Hedging losses and recovery in the aviation industry
By Jenal Mehta
09:53, 6 December 2021
The travel industry bore the biggest brunt of the lockdowns, with airlines mostly shut down in response to travel restrictions. All airline companies saw big losses during this time period, however, the level of losses were not distributed evenly.
Fuel costs can make up a majority of airlines’ operational expenses. With fuel prices being a volatile commodity, most airlines try to hedge these expenses in order to reduce unexpected financial statement shocks.
Although many global companies follow some kinds of hedging practices, those that use forward contracts rather than option hedging saw the biggest losses during the pandemic. Airlines that were locked into fulfilling forward contracts were legally bound to purchase fuel during the pandemic which went unused.
Airlines that operate in non-US dollar currencies also have the added issue of protecting the business from negative native currency movements against the US dollar.
The period between 2020 and 2021 has brought to light demand risks that many airlines potentially did not consider previously when creating hedging strategies. Although oil volatility does not allow the aviation sector to completely abandon hedging, it will now be forced to hedge more intelligently while it faces a lengthy period of recovery from the pandemic.
Fuel costs, for most airlines, make up a significant proportion of total expenses. According to the International Air travel Association (IATA), fuel costs on average run to 19% of operating expenses. Paired with the fact that oil as a commodity is particularly sensitive to multiple factors that determine its price, a small change in oil price has a magnified effect on an airline’s profits. Thus, hedging fuel becomes vital for airlines. Rather than purchasing oil at current ever-changing market rates, hedging helps lock in prices, which keeps the company’s bottom line stable.
As a consequence of oil being traded in US dollars, airlines that operate with other currencies are uniquely positioned to be affected by foreign exchange volatility in addition to oil price volatility.
Under normal circumstances, any increases in fuel costs not covered by hedging would translate to increased fare charges to customers – keeping profit margins largely unchanged. Since 2020, of course, this has not been possible and resulted in airlines’ losses to deepen further.
However, not all carriers that hedged faced similar amount of losses. The past two years has brought to light the importance of the type of hedging methods used by airlines and how it affects profitability.
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Both forward contracts and options allow a company to lock in the price of a commodity today, which will be delivered in the future. However, the method of achieving this differs quite significantly.
Forward contracts are deals made between two parties that decide at the time of contract creation on the price and delivery date. These contracts are legally binding and have to be fulfilled. This is great for adverse price movements. However, during a period of reduced price and consumption levels, a company can be bound to fulfil a contract which brings it losses. The likes of Ryanair, easyJet and International Airlines Group (IAG) were bound by such contracts. Due to these hedge inefficiencies, each of the companies faced the following significant losses in 2020 in terms of revenue percentage:
Options are like insurance policies. The company pays a premium to have the choice of buying a commodity at a fixed price. If prices rise, it can choose to use its option contract and buy fuel at the agreed price. If prices fall, it can choose to pass on the option contract. This method is generally used by companies that have higher profitability to be able to afford the premium costs which have to be paid even if the option was not made use of. During the pandemic, Air France, Luftansa and Southwest Airlines, all users of option hedging, saw minimal hedging costs as percentage of their revenue:
Airlines with higher profitability can afford to absorb some volatility – and thus use options, which are triggered only in severe circumstances. While budget airlines, which typically may not want to spend on option premiums, requiring certainty rather than just insurance, tend to go for forward contracts.
As Rico Luman, a senior sector economist at ING, explained: “The most important reason for the difference [in choosing between forward contracts and options] is that low-cost carriers have very tiny margins (and high volumes) and therefore want to be secured of future costs for quite a long time ahead. Fuel costs usually can’t be passed on immediately to customers, especially in current market circumstances. Traditional airlines can generally bear more risk because of higher margins.”
Hedging after a pandemic
Moving forward, airlines planning hedging strategies will have to consider periods of high demand drops. In the immediate aftermath of the pandemic, the start of 2021 saw hedging methods being changed by many airlines. Due to limited visibility regarding travel restrictions, most reduced the amount of fuel hedged based on relevant balance sheets. While others switched from forward contracts to options.
Airlines are unlikely to completely move away from hedging. Luman said: “Airlines are relatively sensitive to kerosine prices as this usually reflects 15-30% of their costs.”
“This is not a time frame for taking more risk for airlines. Besides, oil prices can easily rise again going forward as investments in the oil industry are under pressure due to the energy transition while demand is still there,” he added.
John Kicklighter, chief strategist at DailyFX, says hedges will need to become smarter: “Fuel costs from crude to refined has eased back through November, but the volatility of these commodities remains. When volatility is this high, the probability for sudden increases in cost warrants intelligent hedges.”
Long haul to recovery
The recent discovery of the new Omicron variant has prolonged the already lengthy recovery period predicted for this industry. There is a consensus that the recovery will run beyond 2022 and it will be highly dependent on vaccine uptake.
A publication by Euro Control predicts traffic to return to 2019 levels only by the year 2025. Meanwhile, IATA expects domestic air travel demand in 2022 to have reached 93% of 2019 levels, while international demand lags behind at 44%, with both depending on vaccine uptake and changes to travelling regulations.
Luman agrees with this difference in recovery: “The recent emergence of the Omicron variant has weakened the short-term outlook and pushes back recovery in general. Intercontinental traffic especially is expected to remain low for quite a while still. But it also depends on which airline you have in scope. Recovery in domestic markets of large countries like US and China is far ahead. And airlines focusing on these domestic markets. like Southwest, could perform better than the industry average.”
Kicklighter added: “Airlines can perhaps work back towards stable profitability through the summer, but pre-pandemic earnings will require too many favourable circumstances – such as persistent consumer wealth growth, steadfast growth forecasts, easing fuel costs, a significant return of business travel, etc.”
A report by KPMG is optimistic about the return of travel demand, but warns it might be a long and difficult road to get back to normal pre-pandemic levels. Further, leading risk management consultation firm Oliver Wyman has said that the higher-priced airlines will have to compete with low cost carriers, so as to appeal to a broader consumer base. In essence, all airlines will have to constantly reassess strategies in face of changing demand patterns, and therefore profitability pressures are due to remain for several years to come.
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