The cost for fuel is one of an airline’s biggest cost driver. If fuel prices are getting out of control, the overall cost will be heavily affected, too. However, there are ways that an airline can protect itself against it – by hedging fuel. There are several kinds of fuel hedging.
This is a contract between two parties. They agree on:
Both delivery and payment will take place in the future, however, the date is agreed and stated in the contract.
Let’s assume it is the 1st of January: current price is $1.50/gallon
- You hedge a certain amount for $1.50/gallon by 30th July
- On 30th July, you do not want to take delivery and sell back
- Current market price 30th July: $1.80/gallon
- Your gain: $0.30/gallon ($1.80-$1.50)
- you hedge a certain amount for $1.50/gallon by 30th July
- Current market price 30th July: $1.40/gallon
- Your loss: $0.10/gallon ($1.50-$1.40)
Of course, it is much more complicated in reality. The basics are the same: if you are (heavily) exposed and want a certain guarantee or assurance, you can do so with a futures contract.
- Expected rising fuel prices: purchasing a futures contract
- Expected declining fuel prices: selling a futures contract
Hedging fuel is not a bet! It is rather an assurance which gives certainty for planning ahead.
A futures contract states a specific date in the future. That is not always feasible or realistic for certain companies, such as airlines, since they use fuel every single day. They do not fill their planes once every couple of months, then having enough for a while. Therefore, swaps do not mention a specific date, but rather a date range.
This could include a 90-day range during which a customer is obliged to buy a minimum amount. Depending on the current market price, they may pay less or more.
Similar to swaps, with one important difference: the contract states the fight to buy, not the obligation. This is often an advantage, however, it comes with a financial premium on top.
Hedging fuel is about reducing risk and planning security. Each airline must know which strategy suits them best. They all protect, however, at different conditions and costs.
- Swaps: strict, premium to be paid
- Call option: flexible, worst case, only the premium to be paid
- http://edition.cnn.com/2011/TRAVEL/03/21/airlines.fuel.hedging/ (Cover photo)