Cathay Pacific, being Asia’s largest international airline, experienced a net loss of HK$575m in 2016, compared with a HK$6b profit in previous year. One of the reasons behind is that it lost HK$8. 46b on fuel hedges in 2016, largely incurred on hedges put in place when the fuel price was much higher than today.
Despite the low fuel price in current year, Cathay Pacific will continue suffering a difficult time for the next two to three years due to its fuel hedging. As a result, Cathay Pacific launched a strategic review, saying it would undergo a re-organisation, to revamp its workforce and to shorten its fuel hedging programme.It appears that unpredictable price avalanche have led some to question the long-term benefits of hedging. This initiate our further study on the fuel price risk, and to find out how the airlines cope with it. Fuel price risk of airlines Fuel cost is definitely a significant cost to airline companies.
As shown in figure 1, fuel cost account for about one-third of total operating expenses of the airline. As such, airlines treat hedging as a strategy for increasing the certainty of fuel prices. Airlines that locked in prices prior to big increases in oil price will achieve competitive advantage.Why does the oil price volatile Crude oil is one of the most economically mature commodity markets in the world, global supply and demand determine its price. As shown in figure 2 below, the world crude oil price is volatile, varying from $15/barrel to $150/barrel in past 20 years. And the current WTI crude oil price is $52.
24/barrel. [pic 1] Figure 2 World crude oil price between 1999 and 2017 First of all, considering the oil consumption, oil price goes up when there is an increasing demand. Structural conditions in each country's economy influence the relationships among oil prices, economic growth, and oil consumption.In 2015, more than 53% of world oil consumption consume by the Organization of Economic Cooperation and Development (OECD), including US, much of Europe and other advanced countries. Large economies consume more oil than the non-OECD countries, but have much lower growth in oil consumption.
The US Energy Information Administration (EIA) projects that virtually all the net increase in oil consumption in the next 25 years will come from non-OECD countries. Particularly, China's strong economic growth has recently resulted in that country becoming the second largest oil consumer in the world.China's rising oil consumption has been a major contributor to incremental growth in worldwide oil consumption. On the other hand, considering the supply of crude oil, 40% of the world’s crude oil is produced by the Organization of the Petroleum Exporting Countries (OPEC), including United Arab Emirates, Iran, Iraq, Saudi Arabia etc. This organization seeks to actively manage oil production in its member countries and maintains targeted price level by setting production targets as well as spare capacities.
Crude oil price increase when OPEC production target is reduced.Besides, the spare capacity indicates the world oil market's ability to respond to potential crises that reduce oil supplies. Oil price tends to increase when OPEC spare capacity reaches low levels. For example, during the period between 2003 and 2008, OPEC's total spare capacity remained near or below 2 million barrels per day (or less than 3% of global supply).
This provided very little cushion for fluctuations in supply in a context of rapidly rising demand, and thus, lead to the upward trend of oil price.In addition, remaining 60% of world oil production comes from non-OPEC, including North America, regions of the former Soviet Union, and the North Sea. Disruptions of non-OPEC production reduces global oil supply will lead to higher oil prices. Also, Non-OPEC production occurs largely in areas that have relatively high finding and production costs. The uncertainty about when the production will return to markets further adds to price volatility.
Nonetheless, geopolitical and economic events would affect the supply and demand of crude oil.Figure 3 below showing the crude oil prices during 1970 – 2015, pinpointed with some key events during the period. Events that disrupt supply or increase uncertainty about future oil supplies tend to drive up prices. Much of the world's crude oil is located in regions that have been prone historically to political upheaval. Given the OPEC's market significance, events that entail an actual or future potential loss of oil supplies can produce strong reactions in oil prices.Several major oil price shocks have occurred at the same time as supply disruptions triggered by political events, like the Arab Oil Embargo in 1973-74, the Iranian revolution and Iran-Iraq war in the late 1970s and early 1980s etc.
And most recently, the oil price surged about 15% once after the US launched an airstrike on Syria. Furthermore, weather can also play a significant role in oil supply. For example, oil and natural gas production shut down during hurricanes in 2005. This made oil and petroleum product prices increased sharply as the supply dropped.
[pic 2]Figure 3 Crude oil prices and key geopolitical and economic events After all, due to the global upsurging demand and a relatively stable supply of crude oil in past 20 years, we can see an overall upward trend of the oil price. This become the major reason that airlines tend to undergo fuel hedging so as to provide protection against sudden and significant increases in jet fuel prices, given the fuel costs is one of the major costs items of the airlines business. The use of commodity futures, options and other derivatives will be discussed in latter part of this report.The impact of shale oil and shale gas to energy prices The crude oil price is affected by the rapid technology development of shale oil and shale gas extraction.
Crude oil and natural gas belong to the conventional energy. The oil reserve in the world is shrinking day by day. The price is supposed to move up naturally with no doubt. Starting from 2000s, US enterprises are working very hard to explore new technology to extract nonconventional energy, i.
e. shale oil and shale gas. Technology breakthrough has given great impact to the price of crude oil.In recent years, new technologies called horizontal Drilling and hydraulic Fracturing have been applied in the industry. They are very efficient in extracting shale gas.
According to the Annual Energy Outlook issued by the Energy Information Administration (EIA), the shale gas will increase its importance in the future. EIA predicts that in 2020s, the supply of natural gas in US will be greater than the demand due to the rapid development of shale gas. EIA also estimates that US as a traditional energy importer will become an energy exporter by that time. The price of energy has been greatly affected.
The OPEC is being challenged by new comers. Theoretically, the decrease in energy prices can slow down the development of shale gas and shale oil industry. The cost of extraction of shale gas and oil must be higher than the extraction of natural gas and crude oil because the formers require higher technologies. The game behind all the giants has led to high volatility of crude oil price.
[pic 3] Figure 4 The projection of increase in Shale gas from 2010s to 2035s by EIA Forward and future Contracts There are no exchanged traded jet fuel futures in the US exchange market.Therefore, hedging strategies of most airline companies have been set up between crude oil and heating oil because they are actively traded in the futures market. They are not perfectly correlated with jet fuel but are still highly correlated. Therefore, the airline companies face basis risk when involving heating oil and crude oil in their hedging strategies. Airline companies can work out with the specialists i.
e. fuel management companies, large oil companies and financial services institutions to tailor-made forward agreements for jet fuel hedging purposes.Forward contracts are over the counter (OTC) agreements between two parties i. e. the airline companies and the specialists.
The contents of the agreements are whereby one party purchases a fixed amount of jet fuel from the other at an agreed price at a future date. In reality, airline companies enter into a forward contract with fuel management companies such as Mercatus Energy Advisors, Pricelock, Global Risk Management and World Fuel Services. They can choose to deal with the Oil companies such as ExxonMobile, BP and Koch Industries etc.The role of Investment Banks i.
. Goldman Sachs, BNP Paribus, Barclays Plc, Wells Fargo, Morgan Stanley and Citigroup involves either in matching counterparties or speculating activities. Derivatives such as future, option and forward agreements are zero sum games. The counterparty may go bankruptcy and unable to meet the obligation. So, there is counterparty risk involving in forward contracts.
Example of Forward Agreements The Finance Director of Cathy Pacific, Martin Murray has pointed out that they have hedged from 2015 to 2018. 60% of the hedged position is at USD 95. 7% of the position is hedging at an average of USD 82.Murray insists that Cathy Pacific is well protected against upward fuel volatility going forward.
It was most likely that the hedging strategic team in Cathy Pacific has hedged jet fuel cost by entering into forward contracts of ICE Brent crude oil. The Brent crude oil price was peak in USD 115 in June 2014. It had dropped to nearly USD 45 in January 2015. The forward contracts are OTC contracts with underlying product of Brent crude oil between Cathy Pacific and the other counterparties at USD 95 and USD 82 at the future date of 2018.
Cathy Pacific has locked the oil prices at USD 95 and USD 82 from 2015 to 2018. At the date specified in the contracts, both parties have the obligation to fulfill the transactions. Cathy Pacific will continue to enter into the forward contracts even the Brent crude oil price is USD 45 in January 2015. Once the oil price rises in the coming years, the hedge will really help a lot. Options Airline companies can use OTC and exchange traded options to build up hedging strategies.
In reality, airline companies prefer OTC options rather than exchange traded options because they are customizable.In order to cope with counterparty risk, airline companies trade options with several investment banks to diversify the risk. At the same time, the diversification among different counterparties also keeps the secret of the underlying strategies. For example, airline companies can long a call from one investment bank protecting from adverse oil price increases above the strike price.
The company can short a put to another investment banks receiving a premium to pay for the cost of longing the call. Shorting a put gives up the benefit of oil price reduction.This strategy is called collars. It is better not to reveal hedging strategies to individual counterparty since options contracts are zero sum game. One party’s lose will be the other’s gain. Since jet fuel is not available in US exchange market, the option of it must be tailor-made by the investment banks.
Exchange traded options with underlying futures of Brent Crude oil, WTI Crude oil and heating oil are commonly used. There are two reasons. Firstly, some financially weak airline companies find it very difficult to find counterparties.They will have to rely on exchange traded options for hedging. Secondly, exchange traded options of WTI Crude oil, Brent Crude oil are well developed with market depth.
Although there are 1-month, 3-month, 1-year and 3-year options etc. available, the phenomenon is that the most active traded options are always concentrated on those short term options. Even though there is market makers, the bid and ask spread price can be unreasonably wide. The options price quoted by the market maker can be unfavorable to the airline companies.
It is very hard to decide the reasonable price of the option because the option pricing elements such as implied volatility and value of time etc. are very difficult to monitor especially to those options which are out of the money. Airline companies have to deal with this liquidity risk. Hedging strategies involving options require a substantial amount of monitoring. Oil price can move up and down in the short run. In the long term, the oil price has price cycle.
A substantial monitoring means that the sophisticated hedging strategic teams have to position the current fair price of oil and predict the future movements.All strategies will rely on the position and prediction. The strategic teams can long a put or short a call when they think the oil price is about to drop. They can long a call or short a put when they predict that the oil price will increase.
When the airline company has entered into a forward contract with an investment bank at a specified price at future date, then the team can short a call at that future date with strike price under or equal to the specified price. This strategy is called covered call.If the oil price turns out to be higher than the specified price of the forward, the contract can cover the lost. Otherwise, the company can receive premium from shorting the call. Introduction – hedge with exchange traded futures contract Apart from option and forward, future contract would be the most common way for airline to hedge away the jet fuel price to stabilize their operational cost.
Since those contacts are standardized and high liquidity. The concept is direct and easy, the selling side is agrees to selling the oil they have for a predefined price and date.You can trade crude oil futures at NYMEX and ICE (Intercontinental Exchange) trading unit and price would be different across different exchanges like Brent crude oil futures are trade in 1000 barrels (42000 gallons) per contract with price quotation in US dollars and cents per barrels. For instance, a DEC 2024 future contract is price at 58.
25, the total settlement price will be 58250 USD per contract. Yet you can buy the contract with initial margin in between 17% to 29% of the settlement price of the whole contract and marked to market daily.About the liquidity of the future contract oil, for e. g.
the crude oil future trade in ICE could up to 20 million contracts per month. You can long or short even if you don’t have the underlying commodity in your possession since you can have cash settlement on the expiry day. And it’s actually most of the case for the future contract, up to 99% of the settlement were made with cash settlement. The upside risk and downside risk can be illustrated with the graphic below: Difficult of hedge with exchange traded futuresThe difficulty to make future contact that can hedge away the oil price risk would be the hedging ratio, and subject to how the risk manager predict of the oil price trend, since oil price is energy that had high beta with worldwide economic, if airline aim to make profit out of long term hedging with long future contact, that would be as hard as predict the world economic or as simple as gambling of oil price. Beside, unlike forward contract, that can be custom made according to the airline needs, forward contracts are to be traded OTC, that increase the difficulties to airline risk manager to collect and trade publicly.
Common model used with future contact oil hedging And since there aren’t no one can predict the oil price of the future, here come a lot of research on the best hedging ratio and model that hopefully can benefit from even gaining in the oil hedging. The following part will be introducing some of the popular tools when it comes to predicting the optimal hedging ratio, by using different models , like the most OLS(), GARCH(), native(), but the result were different across different period of time and market. There is no clear evidence that a best model to explain the oil market.
