Asia Pacific Airlines at a Loss Over Fuel Hedges

Airlines in Asia Pacific are slashing fuel hedges, some to almost nil, after losing billions when oil dived last year, and as risk management costs rise due to volatile markets and credit-wary bankers.

Anat Givon / AP

While oil prices around $50 are a lesser worry for carriers besieged by declining cargo and passenger traffic in a global recession, analysts warn they may be missing the opportunity to guarantee lower fuel costs if prices extend their rally in  coming months, as many forecasters expected.

Once bitten, twice shy, reckon some airlines who are still paying off hedges locked in as crude oil rocketed to a record of $147.27 last July, before sinking back to $51 a barrel.

Jet fuel prices in trading hub Singapore have tumbled more than 70 percent from July peaks.

Others are put off by the rising cost of buying options in an oil market that is still finding its feet, or the fact that the investment banks who traditionally dominate the hedging business are more wary than ever of overextending themselves.

"The credit positions/exposure held by market-makers, that is, the banks, has ballooned," said Tony Nunan, risk management executive at Mitsubishi Corp in Tokyo. "I can't see banks offering highly competitive rates on options to airlines, since they are already carrying large enough airline credit risks," he added.

As a result, airlines across the region are paring back after the global industry lost up to $8 billion last year, since many have committed themselves to paying higher prices in the last months of 2008 because of hedging, the International Air Transport Association (IATA) said.

Air New Zealand hedged 77 percent for January to March this year, but posted a lower hedge of 66 percent for April-June. Thai Airways, which used to hedge a third of its fuel every three months, does not have any from April.

Singapore Airlines suffered S$341 million (US$224 million) in hedging losses from October to December, while Cathay Pacific Airways' unrealized mark-to-market losses on fuel hedging hit HK$1.9 billion (US$245 million) by end-February.

"Airlines are struggling to understand how to hedge this market, whether via options or cracks, or flat prices," said a derivatives trader in Singapore, who declined to be named. "It has to do with the uncertainty of their load as well. Under such financial scenario, they may end up overhedged if the load decreases."

Costly Option

Most airlines in this region use options to hedge, giving them the right, but not the obligation, to buy fuel at a fixed price in the future. While it protects them from further rises, it increases their premium costs when prices fall, especially in a volatile market with rising volumes.

This happened when oil prices fell much more than expected, which saw many of these "put" strikes breached to the downside, analysts said. The airlines have become "long" at the put strikes and these are under water.

For example, the cost of ATM (At The Money) WTI Call rose to $4.10 a barrel on March 17, from $3.40 on Feb. 16, data from Hudson Capital Energy showed. At over 70 percent, implied volatility for ATM crude is down from a peak above 100 percent in December, but still double pre-September levels.

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"Directionally, option premiums would go up with the increased volatility. The banks would include a lot more fat in pricing their options given the credit problems," said Gerard Rigby of Fuel First Consulting in Sydney.

The other option for airlines is to hedge by buying forward crude contracts or swaps outright, which guarantees them a fixed price but does not offer the potential for savings if oil prices actually fall below the level that they paid.

For many in the industry, however, that drifts dangerously close to calling the market -- buying fourth-quarter crude now at $50 is for many as much a punt on rising prices as doing nothing is a punt on lower prices -- rather than insuring against risks.

"Personally, airlines should not hedge their fuel price too far forward. They should look at their business model," said a veteran trader, who declined to be named.

"Most airlines sell their tickets about two to three months in advance, and I believe that airlines should then hedge two to three months forward," said one veteran trader. "Never one to two years in advance  -- I'd call that speculative trading."

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