Fuel Hedging Strategies and Airline Profitability: A Review

Introduction

Airline operations are typically affected by several factors, especially oil prices and exchange rates, which have the capacity to generate considerable operational complexity. Fuel prices represent one of the major risks that complicate airline operations and have substantial impacts on airline profitability. Consequently, airlines develop and adopt several risk mitigation measures in order to enhance their profitability. Fuel hedging is one of the risk mitigation strategies adopted by airlines to help reduce operational risks and improve profitability. The significance of fuel hedging as a risk mitigation strategy is evidenced by the ongoing volatility of fuel prices. As airlines continue to adopt this strategy, numerous studies have been carried out to examine its effectiveness. Existing literature examines the economic rationale of fuel hedging with regard to the role and impact of this strategy in promoting airline profitability.

The continued use of fuel hedging by airlines has been examined by several researchers and is well-documented in existing literature. This issue has attracted considerable attention because of the increased volatility of fuel prices across the globe, driven by numerous economic factors that affect countries worldwide. Morrell & Swan (2006) contend that hedging fuel costs is widely practiced by many international airlines despite the lack of strong theoretical justification (p. 713). Airlines adopt fuel hedging to protect fuel costs since it involves locking in the cost of future fuel purchases. This strategy safeguards against unexpected losses from increases in fuel costs and prevents windfall gains from decreasing costs of fuel (Morrell & Swan, 2006, p. 713). Therefore, airlines use fuel hedging primarily to stabilize fuel expenditure, given that fuel accounts for approximately 15% of an airline's operational costs.

Theory and Practice of Fuel Hedging

According to Morrell & Swan (2006), the theory underlying fuel hedging is that fuel hedges enable an airline to reduce a significant source of profit swings and the resulting pressure on stock prices (p. 715). Carter, Rogers & Simkins (2004) support this theory by arguing that airline executives typically find it impossible to pass higher fuel costs on to passengers through ticket price increases because of industry competitiveness (p. 3). As a result, airlines hedge fuel prices in order to prevent large swings in operating expenses and bottom-line profits. Existing literature demonstrates that airlines generating adequate returns tend to be those that hedged fuel prices, while those that did not hedge often registered unsatisfactory revenues or losses.

Simmons (2015) argues that the sole purpose of fuel hedging by airlines is to reduce risk in the face of an uncertain future regarding fuel price volatility (p. 1). Westbrooks (2005) shares this view, stating that fuel hedging is one of the creative measures adopted by airlines to help reduce risk and cost (p. 19). This is primarily because airlines continually struggle to cope with challenging economic conditions. Fuel hedging is adopted to enhance the bottom line through increasing earnings or revenues (Westbrooks, 2005, p. 19). Westbrooks (2005) further argues that the theory behind fuel hedging is that it resembles an insurance policy safeguarding companies against rising fuel costs or price volatility. From this perspective, hedging is also an investment similar to other investments in that it carries its own risks. This is because fuel hedging requires airlines to predict the future price of a commodity and make an informed decision correlated with leadership's risk aversion (Westbrooks, 2005, p. 22).

Carter, Rogers & Simkins (2006) further contend that recent literature shows the theoretical justification for fuel hedging is that it can increase value (p. 55). This position rests on the premise that most existing theoretical research in corporate risk management postulates that hedging is one of the mechanisms through which companies can increase their value and profitability. Trempski (2009) concurs, stating that most recent literature on hedging emphasizes the notion that it enhances company value (p. 2). Within this body of research, one group of scholars argues that hedging contributes to higher company value, another contends that hedging is a non-value-adding initiative, and a third group holds that hedging adds value only under specific circumstances (Trempski, 2009, p. 2).

Simmons (2015) notes that there are different hedging strategies available to companies depending on their needs and goals (p. 1). These include fixing the price of an input, setting an upper limit on input price, and establishing the input price within a range defined by upper and lower limits (Simmons, 2015, p. 1). Westbrooks (2005) identifies three basic tools that hedging strategies must incorporate: forwards, futures, and options, or some combination thereof (p. 22). Airlines use forward contracts to hedge fuel prices by establishing an agreement with fuel suppliers to purchase fuel at a specific price, quantity, and date. Through futures contracts, airlines enter agreements to purchase fuel at a future time with the assurance that the contract will be executed at expiration (Westbrooks, 2005, p. 23). Options contracts give airlines the right, but not the obligation, to purchase fuel at specified prices and dates.

While agreeing that forwards, futures, and options are the primary strategies for fuel hedging, Morrell & Swan (2006) note that through options, airlines do not need a margin when hedging fuel costs (p. 715). These researchers observe that forward contracts for fuel hedging are typically over-the-counter agreements, while futures contracts are standardized and protect parties against counterparty risk. Airlines have recently shifted toward using a combination of call and put options commonly known as a collar (Morrell & Swan, 2006, p. 716). This combination protects the company against price increases beyond a strike price above the current futures price, at the cost of an option premium paid immediately (Morrell & Swan, 2006, p. 716). Airlines also prefer swaps, which are customized futures contracts that enable an airline to lock in payments at future dates based on the current price of fuel.

Trempski (2009) highlights a different strategy on the premise that the airline industry is most inversely correlated with fuel prices (p. 1). In attempts to reduce fuel price exposure, some airlines use derivatives to lock in fuel costs, thereby obtaining temporary protection against high fuel costs while also forgoing the benefit of lower prices should crude oil costs fall (Trempski, 2009, p. 1).

Cobbs & Wolf (2004) identify several jet fuel hedging strategies available to airlines through an analysis of industry practices. These include over-the-counter instruments such as options (including collar structures and swaps), exchange-traded futures on crude and/or heating oil, and the option of not hedging at all. The "not hedging" approach means airlines absorb the risk of rising fuel prices within their existing business models (Cobbs & Wolf, 2004). Some airline executives have acknowledged that the risk of rising commodity prices persists regardless of whether or not they choose to hedge.

Carter, Rogers & Simkins (2006) identify additional strategies beyond futures, forwards, and options, including swap contracts such as plain vanilla, basis swaps, and differential swaps, as well as collars such as zero-cost and premium collars (Carter, Rogers & Simkins, 2006, p. 5). A plain vanilla swap is a simple agreement in which a floating price is exchanged for a fixed price over a specified period of time. Unlike other swaps, a plain vanilla swap is an off-balance-sheet financial arrangement that does not involve the transfer of a physical commodity; instead, both parties settle obligations by transferring cash. When applied to fuel hedging, a plain vanilla swap specifies the volume of fuel, its floating and fixed prices, and the swap's maturity period (Carter, Rogers & Simkins, 2006, p. 5). These swaps are based on variations between the fixed and floating prices of the same product.

A differential swap, by contrast, is an agreement based on the difference between a fixed differential for two different products and their actual difference over a certain period. Such contracts are used by companies to manage basis risk arising from other hedging instruments or activities. A zero-cost collar is structured so that the premium received from selling a put option fully offsets the purchase price of the call option (Carter, Rogers & Simkins, 2006, p. 7). A premium collar is an arrangement in which the cost of the call option is only partly offset by the premium received from selling a put option.

The impact of fuel hedging on an airline's value has attracted considerable research, particularly from corporate risk management scholars. Existing literature has comprehensively examined whether fuel hedging increases an airline's value. Studies and current literature on this question can be classified into two camps as follows.

Allayannis & Weston (2001) examined the link between the use of financial derivatives, including hedging, and firm value. Using Tobin's Q ratio, the researchers found that the use of financial derivatives is positively linked to the market value of a firm (Allayannis & Weston, p. 273). Companies that use currency derivatives in the face of financial market risks experience a 4.87% increase in value compared to those that do not. Hedging is one such currency derivative used to increase value and reduce risk exposure. Existing evidence indicates that firms adopting a hedging policy experience increases in value relative to those that remain unhedged, and that companies quitting hedging experience a decline in value broadly similar to those that never hedged.

Impact of Fuel Hedging on Firm Value

In a study on whether hedging affects firm value, Carter, Rogers & Simkins (2006) state that fuel hedging has a positive relationship with firm value, as demonstrated by investment patterns in the airline industry (p. 54). Fuel hedging increases firm value by permitting airlines to fund investments when fuel prices are high. As a result, investors view this risk mitigation instrument as a positive net present value mechanism that increases overall firm value. Fuel hedging is shown to function as a mechanism for eliminating underinvestment incentives, which are likely to arise when a company experiences financial distress (Carter, Rogers & Simkins, 2006, p. 54).

Morrell & Swan (2006) concur that fuel hedging increases firm value, arguing that this financial instrument helps airlines protect profits against an unexpected upturn in fuel costs (p. 725). When oil supply decreases, airlines face losses in business and consumer confidence, resulting in reduced air travel. Through fuel hedging, airlines counterbalance potential losses from reduced travel and high fuel costs by purchasing oil futures at lower prices (Morrell & Swan, 2006, p. 725). An airline is increasingly likely to hedge over 100% of its fuel if a simultaneous decline in revenue and rise in fuel prices is anticipated. This implies that airlines can effectively shift revenues forward or backward by accurately timing the sale of their fuel or oil futures.

In a study on whether fuel hedging makes economic sense for airlines in the United States, Vieira et al. (2014) found that hedging fuel costs does make economic sense, though investors tend to negatively perceive increases in hedge positions (p. 1). Based on empirical evidence, fuel hedging adds value to airline companies by enabling them to manage risks associated with fuel prices (Vieira et al., 2014, p. 10). This value addition is driven by the fact that fuel costs have been increasingly volatile and can account for up to 40% of an airline's operating costs. However, when determining the most suitable hedging approach, airlines should consider both implicit and explicit costs associated with their existing hedging policy.

Cobbs & Wolf (2004) argued that fuel hedging has proven to increase firm value and create competitive advantage, despite much of the airline industry remaining unhedged (p. 1). Empirical evidence shows that the most successful airlines in recent years have established comprehensive fuel hedging policies and programs. In contrast, airlines on the verge of bankruptcy are often in that position largely because of their exposure to volatile fuel prices stemming from the absence of a fuel hedging program (Cobbs & Wolf, 2004). Such airlines incurred actual fuel costs at or above the average market price for the year, while airlines with hedging programs achieved actual fuel prices that were relatively below average. Although fuel hedging involves certain costs such as personnel expenses and bid-ask spreads, existing evidence shows that its benefits outweigh these costs.

According to van de Pol (2010), fuel hedging increases firm value by giving airlines greater control over fuel prices, making them less dependent on and less affected by fuel price volatility. Through this risk mitigation strategy, airlines can reduce exposure to fuel price increases through agreements and charter arrangements. Van de Pol (2010) concurs with Carter, Rogers & Simkins (2006) that fuel hedging adds firm value because investment opportunities in the airline industry are positively correlated with fuel prices. When fuel prices increase, airlines become vulnerable to financial difficulty, and hedging enables them to avoid such distress. High fuel costs therefore present favorable investment opportunities for airlines that have hedged against these prices (van de Pol, 2010). Increased firm value from fuel hedging is also achieved through reductions in financial distress costs and underinvestment costs (van de Pol, 2010; Carter, Rogers & Simkins, 2006, p. 54).

Lin & Chang (2009) examined whether fuel hedging adds value in the global airline industry. Based on a unique dataset of 69 airlines from 32 countries, the researchers found that fuel hedging — particularly jet fuel hedging — increases the firm value of airlines globally (Lin & Chang, 2009). For U.S.-based airlines, fuel hedging was found to enhance firm value consistent with findings from other regions. However, the researchers did not find a significant link between fuel hedging and firm value for airline companies with alliances compared to those without alliances (Lin & Chang, 2009). They also found that fuel hedging increases firm value more during periods of volatile fuel prices than during stable price periods. The authors conclude that airlines can protect and even enhance their value by employing suitable hedging activities.

He (2015) examined the impact of fuel hedging on firm value in the U.S. airline industry, analyzing data from 1992 to 2013. The researcher found a positive hedging premium, indicating that fuel hedging adds significant value to airline companies. He (2015) confirms a positive link between fuel hedging and firm value consistent with the findings of Carter, Rogers & Simkins (2006), concluding that airline companies can enhance their value by increasing their hedged proportion of successive fuel requirements — particularly at medium hedge levels between 11% and 36%. Furthermore, fuel hedging can significantly increase firm value when the proportion of hedged fuel is increased and the amount spent on fuel is high, specifically when it exceeds 27%. He (2015) also found that investors tend to value fuel hedging more during periods of high fuel price volatility, and that selective hedging strategies can be particularly helpful in increasing firm value.

Junior & Laham (2010) confirmed the correlation between fuel hedging and firm value as demonstrated by Carter, Rogers & Simkins (2006). Rejecting the hypothesis that fuel hedging has no meaningful impact on firm value, Junior & Laham (2010) found that airlines that began using fuel hedging carried a statistically significant premium of 10.8% compared to those that did not. This premium implies that airlines with elaborately developed fuel hedging programs generate a 10.8% increase in their overall value (Junior & Laham, 2010, p. 11). The researchers therefore conclude that fuel hedging impacts value positively by increasing the overall firm value of airlines.

Mohammad (2014) examined the value of fuel hedging in the American airline industry between 2006 and 2010. The study found that airlines utilizing jet fuel hedging trade at a premium, and that 100% hedging generates a 22.2% increase in overall value (Mohammad, 2014, p. 47). These results are consistent with previous studies indicating a positive association between fuel hedging and firm value. Notably, fuel hedging increases firm value by reducing the airline's exposure to volatile fuel prices and their associated financial consequences.

Drawing on evidence from Canadian oil and gas companies, Dan, Gu & Xu (2010) show that fuel hedging increases firm value in the airline industry. Using Tobin's Q ratio, the researchers found that fuel hedging has a probable positive effect on firm value, while excess leveraging has a negative effect (Dan, Gu & Xu, 2010). The researchers also found that fuel hedging is strongly linked to stock returns because of the relationship between changes in oil and gas prices and equity performance.

Trempski (2009) conducted a quantitative analysis on whether fuel hedging adds value to airlines based in the United States (p. 1). The study proceeded on the premise that airline operations are heavily dependent on fuel prices, with profits increasing as fuel prices decline and vice versa. Contrary to the belief that fuel hedging increases an airline's value, Trempski (2009) demonstrates that hedging is not valued by investors as reflected in stock prices (p. 2). Even if fuel hedging may increase an airline's operational value, it does not matter to investors whose returns are not dependent on whether the airline company adopts a hedging strategy. This is mainly because airline shareholders are more concerned with the cumulative risk exposure across their individual portfolios rather than that associated with individual stocks. Trempski (2009) therefore refutes the hypothesis that fuel hedging increases an airline's value when value is measured through individual shareholder stock prices.

Simmons & Austin (2015) conducted a study on whether hedging reduces risk through an analysis of large domestic airlines. While management uses hedging to fix fuel prices or set them within a predetermined range, hedging cannot guarantee that an airline will pay lower prices than rivals that remain unhedged. Furthermore, fuel hedging does not prevent unhedged airline companies from benefiting when fuel prices decline. If all airlines hedge, they are equally protected against unexpected increases in fuel prices — meaning they all pay the same price — thereby eliminating any hedging-derived competitive advantage.

Simmons & Austin (2015) further refute the hypothesis that fuel hedging increases firm value by noting that hedging commitments typically require collateral and cash that may exceed the financial capacity of some airlines (p. 17). By choosing to hedge, airlines put their competitors at a disadvantage in the event of a fuel price increase, while unhedged airlines put their rivals at a disadvantage in the event of a price decline. Consequently, airlines that hedge may end up paying more for fuel than their unhedged competitors when prices fall, suggesting that hedging does not unconditionally increase firm value.

Vieira et al. (2014) also challenge claims that fuel hedging increases overall firm value. The researchers found that even though hedging makes economic sense for U.S. airlines, its use has been questioned by investors who believe that increasing hedge positions actually decreases valuation, raising broader economic concerns. The researchers argue, through corroborating findings, that management is likely to destroy value in the event of over-hedging (Vieira et al., 2014, p. 11).

Even though hedges may help in preventing significant disruptions to cash flows, airline companies do not necessarily deploy those benefits to increase capital expenditures when faced with a fuel crisis. In some cases, investments that could increase firm value decline as fuel prices continue to rise. These findings were supported by the hypothesis that fuel costs remain negatively linked with a company's cash flow measure — net income plus depreciation (Vieira et al., 2014, p. 10). Therefore, some recent fuel hedging strategies may not make economic sense if investors perceive that currency derivatives fail to offset their associated costs.

Conclusion

Existing literature demonstrates that fuel hedging functions as both a risk management tool and a value-creation mechanism for airline companies, though its benefits are not unconditional. The dominant body of evidence, drawing on studies across multiple countries and time periods, supports a positive relationship between fuel hedging and firm value, with documented increases in airline profitability attributable to reduced cash flow volatility, lower underinvestment costs, and protection against fuel price shocks. At the same time, dissenting studies caution that hedging can destroy value through over-hedging, may impose collateral requirements beyond some airlines' financial capacity, and does not guarantee a cost advantage over unhedged competitors. The most reasonable conclusion drawn from synthesizing this literature is that fuel hedging adds value and enhances profitability under conditions of high fuel price volatility, when hedge ratios are maintained at appropriate levels, and when management employs selective hedging strategies rather than blanket coverage. Airlines seeking to maximize the profitability benefits of fuel hedging must therefore balance the protective benefits of locking in fuel prices against the risks and costs inherent in the hedging instruments themselves.