ANALYSIS: European airlines' hedges caught out by fuel-price dive
Carriers that hedged large proportions of their fuel use for 2020 face being trapped by the plummeting price of jet kerosene, which is hitting 20-year lows.
Many were banking on steady demand growth and a benign economic environment this year. Ratings agency S&P Global noted in August 2019 that airlines were stepping up their hedging for the period through 2021 because of weaker prices, something they expected to be short-lived.
Instead, the impact of the coronavirus pandemic and the associated travel restrictions have hit the global economy and led to a collapse in fuel prices, while for airlines, passenger demand has dwindled. IATA now forecasts that airline revenues will decline by over $250 billion this year.
Data from the energy information provider ICIS – which, like Cirium, is part of RELX – shows that the price of jet fuel for barge delivery to northwest Europe for 24 March has fallen to $280.25 per tonne, from around $650 at the start of the year.
In February, European airline group IAG said it was hedged for 94% of its fuel needs in the second quarter of 2020 at a price of around $610-640 per tonne. At the time, the spot price for jet fuel was around $490 per tonne, so IAG was already losing on its fuel hedges even before prices collapsed further. IAG was hedged for 82% of its expected needs in the fourth quarter of 2020 at around $565-630 per tonne, it says, and for over half of its requirements up to the second half of 2021 at around $525-615 per tonne.
IAG did not specify whether it hedged primarily with swaps, under which the group is obliged to buy the fuel, or with options, under which it can make the purchase or not at its own discretion.
Speaking at the Airline Economics Growth Frontiers conference in Dublin earlier this year, Goldman Sachs vice-president Justin Fisher explained: "Some [carriers] hedge further out with options, and as they move closer [to the present time they hedge] with swaps, as there is a little more certainty around the band which you expect fuel prices to trade."
The suddenness of Covid-19's impact on European airlines could expose faults with this strategy.
IAG says it "hedges its fuel purchases in advance, typically gradually building its cover over three years", adding: "This hedging programme smooths the effects of rising (or falling) prices and 2018 benefited particularly from prices locked in at lower rates in previous years." In its annual report for 2019, cash-flow hedges for fuel and oil contributed €106 million ($115 million) towards the group’s profits.
UK low-cost carrier EasyJet notes in its 2019 annual report that with fuel representing 24% of its costs for 2019, it "continues to hedge fuel costs in order to mitigate against the risk of major volatility in fuel prices".
Demonstrating the difficulties that airlines face when hedges go the wrong way, EasyJet notes that the average price of Brent crude declined by 6% from $70 to $66 over 2019, yet its fuel cost per seat increased by 8.4%, "driven by a higher hedged fuel price compared to the prior year, partially offset by a continued investment into more fuel-efficient aircraft".
As of 30 September 2019, EasyJet was hedged for 74% of requirements to the end of March 2020 at $632 per tonne, and was 68% hedged for the year to the end-September 2020 at $655 per tonne. Given that the barge delivery price is currently $280.25 per tonne, this indicates that the airline will pay a significant premium to the spot price for jet fuel.
"In order to manage the risk exposure, forward contracts are used in line with the board-approved policy to hedge between 65% and 85% of estimated exposures up to 12 months in advance, and to hedge between 45% and 65% of estimated exposures from 13 up to 24 months in advance," said EasyJet.
Ryanair stated in February that it was 90% hedged for the full-year 2020 at $71 per barrel and for 2021 at $61 per barrel, "delivering over €100 million fuel savings into FY2021". The Irish budget carrier is known to use swaps for its fuel hedging, which exchange floating-rate payments for fixed ones, so likely faces heavy losses.
Last month, Air France-KLM said it was hedged for two-thirds of its 2020 fuel requirements at $619 per tonne. At a market price of $549 per tonne for the year, based on the forward curve as of end-February, this would result in an annual loss on its fuel hedging of €650 million, it said.
Lufthansa Group notes that it has crude oil and kerosene hedges for around 78% of its requirements for 2020, in the form of both futures and options. For 2021, around 32% of its expected fuel requirements were hedged in February.
"As fuel is priced in US dollars, fluctuations in the euro/US dollar exchange rate can also have a positive or a negative effect on reported fuel prices," it says.
Several European airlines have highlighted that their fuel costs were softened in 2019 by a weaker US dollar, which makes crude products that are priced in dollars cheaper in the local currencies that make up their earnings. A strong US dollar risks pushing non-US carrier's fuel costs even higher, although most airlines also hedge their currency exposures, offsetting some of this.
Although airlines' hedges may contain put options that allow them to sell fuel at certain prices and dates, mitigating some of their losses, it is unclear how prevalent the use of these instruments is.
Carriers are usually content to risk their hedges going the wrong way because yields move more gradually than fuel prices. This means that even when fuel prices fall below their hedges, "your yields are still going to be higher for longer as you catch up with [weaker fuel prices]", explained Goldman Sachs' Fisher in February. For this reason, airlines "still see swaps [under which they are obliged to buy fuel at hedged prices] as being very defensive", as they eliminate exposure to the risk that fuel prices will rise.
However, it is unclear whether this logic applies in the current situation of major market dislocation amid collapsing fuel prices, which could also result in sharp changes to yields.
"What you are seeing now is extreme," says aviation analyst Seth Kaplan, with airlines likely to see heavy losses from their hedging programmes. He highlights that most US carriers stopped hedging years ago when they realised it was essentially "expensive insurance" against higher fuel prices. "They said: 'We are airlines, we do not need the cost and complexity of hedging,'" he recalls.
Hedging already differs from region to region, with carriers in the Middle East and India also generally avoiding the practice.
This raises the prospect that European and Asian airlines could re-evaluate whether hedging is a useful way for them to manage their fuel costs, says Kaplan, adding that carriers such as Ryanair had their fingers burnt once before by hedging during the 2008 financial crisis: "I am sure they are looking at the numbers and wondering whether it is worth it."
Cirium
