but were still around a fifth costlier than the start of the year.

The cost of jet fuel jumped almost 70 per cent over the past year to US$144.00 a barrel in Singapore trading, though it came off the record of US$181.65 a barrel reached last month.

But premiums in options are still high as volatility persists, said Rigby.

For example, the cost of ATM (At The Money) WTI Call dropped US$2 a barrel to US$17 a barrel but almost doubled from US$9.50 in November for calendar 2009.

“Option premiums are a function of volatility and price levels, so evidently they have become more expensive,” said Gerard Raynor of Societe Generale in Paris.

Fuel hedges — financial products that give a buyer the right to buy fuel at a guaranteed price — protect companies from price rises, but also increase their costs when prices fall. Hedging contracts are usually options.

Some argue that airlines’ attempt to overreach by making money in oil trading distracts them from their basic business.

“If they have bought calls, then they could just be losing the price of the premium. But at US$17 per barrel, that is a lot to lose straight up. It is always the hardest question to answer for hedgers — do they hedge now or wait for the market to dip?” said Rigby.

CONSISTENCY

But derivatives traders spoke against frequent changes to the hedge ratio to save on premium costs, and urged airlines to adopt a more consistent strategy by having a fixed quantity of hedges.

“The more often you change your hedge ratio, the more you are gambling,” said Peter Lengyel, a consultant with JBC Energy in Vienna.

“Airlines are not traders. They are not in the business of buying and selling. They go into the market to protect price levels on fuel purchases and these are strategic decisions.”

Carriers embark on different hedge strategies, depending on their risk appetite. Established ones with deep pockets, such as Singapore Airlines (SIA), tend to hedge within a range regardless of oil price moves.

SIA hedged about 36 per cent of its fuel needs at an average price of between US$104 and US$109 a barrel, in line with its policy to hedge between 30 and 60 per cent.

Air New Zealand shaved fuel hedges to 65 per cent in the first quarter of financial year 2009 (July-September), from 83 per cent of the last quarter of financial 2008 (April-June).

Japan Airlines Corp trimmed hedges to 75 per cent for March 2008-April 2009, from about 90 per cent a year ago.

Australian flag carrier Qantas cut hedges to 65 per cent for financial year 2008-2009 (July 1 to June 30), at around US$116 a barrel for crude inclusive of option premium, from a previous hedge of 100 per cent locked at US$75 a barrel.

“Hedging is now more expensive. Option premiums have surged as the oil price has increased and there is more uncertainty in the market,” said a spokesperson from Qantas.

But All Nippon Airways Co held onto a heavy hedge of 80 per cent. Thai Airways hedged about 30 per cent of three months’ demand.

Smaller ones, such as Malaysia’s AirAsia, are more flexible in their hedge. AirAsia, which hedged around 40 per cent as of October 2007, said in June it had not done so for second-half 2008, betting on oil prices to moderate.

Jet Airways Ltd, India’s top private carrier, shelved hedging plans due to high crude prices. Air India, which used to hedge 10 per cent of its fuel needs on global bourses four years ago, is unhedged currently.

BOOK VALUE

The International Air Transport Association (IATA) said this week global air passenger traffic saw its slowest growth for five years in June, and warned the situation would “get a lot worse”. IATA has predicted airlines could lose US$6.1 billion this year.

Cathay Pacific, Asia’s third-most valuable carrier, had issued a profit warning, while Qantas might fire 1,500 staff and scrapped its growth plans.

Airlines that have cut their hedging needs are looking at the risk that oil may drift below the current guaranteed prices under their contracts. But experts also say that the hedge book has also become a key factor in the way people look at the value of the firm.

“Some airlines in the past don’t hedge fuel, but this is actually not accepted by the public and stock market nowadays,” said Kelvin Lau from Daiwa Institute of Research in Hong Kong.

“Therefore a small percentage of hedging should be sufficient to please the public and avoid too much loss on any oil price volatility.” - Reuters