Commodity price hedging is a popular trading strategy frequently used by oil and gas producers as well as heavy consumers of energy commodities such as airlines to protect themselves against market fluctuations.
During times of falling crude prices, oil producers normally use a short hedge to lock in oil prices if they believe prices are likely to go even lower in the future, while heavy consumers like airlines do the exact opposite: Hedge against rising oil prices which could quickly eat into their profits.
However, hedging is far from a silver bullet that is guaranteed to protect anybody from volatile markets, something that many airlines are now feeling keenly.
Many large carriers use hedges to lock in years of fuel costs in a bid to smooth out turbulence in highly volatile energy markets. But in this era of persistently low oil prices, this time-tested insurance is proving to be more of a liability than an asset.
And many big carriers are now pulling back from oil hedging after suffering massive losses due to low oil prices.
Bad hedges
Indeed, some of the world’s biggest airlines are ditching or shrinking their mammoth fuel-hedging programs after losing billions of dollars in the derivatives.
British Airways parent IAG SA (OTCPK:ICAGY), owner of iconic European airline brands such as British Airways, Iberia, and Aer Lingus, now says it will cut its year-ahead fuel hedging to about 60% of its requirements down from 90% hedged for the comparable period when the pandemic began.
Similarly, Deutsche Lufthansa AG (OTCQX:DLAXY) says it will cut its hedging volumes by about 20 percentage points.
At the crux of the matter is a double whammy of low oil prices as well as low capacity due to travel restrictions, essentially leaving many airlines overhedged.
For a better understanding, let’s see how this works at a granular level.
Fuel hedging
Under any other circumstances, air carriers would be happily popping champagne corks after the latest massive oil price slump. After all, fuel typically accounts for up to 20% of an airline’s operating expenses. Crude oil prices remain well below nearly $100 a barrel they commanded just a few years back.
Yet, many carriers have had little to celebrate as they had locked in oil prices at far higher fuel prices, not to mention the drastic drop in air travel demand amid global travel restrictions.
No less than 40 airlines went under in 2020 due to Covid-19., the highest number in history during such a short period of time. Others, such as British Airways, suffered monumental losses that sent several heads rolling.
Many airlines use hedging to mitigate the risk of fuel price volatility. Fuel hedging means an airline agrees to purchase a certain amount of oil in the future at a predetermined price. Airlines hedge fuel costs in a number of ways, including purchasing current oil contracts, buying call options, or purchasing swap contracts.
Last year, Singapore Airlines Ltd., suffered its first annual loss in its 48-year history after taking a $638 million charge on oil hedges. Singapore Airlines had an unusually farsighted approach to its fuel bills, with the company hedging fuel costs up to five years out, way higher than the industry standard of a one- to two-year horizon.
However, U.S. carriers have mostly been spared.
That’s because most U.S. airlines do not hedge at all and are therefore likely to enjoy the benefit of low oil prices in the form of significant cost savings. Carriers like Southwest Airlines and JetBlue who focus on the domestic market hedge only lightly after suffering similar losses during prior oil price crashes such as 2014.
Chinese and Indian airlines don’t typically hedge on fuel, meaning they have also been benefiting from lower-than-expected oil prices.
