Risk Management Fuel Prices Are a Major

Risk Management

Fuel prices are a major contributor to the profitability of an airline, as they tend to be more volatile than ticket prices. In response to this variability, airlines typically engaging in fuel price hedging strategies. On the operational level, many airlines rely on a focus on shorter average flight distances. This keeps the fuel cost down relative to passenger revenue. However, the most common method of dealing with fuel price volatility is to utilize a financial hedge, typically a series of either futures or forwards to lock in the price of fuel.

The first thing to realize is that the company cannot perfectly hedge the top end of the fuel price range. At some point, the price paid is going to have to be lower than the top price or the airline will lose a lot of money when the price drops again. During a major run-up, like occurred in the first half of 2008, it can be difficult to know where the top of the market is. By the same token, leaving too much of the airline's fuel needs unhedged is just as risky.

Optimally, the airline would be able to determine the fuel price level at which it can be profitable at current ticket prices, and set its hedges there. This would guarantee a level of profit. This requires the airline to take a proactive approach, and have a strategy for the level of hedging that it wants to do at each price level. Waiting until a price spike to undertake a hedging strategy is likely to leave the airline with a choice of locking in prices at a loss or facing even more massive losses on the open market. The latter scenario unfolded in 2008 and that year saw most airlines lose money. Airline hedging strategies are simply unable to deal with volatility, because airlines do not wish to be overhedged in case the price drops. This scenario resulted in a $247 million charge for Southwest in 2008 (Bachman, 2008).

My objective with a hedging program would be limit earnings volatility, knowing that eliminating fuel-related volatility was not going to happen. This would typically involve the use of short-term hedges, unless there was a reasonable expectation that fuel prices were going to sustain their high levels. A fair amount of fundamental analysis would go into this assessment, especially since the hedge is going to be with crude or another proxy, rather than with jet fuel.

To reduce fuel price volatility, a certain percentage of fuel needs would be hedged, while the rest would remain unhedged. Each airline has a different strategy for this, and Southwest prefers a high level of hedging as this delivers greater cost certainty. I would focus on long-term hedging when prices are low and short-term hedging when prices are high, as this strategy would minimize (but not eliminate) upside and downside risk for the fuel being hedged. In addition, the percentage of fuel being hedged would be dependent on whether or not the price is considered high or not, and whether it is rising or not.