Airline Fuel Hedging Programs

Airline Fuel Hedging Programs

Introduction

Fuel costs are among the essential and highly valuable expenses for the airline industry around the world. They constitute about 12% of the total expenditure in that two-thirds of the flying costs are fixed, but the price of fuels is unpredictable, for they can swing the industry from profit to losses. For years the airline industry has continued to be brutally competitive with the increased travel rate as flying worldwide has become an integral part of the current society. Technological advancement has played a pivotal role in creating greater price transparency as well as reduced margins. With the increased fuel costs expenses, airline companies, including Southwestern and Delta airlines, have designed fuel hedging strategies to minimize the risks of the fluctuating price movements against open trade. A fuel hedging program is a contractual tool that airlines adopt to reduce their vulnerabilities that accrue fuel price fluctuation. Fuel hedging has enabled airlines to have control of their forecasting expenses and reduced margins.

Throughout history, fuel costs have consistently been the largest costs that every airline faces. This is due to the volatility of fuel prices due to varying market forces which poses a challenge for airlines. Gaining control of fuel costs is an operations strategy that ominously helps influence and enhances its competitiveness in the airline industry. Companies have adopted financial risk management procedures that have helped them save billions of dollars in fuel costs using hedging strategies that focus on the energy derivative market. Hedging strategies are dependent on procurement contracts that supply oil at a lower price than the market price, especially when the market price is forecasted to increase shortly. This operations strategy helps airlines to have control over expense forecasting. The hedging forecasting should be handled with care as it may cause a greater financial issue if not properly forecasted. For instance, a drop in oil prices below the normal hedged price can cause substantial loss to the company, especially Southwest Airlines and China Eastern Airline, which have incurred huge costs due to their price hedging strategies.

Having a constant supply chain of goods and services is essential to the success of an organization. Companies often face various sourcing decisions with both internal and external means posing serious implications for a company’s operational performances and productivity. Although there is a rich literature on internal or external sourcing decisions, financial repercussions are unclear, as Manuela et al. (2016) observed. Delta Airlines adopted an internal sourcing strategy as a hedging program by procuring an oil refinery in Trainer, Pennsylvania, responsible for one-third of the jet fuels on the East Coast of America. Initially, they aid over $150 million and later invested another $100 million for its upgrade. Their primary aim was cutting the cost of price, thereby saving the company up to $300 million annually, which will enable them to purchase 60 more aircraft from their savings (Manuela et al., 216).

Notably, Southwestern Airlines was the first in the industry to the way of fuel hedging. While the prices were high in 2007, up to $90 a barrel, it enjoyed the lowered cost of $51 a barrel. Along with China Eastern, Southwest Airlines are known for their long-term hedging strategy to lock a lowered price, which helps them manage their fuel expenses (Liu and Jones, n.d). However, long-term hedging strategies have consequences, as in 2009, Southwest Airlines paid more than the market price, leading to high losses. Similarly, China Eastern Airlines felt a victim of the long-term hedging strategy in the same year, which registered over 13 billion.

Delta Airlines’ “innovative approach” to internal sourcing raises many concerns. First, the Trainer oil refinery was an old facility that relied heavily on expensive-grade crude oil. Moreover, the price per barrel and the refined products did not make any difference and was the main reason why Phillips 66 sold it. The way with which Delta was to renovate the facility and still secure a profit was unclear. The projected savings upon the purchases was also unclear and the impact it may bring on productivity. In their research, Manuela et al. (2016) noted that Delta Airlines oil refinery acquisition effectively secured constant financial performances in the long term and will help the company, especially when the prices are higher. In an industry that is dependent on oil, one of the unpredictable and one on which the airlines’ financial performance depends, the acquisition of a refinery was an excellent idea.

On the other hand, fuel hedging strategies used by Southwest Airlines along with China Eastern Airlines have ensured successful operations as most United States Airlines companies registered huge losses while some went bankrupt. Southwest Airlines has been cited in most literature for utilizing long-term hedging programs to its advantage (Liu and Jones, n.d). However, decisions on hedging strategies are challenging and risk, especially when deciding how many fuels to hedge, prices to settle on, and the contract period. In most cases, they had registered huge losses, especially in 2009 when the fuel prices went down below the hedging prices.

The cost of fuel is the biggest concern in top operational managers in the airline industry. I believe a fuel hedging strategy is an ultimate solution for curbing the volatility of fuel prices. However, thorough forecasting should be done before adopting a hedging strategy to avoid huge losses that may accrue in the future. Therefore, I believe airline companies will continue to use fuel hedging since it has registered huge success in the present and the past using Southwest and China Eastern Airlines. For instance, Southwest paid less than $3 a barrel in the first quarter of 2008, which was way below the fuel cost’s market price. I believe there is more to gain than to lose when using the right fuel hedging strategy (Liu and Jones, n.d).

 

References

Liu, Chin-Yen A., & Jones, K.J. (2016).  Integrated risk management on fuel hedging program: A case study on Southwest and China Eastern airlines. Academy of Business Research Journal. 2, 74-85.

Manuela Jr., W.S., Rhoades, D.L., & Curtis, T. (2016, August).  An analysis of Delta Air Lines’ oil refinery acquisition. Research in Transportation Economics 56, 50-63.

Mazareanu, E. (2020). Aviation industry – fuel cost 2011-2020 | Statista. Statista. Retrieved 28 February 2021, from https://www.statista.com/statistics/591285/aviation-industry-fuel-cost/.

Morrell, P., & Swan, W. (2006). Airline Jet Fuel Hedging: Theory and Practice. Transport Reviews26(6), 713-730. https://doi.org/10.1080/01441640600679524

 

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