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Abstract
Most international airlines hedge fuel costs, but the theoretical justification behind this action is weak. The paper explores the nature and extent of airline fuel hedging and asks why airlines hedge. The availability of hedging instruments is first discussed, with the most liquid markets in crude and exchange traded contracts. Aviation fuel contracts are possible, but with counter‐party risk. Most major passenger airlines with sufficient cash and credit now hedge at least part of their future needs. Hedging does protect profits against a sudden upturn in crude prices caused by political and consumer uncertainty leading to slower economic growth. However, if higher oil prices are induced by strong economic growth and oil supply constraints, hedging increases volatility with hedging gains reinforcing improved profits from higher traffic and improved yields. If hedging does not reduce volatility, it may still have an accounting role in moving profits from one time period to another, insure against bankruptcy, and signal the competence of management to investors and other stakeholders.
Notes
1. A recent cogent public statement to that effect was made 3 November 2005 by Steve Yick of easyJet in a talk given at Cranfield University. See also the comment by Eddington (AFX News, Citation2004).
2. Indeed, if oil futures have a negative beta, the value will appear as a premium in the future price over the expected value of oil. The expected loss would be the market’s payment for the value of the negative beta risk. This has been offered as a possible explanation for 6‐year futures in 2005 being above the inflation‐adjusted cost of new long‐run alternative fuel sources, such as Canadian oil sands.
3. The original version of CAPM defined the ‘market’ as only stocks. A broader CAPM theory includes all investment vehicles‐bonds, real estate, commodities and futures including oil‐in the total market and its beta.
4. The authors have been involved in bankruptcy discussions at Eastern, America West, TWA, National, Hawaiian and United Airlines.
5. Leaving aside the aviation gasoline that airlines operating small piston‐engined aircraft require.
6. There are rare occasions when prices are quoted in local currency, and some airlines ask for the transport element in fuel prices to be charged separately in local currency (since this cost is incurred in local currency).
7. Modern jet aeroplanes minimum cost speeds can be slightly higher than minimum fuel burn speeds, because labour, maintenance and ownership costs accrue with time. However, the differences are small. Tankering fuel from low‐ to higher‐cost airports costs fuel burn, and can be reduced with costs high everywhere. Again, tankering involves a small fraction of most airline operations.
8. Industry fleet purchases average about 6% a year.
9. The authors have reviewed business plans for numerous potential start‐ups. None of the ones seen contemplated hedging fuel costs.
10. For example, see British Airways (Citation2003): losses were reduced by the sale of their low‐cost airline subsidiary and 31 jet aircraft.
