China's state-owned airlines have had a turbulent year and are warning of first-half earnings to match when they report later this month.
With the bulk of their earnings in renminbi and fuel and aircraft costs denominated in US dollars, China's big three airlines benefited from the Chinese currency's steady appreciation against the greenback over the past decade.
China Eastern, the country's biggest carrier,was the latest to brace shareholders for disappointing numbers. Last month it said it would book a first-half profit of less than Rmb 50 million ($8 million) compared with a Rmb 582 million profit for the same period in 2013.
Based in Shanghai, China Eastern has also borne the brunt of recent cancellations stemming from Chinese military exercises, which have caused widespread disruption to flight services across eastern and central China. As many as 26,000 flights could be affected by the time the People's Liberation Army operations end in mid-August.
An unexpected reversal of the renminbi's uptrend, with the Chinese currency slipping from Rmb 6 to the dollar to Rmb 6.25 earlier this year, has inflated the value of the carriers'already high debt levels in local currency terms.
"Most of the negative foreign exchange impact comes from the balance sheet and the mark-to-market of their US dollar debt," says Patrick Xu, aviation analyst at Barclays. "These companies are very highly geared."
Macquarie estimates that at the end of last year, before the renminbi began to fall against the dollar, the big three's net debt to equity ranged between 180 percent and 267 percent. China Eastern is the most heavily indebted, with its gearing expected to rise to almost 500 percent next year.
But analysts at both Barclays and Macquarie have either buy or hold recommendations on Air China and China Southern, citing strong underlying passenger demand, their monopoly pricing power on lucrative domestic routes and a resumption of the renminbi's upward trend against the dollar. Barclays also recommends buying China Eastern shares, while Macquarie has an under-perform rating on the stock.
Chinese airlines'pricing power has insulated them from the worst effects of stubbornly high fuel prices. While fuel is their biggest expense item, accounting for more than one-third of total costs, the big three – which cumulatively spent Rmb 99.9 billion on fuel in 2013 – are able to pass along about 75 percent of fuel increases to domestic passengers and 50 percent to international passengers.
The airlines are also contemplating a resumption of fuel hedging activities. China's regulator banned the carriers from buying crude future contracts – a key form of protection against rising fuel costs – after they incurred heavy losses in 2009 by betting the wrong way on crude oil price movements.
Air China said in March that its board had approved a resumption in hedging activities "according to market conditions", but confirmed on August 13 that it had not yet resumed the practice. China Eastern and China Southern declined to comment on any plans to resume hedging.
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In contrast, Hong Kong-based Cathay Pacific, which is also insulated from currency fluctuations by the Hong Kong dollar's peg to the US dollar, has said it has locked in 25 percent of its fuel requirements through the first half of 2015 at Brent crude oil prices of less than $100 a barrel. Singapore Airlines hedges up to 60 percent of its fuel requirement. On Friday Brent crude oil was trading around $103 a barrel.
In announcing a HK$347 million ($45 million) first-half profit last week Cathay cited a fuel hedging gain of more than HK$1 billion although its overall fuel costs still rose because of a 6 percent increase in consumption.
"Managing risk associated with high and volatile fuel prices remains a priority," said John Slosar, Cathay chairman. "Our fuel hedging extends to 2017 and we have taken advantage of downward movements in fuel prices to take up new positions."