What is Fuel Hedging and Why Do Airlines Do It?

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Airlines’ profitability is more than a little bit dependent on jet fuel prices, and yet there are limited resources available to mitigate the risks of a volatile oil market. The most widely used tool for this purpose is fuel hedging, which is when airlines agree to purchase oil in the future at a predetermined earlier price. Interestingly, airlines have quite variable approaches to doing this.

Kerosene costs are one of the most significant expenses faced by airlines. Photo: Getty Images

How does fuel hedging work?

Usually, airlines hedge the risk of a possible increase in oil prices by purchasing forward contracts. A forward is a customizable contract, where two parties agree to buy or sell a certain quantity of an asset (most often commodities) at a specified price on a future date.

For example, at the beginning of 2019, airlines were expecting oil prices to rise. On the other side, aviation fuel market vendors like Air BP, Shell or Exxon Mobil wanted to lock future sales at a set price, which would provide them with stable revenues.

Essentially, by entering into futures contracts, both parties decide to give up potential profits in return for certainty. What is also worth mentioning is that there is always a “winner” and a “loser” once the forward contract reaches maturity.

If the price of jet fuel at maturity is above the one agreed upon in the contract, the airline “wins”. Thanks to the hedge, it has spent less on jet fuel than it would have done if it had purchased it on the market on that date. In the event where the jet fuel market price at expiry is lower, the supplier (the BPs and Shells of this world) “wins”, as it makes more money off the jet fuel thanks to the forward. The latter is exactly what happened to some European airlines throughout 2019.

The different approaches to fuel hedging

Ryanair is known for its hedging activities, which are well described in its annual report.

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Ryanair has historically entered into arrangements providing for substantial protection against fluctuations in fuel prices, generally through forward contracts covering periods of up to 18 months of anticipated jet fuel requirements.

The Irish LCC has hedged 90% of its estimated jet fuel requirements for the fiscal year ending March 31, 2020, as well as 37% of requirements for the next fiscal year. The price for the FY 2020 Ryanair futures is $709 per metric ton.  It means that Ryanair is currently overpaying by around $80 per metric ton of kerosene (as IATA’s jet fuel price monitor for December states a price of $630/mt). Under IFRS, Ryanair disclosed a negative fair-value adjustment of €185.2m due to its hedging activities in 2019, as it has hedged at a higher price than the market one.

The Ryanair Group has lost almost $200 million due to its fuel hedging activities in Fiscal Year 2019. Photo: Ryanair

Additionally, the price at which Ryanair entered into future contracts for FY 2021 is $632 per metric ton, suggesting that the market expects the prices of jet fuel to remain relatively constant over the next year.

Lufthansa Group’s strategy seems to differ slightly, as it uses both futures and options to hedge risk. Interestingly, the approach varies depending on the carrier within the group. For example, all charter flights are fully hedged at the moment when the contract is signed. The Group’s traditional carriers, Lufthansa German Airlines, SWISS and Austrian, follow the hedging plan indicated below:

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Lufthansa’s group fuel hedging strategy as of February 2020. Graphic: Lufthansa group, annual report

As of 22 February 2019, there were crude oil and kerosene hedges for circa 76% of the forecast Group fuel requirement for 2019, in the form of futures and options at $66.41 per barrel. For 2020, around 29% of the forecast fuel requirement was hedged at that time for $70.09 per barrel. Today’s price per barrel is $79, so Lufthansa’s Group hedges remain highly profitable for the group.

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