Hedging Your Flights

Consider this the next time you're enjoying your in-flight movie and sipping a complimentary Sauvignon Blanc at 30,000 feet: the fuel powering the engines, keeping your jet at cruising altitude and speeding you onwards to your destination is the single biggest cost airlines must bear.

Fuel costs are sky-high, according to the U.S. Air Transport Association (ATA). Just a penny increase in the price of a gallon (3.785 liters) of jet fuel would add as much as US$195 million to the annual fuel bill for U.S. airlines alone, given a consumption rate of 19.5 billion gallons per year, ATA data shows. If the price of jet fuel rose by a buck over the course of one year, that would translate to about US$19.5 billion more in operating expenses. Get the picture?

And according to the ATA quarterly airline cost index, fuel has overtaken labor as the industry's top cost and now constitutes 20% to 30% of industry operating expenses. With no alternative source of aviation energy commercially available -- it would take a brave soul to board a solar-powered jumbo scheduled for a night-flight -- making the right call on fuel purchases is critical to a carrier's commercial success.

For the airline's fuel buyers, navigating a way through often-turbulent energy markets, with their peaks and troughs, is no mean feat. Without the help of a time machine, you can't second guess the oil markets -- how many pundits predicted benchmark oil prices would near US$80 a barrel? That's why airlines try to limit their exposure to volatile market conditions by hedging.

This is a practice where airlines lock in part of their future fuel purchases at a set price. In short, airlines buy fuel in advance, under a contract guaranteeing a certain price no matter what the market does. Some contracts are purchased years in advance.

Scratching your head? Let's take a real life example.

The price of standard crude oil on NYMEX was under US$25 per barrel in September 2003. By August 11, 2005, it had risen to over US$60 per barrel, and topped out at a record price of US$78.40 per barrel on July 13, 2006. Crude oil currently as of March 22 is priced at US$61.72 per barrel.

However, many airlines have already purchased fuel in advance to ensure price stability and transparency for themselves and their customers. For instance, Virgin Blue said it had 95% of its fuel requirements hedged at US$70 a barrel for the rest of the current fiscal year. The hedging was probably executed around July 2006 when the price of oil had skyrocketed above US$78. At the time, hedging at US$70 was a savings. Who would have thought oil prices would tumble over 20% in less than a year?

So, sometimes hedging works and sometimes it doesn't. But it does assure price stability for customers.

Not every airline, however, can protect itself this way. Hedging is typically off-limits for smaller and underperforming airlines. U.S. Air Transport Association's Web site explains why: "It requires a relatively healthy financial condition, a willing counter-party, and often a hefty up-front transaction cost."

For those who can afford to hedge, what exactly do they do? Futures, options and derivatives markets help mitigate the risk. The strategy involves multiple transactions that offset profits or losses on a futures transaction against losses or profits on the physical purchase or sale of oil, says the ATA. Hedging helps to limit uncertainty over future costs. The emphasis is on the word 'limit' -- no airline is a hundred percent hedged and the practice can't guarantee total insulation from the vagaries of an unpredictable market.

In February, some Asian airlines have started to pare back some of their hedges, reflecting the pullback in oil prices, a Reuters report recently noted. Buyers are betting fuel prices have peaked after crude prices slumped from a record-high close to US$80 a barrel to below US$50 in mid-January. Japan Airlines hedged 41% of its fuel for the business year from April onwards. Compare that with 89% for 2006.

Oil prices have backed off, giving some much-needed relief for the airline industry and allowing buyers to take their fingers off the hedging button. Singapore Airlines, the world's biggest airline by market value, has said that the price of jet fuel, its single-biggest cost item, has declined. Be that as it may, prices remain historically high. It's more like a salutary note warranting some caution perhaps since we have no idea whether we're out of the woods at all. Upside risks in the oil market may have receded but have not disappeared entirely. Tensions between Iran, which holds OPEC's second largest reserves, and the U.S. are rising and a cold snap across the northern hemisphere may put oil prices back on the boil.

All this, of course, complicates the job of the airline's fuel buyer. So the next time you see the chap in business class poring over spreadsheets on his notebook, crunching numbers furiously and sweating buckets, don't be alarmed, he's probably figuring out how to hedge his airline's fuel purchases. And keep your plane in the air.