Should Airlines Hedge Out Their Fuel Price Risk?

The airline industry is brutally competitive and is known to operate on razor-thin margins. Labour and fuel make up the largest proportion of an airline s operating costs (1). The former is largely fixed in the short-term whereas fuel prices can vary greatly based on the crude oil prices and therefore significantly affect the cash flows and the profits of the airline. Therefore, majority of airlines hedge their fuel prices to reduce a major swing in their profits and therefore gain higher share prices for the company.

There are several different methods for hedging fuel prices. The most basic mechanism involves a futures price contract, where airlines agree to buy a certain quantity of fuel at a specific price on a future date (2). Therefore, the airline is shielded against rising fuel prices in the near future, thus reducing the volatility in profits.

The airlines can also purchase call options to hedge against fuel price volatility. A call option allows the airline to purchase the fuel at a specified price within a certain date range. If the fuel prices rise within that date range, the airlines can invoke the call option, thus minimising any losses from the rising fuel prices. In order to hedge against declining fuel prices, a put option is used which follows similar terms of contract. Other hedging strategies include collar hedges and swap contracts, both of which are adaptations of the call/put options strategy (2).

Hedging fuel prices has one main advantage minimising the risk associated with rising oil prices, therefore leading to greater stability in profits. Oil prices have historically been volatile, and sensitive to geopolitical events. In 2018, a year of fluctuating oil prices, Southwest Airlines fuel costs increased 9% compared to 33% at American Airlines. This difference was due to Southwest implementing hedging strategies whereas American didn t adopt any hedging policy that year (3). However, hedging activities have also led to great losses for airlines. In 2016, Delta Airlines CEO admitted to losing about $4 Billion cumulatively on oil hedges (4). More recently, the oil price crash due to the reduced demand caused by Coronavirus and the OPEC-Russia price war has led to a loss of $1 Billion for Air France-KLM group from fuel hedging (5). Both these cases involved airlines hedging against rising fuel prices, but the oil price moved in the opposite direction leading to losses.

It is important to note that there are alternative risk management strategies to fuel hedging. In 2012, Delta Airlines bought an oil refinery in an unprecedented move to save fuel costs. This allowed them to save $300 million on fuel costs (6) but entering a different industry with limited expertise meant long-term profitability could not be maintained (7).

There are several other factors associated with hedging that could impact overall profitability. Structuring a hedge requires an upfront cost and also employee salaries for the hedging team. Furthermore, the premiums for call options and the upfront costs of a futures contract both change based on the market conditions and therefore it is also important to consider these before finalising a strategy (8) (9).

An airline can deal with rising fuel prices either by hedging or by increasing the ticket prices for the end customer. However, for budget airlines like Ryanair, whose competitive advantage comes from offering low-cost tickets, transferring the increase in fuel price to customers would act against their current business strategy. This could lead to customers moving to other budget airlines (e.g. EasyJet), and hence to lower revenues.

Ryanair has been hedging fuel prices on a quarterly basis for the past few years and this has allowed the company to renew their futures contracts with the changes in the oil prices. These fuel costs can account for roughly 43% of Ryanair s operating costs (10) and therefore it is imperative that the airline continues hedging its fuel prices to minimise costs and maximise profits. As of 2020, Ryanair has hedged 90% of its fuel consumption (10), locked in at an average of $77 per barrel (11). Given the recent drop in oil prices to below $30 per barrel (12) combined with a significant reduction in travel demand, Ryanair is expected to make significant losses on this hedging strategy. However, these historically low oil prices are expected to rebound once the global travel demand picks up after the containment of the coronavirus pandemic. Therefore, it is strongly advised that Ryanair prepares a plan to hedge fuel prices for the year 2021 in order to secure below market prices.

In conclusion, Ryanair s fuel hedging may not have always played to their advantage but given the probable future rise in oil prices, we recommend Ryanair to continue hedging its fuel price risk.