This presentation shows how important it is to have a comprehensive and targeted approach to hedging across asset classes. An isolationist approach where jet and fx are hedged separately could lead to losses to companies.
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Presentation on fuel and fx hedging for airlines
1. The importance of looking deeply into current airline hedging programs
HEDGING FUEL and FX for the AIRLINE SECTOR
Prepared by
Arshdeep Jindal
Gravitos Limited
www.gravitos.co.uk
2. Hedging remains very important
Source: Morgan Stanley Research
Current Scenario
Relentless efficiencies extracted by companies
in their operations means that ex-fuel costs
have dropped over the years. This leaves fuel as
the single largest expenditure on the income
statement.
Implications for airlines
• Earnings are most sensitive to fuel price
movements today than at any time before.
• A large proportion of the company cost base is
outside the control of management.
Response
The response from airlines has been on expected
lines. They have turned to financial hedging to
better manage this uncertainty.
Aim of a good hedging policy
• Reduce short term volatility in jet fuel prices.
• Not be an outlier in the competitive landscape
by paying too much for fuel in an adverse
market move.
• Protect the company for extreme market moves
to ensure the company does not face a threat of
survival in such a scenario.
All this needs to be achieved within the constraints
of cash flow
3. Fuel and FX hedging are intertwined
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Apr-2010 Apr-2011 Apr-2012 Apr-2013 Apr-2014 Apr-2015
Weekly Brent price in GBP
International fuel is priced in US dollars. Airlines this
side of the Atlantic have their revenues predominantly
in local currencies of GBP and EUR. This short USD
position leads to an additional layer of risk.
Currency Risks
Central banks are competing to debase their
currencies through more extraordinary actions than
ever before. This has left markets vulnerable to
extreme moves.
Source: ICE, Reuters
An absence to actively match hedging profiles of
currency with fuel can add significant volatility to the
effective price.
The graph below shows the effect on achieved price of
fuel in GBP when the currency hedge is executed with
a lag or lead of 1-3 weeks to the fuel hedge.
Source: Gravitos
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1w lag 2w lag 3w lag 1w lead 2w lead 3w lead
+/-GBPcostpertonne
Additional volatility from time mismatch of hedges
2H14 1H14
4. Appropriateness of trades to the fuel market structure
Fuel markets can have a contango or
backwardated structure. International storage
and supply and demand are the main factors
that decide the structure of the forward market
in fuel.
Contango
A market where the future price is higher than
the spot price is a market in contango. This
would imply that fuel is filling up storage. The
holder of a long position in this market will
experience a negative roll yield.
Backwardation
A market where the future price is lower than
the spot price is a market in backwardation. This
would imply that active storage drawdowns are
happening. The holder of a long position in this
market will experience a positive roll yield.
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1m 2m 3m 4m 5m 6m 12m 18m 24m 36m
PriceofBrent
Term Structure Shift
28/03/2014 (LHS)
Source: ICE, Gravitos
Balance between flexibility and protection
• It is important to focus on structures which do
not unreasonably restrict the company.
• Not all volatility is bad as long as it is made to
work for the benefit of the company.
• Focus should be to reduce volatility in the short
term while retaining a degree of optionality in
the long term.
• Protection needs to be balanced between
absolute and relative in a competitive landscape.
5. Appropriateness of trades to the fuel market structure
Fuel markets can have a contango or
backwardated structure. International storage
and supply and demand are the main factors
that decide the structure of the forward market
in fuel.
Contango
A market where the future price is higher than
the spot price is a market in contango. This
would imply that fuel is filling up storage. The
holder of a long position in this market will
experience a negative roll yield.
Backwardation
A market where the future price is lower than
the spot price is a market in backwardation. This
would imply that active storage drawdowns are
happening. The holder of a long position in this
market will experience a positive roll yield.
Source: ICE, Gravitos
Balance between flexibility and protection
• It is important to focus on structures which do
not unreasonably restrict the company.
• Not all volatility is bad as long as it is made to
work for the benefit of the company.
• Focus should be to reduce volatility in the short
term while retaining a degree of optionality in
the long term.
• Protection needs to be balanced between
absolute and relative in a competitive landscape.
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90
95
100
105
110
1m 2m 3m 4m 5m 6m 12m 18m 24m 36m
PriceofBrent
Term Structure Shift
30/09/2014 (LHS) 28/03/2014 (LHS)
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1m 2m 3m 4m 5m 6m 12m 18m 24m 36m
PriceofBrent
PriceofBrent
Term Structure Shift
30/09/2014 (LHS) 28/03/2014 (LHS) 30/03/2015 (RHS)
Appropriateness of trades to the fuel market structure
Fuel markets can have a contango or
backwardated structure. International storage
and supply and demand are the main factors
that decide the structure of the forward market
in fuel.
Contango
A market where the future price is higher than
the spot price is a market in contango. This
would imply that fuel is filling up storage. The
holder of a long position in this market will
experience a negative roll yield.
Backwardation
A market where the future price is lower than
the spot price is a market in backwardation. This
would imply that active storage drawdowns are
happening. The holder of a long position in this
market will experience a positive roll yield.
Source: ICE, Gravitos
Balance between flexibility and protection
• It is important to focus on structures which do
not unreasonably restrict the company.
• Not all volatility is bad as long as it is made to
work for the benefit of the company.
• Focus should be to reduce volatility in the short
term while retaining a degree of optionality in
the long term.
• Protection needs to be balanced between
absolute and relative in a competitive landscape.
7. Oil Market Update
Geo Political Risks
Saudi – Houthi conflict (Bullish)
1. The Saudis have launched airstrikes against
Houthi held areas in Yemen with an aim to
drive the movement out of Sana’a and power.
2. There is a risk this becomes a proxy war
between Sunni majority Saudi Arabia and Shia
majority Iran who support the Houthis.
3. The Mandeb Strait bordering Yemen is a vital
transit point for most oil exports from the
Persian Gulf that transit the Suez Canal and the
SUMED pipeline onto Europe.
US – Iran nuclear agreement (Bearish)
1. Easing of sanctions on Iran will unleash a
torrent of Iranian oil on the international
markets putting intense pressure on prices.
2. Iranian production will go up by 500,000 bpd
immediately and 1.2 million bpd in 3 months.
3. Iran has about 30 million barrels of oil in
floating storage ready to ship once it can secure
insurance for its ships.
Global Stock Builds
1. In the first half of 2015 supply will exceed demand
leading to an international stock build in excess of 2
million barrels per day.
2. In the second half of 2015 the call on OPEC is
estimated to increase by 2 million bpd which will
stabilize inventory levels. However there is a
possibility that Iranian oil spoils this balance.
3. In the US, tank tops at its biggest oil storage site in
Cushing are approaching operational capacity. If US
oil can no longer be moved into storage it will have
to be sold at heavy discounts inland as exports are
banned. This will displace imports and leave
countries with excess oil to market internationally.
In a cartel some are more equal than others
Saudi Arabia and its close allies in the Gulf are waging a
war for market share with non-OPEC producers by
refusing to cut production to support prices which has
led to a selloff. It remains to be seen how much pain can
be absorbed by other oil producers before they agree to
coordinate a cut with OPEC as the Saudis would like.
8. Option Structures suitable for Airlines
Call Option – Caps fuel prices with
unlimited participation in a weak price
environment. Akin to insurance with only
an upfront premium.
Collar – Achieves a cap and a floor to fuel
price. There is limited participation in a
weak price environment. Usually executed
as zero cost to conserve cash.
Seagull – Caps the price of fuel and allows
reduced participation in a weak price
environment. Its cheaper than an outright
call option. If executed on a zero cost basis
the call strike needs to be carefully chosen
Synthetic Call – Buyer fixes the price of his
fuel similar to a swap. However he also
buy a put option which gives him reduced
participation in a weak price environment.
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Effective Price
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P/L of hedge
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Effective Price
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P/L of hedge
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Effective Price
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P/L of hedge
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Effective Price
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P/L of hedge
