Value and effectiveness of fuel hedging by airlines

Fuel hedging is a widely practiced standard across most international airlines, however it has a weak theoretical rationale. When an airline is on the near of bankruptcy, hedging maximizes the value of its costs. When an airline is on the verge of bankruptcy, oil contracts have limited liquidity to be purchased (Chin-Yen & Jones, 2016). Hedging contracts assist airlines in reducing and stabilizing jet fuel costs. They are contracts that bind the agreement to purchase fuel at a predetermined rate and on specific agreed-upon dates.

Fuel hedging becomes legally binding when it reduces potential future costs. They get to be hedged now due reasons of the time value of money and inflation – future prices generally would be lower as compared to present values (Berghöfer & Lucey, 2013). They are a form of insurance policies and helps to protect the cost, and financial structure of airlines which might be heightened by catastrophic prices and unreasonable hiked prices which are highly likely to be seen in future of the going concern companies. Other several factors affect the prices of prices and that are both within and outside the firm and industry at large.

Hedging helps airlines to have fixed fuel costs for a given future period. Volatile costs can be managed on the short run basis. Airlines have only limited time to have the chance to have a clear roadmap on getting an almost “locked” structure on their cost accounting plans which regards jet fuel (Chin-Yen & Jones, 2016). Also, airlines have effectively had overlaps of hedging contracts that have enabled them to have varied portions of fuel requirements which covers several specified periods. Hedging has proved to be effective in preventing sudden losses that are anticipated in future periods and therefore, it would be safe to say that fuel hedging in airlines helped in stabilizing prices in the short run of the companies.

Methods used to hedge fuel cost by the airline companies

The three major methods used by airlines to hedge fuel costs include options, forward contracts and future contracts. These methods allow parties to buy and sell their fuel at set dates and with certain predetermined conditions. Delta airline, China Eastern Airline and Southwest Airline include notable firms that employ fuel hedging techniques on their crude oils. They have used these techniques to manage the fuel cost in both China and the United States, as indicated in their case studies. Their proficiency in this fuel hedging business has become a benchmark to other airlines that seek to reduce their huge costs on fuel and which mostly account for over 40% expense and the company’s total profits (Chin-Yen & Jones, 2016).

The above companies did pay lower amounts as compared to the current market prices that are observably high. The spot prices as at July 2008 were high and thus proved that their hedging strategies worked and had their fuel prices on the lower side (Chin-Yen & Jones, 2016). These companies made notable profits that other airlines in the aviation industry couldn’t afford to have. Their success was highly correlated with internal measures that proved to be viable in implementing the hedge. Most of their competitors had not seen this as a viable option in reducing costs (Chin-Yen & Jones, 2016). External considerations used were legal and other procurement consultancies. They helped in drawing a roadmap in their eventual profitability. The procurement methods were somehow seen to be primitive at first, but it later had a major impact in their various airline fuel hedging programs.

Successfulness of the methods employed

According to the case studies given, the procurement methods only worked for few years after its implementations, and they came into huge losses to the years after July 2008 (Manuela, Rhoades, & Curtis, 2016). It is seen that companies recorded huge profits out of this programs that meant to only lower spot prices of future fuel costs. The three companies hugely relied on future contracts that which were cheap and simple to the eyes of top management executives who were manning these airlines. The contracts were riskier in the sense that any loss incurred was obligated to taken by holders of these specified contracts. In some instances, losses were high and could not be contained and therefore having this long-term forwards, futures and options would be riskier than anticipated.

Lessons learnt

Hedging did not provide enough protection from its price volatility since they were only designed to offset the high jet fuels. Airlines should use fuel derivatives that reduce violations on prices that exposed to both the vendors and the buyers (Berghöfer & Lucey, 2013). There should be a balance between hedging programs and fuel derivatives which requires adequate management levels that would oversee every step.

Another lesson is that business strategies should be designed in such a way that business objectives recognize that are inherent risks that airlines would face and would, therefore, need necessary revisions to cater for the changing conditions. The hedging methods were somehow biased and could not be suitable be employed in the years after 2008 (Manuela, Rhoades, & Curtis, 2016). On the fuel hedging programs, airlines ought to direct their focus on decreasing the fluctuations impacts caused by the fuel prices. Ideally, fuel hedging programs can’t hold for long and airlines should not consider them as long-term techniques for cutting down on prices. They should only have several fuel hedging contracts that would overlap over the coming future years.

References

Berghöfer, B., & Lucey, B. (2013). Fuel Hedging, Operational Hedging and Risk Exposure – Evidence from the Global Airline Industry. SSRN Electronic Journal. http://dx.doi.org/10.2139/ssrn.2309510

Chin-Yen Alice, L., & Jones, K. J. (2016). Integrated Risk Management on Fuel Hedging Program: A Case Study on Southwest and China Eastern Airlines. Academy Of Business Research Journal, 274-85.

Manuela Jr., W.S., Rhoades, D.L., & Curtis, T. (2016, August). An analysis of Delta Air Lines’ oil refinery acquisition. Research in Transportation Economics 56, 50-63.