Asia-Pacific airlines wobble over fuel hedging

By Yaw Yan Chong – Analysis

SINGAPORE (BestGrowthStock) – Asia-Pacific airlines, stung by billions of dollars in losses and Japan Airlines’ bankruptcy, face the test of moving nimbly to protect against extreme fuel price swings and widen hedging activity in an open market.

But old ways die hard.

Oil’s unprecedented volatility in 2008 cost some airlines hundreds of millions of dollars in hedging losses each, but most are hamstrung by structural practices and mindsets that prevent them from putting in place a more responsive hedging program.

Some carriers were able to trim hedging costs when oil markets steadied last year, but most will still struggle to find the right balance when prices suddenly turn, traders and bankers say. Those who hedge are still a minority in this region.

“The problem with the airlines is that they treated hedging as a profit/loss mechanism rather than as insurance, which should then be regarded as cost and as cover in case of the unexpected happening,” said Clarence Chu, a trader with Hudson Capital.

Companies such as airlines mark-to-market derivative positions as profit or loss, in line with accounting rules.

“Most still view it the same way, even after the last round of losses. I’m not sure if you can say they have learnt their lessons but at least they are more willing to listen now,” Chu said.

Carriers tend to hedge their positions with a limited number of counterparties, mostly banks, shying away from the wider market with clearing house or exchanges such as NYMEX and ICE, where prices are more competitive.

RIGOROUS BUT SLOW PROCESS

Despite JAL’s $441 million in hedging losses and its subsequent $25 billion bankruptcy, the disruption to oil and financial markets was minimal. This was unlike the fall of Lehman Brothers two years ago, which forced counterparties to use clearing facilities due to mutual fears over credit worthiness and banks’ squeeze on loans during the financial crisis.

The ready supply of credit and banks’ move to boost customer flows offer airlines few incentives to explore alternative ways to hedge, traders said.

“They’re still hedging the same way, with the same few banks that they have built comfortable relationships with. It’s a bilateral relationship, the banks allow them to trade on credit,” another industry source said.

“Airlines can probably get more transparent prices from the open market on the exchanges such as NYMEX, but they have often baulked at having to pay clearing fees and maintaining margins.”

Most airlines, like other big listed firms whose core business is not trading, have stringent measures to guard against price speculation.

But the safeguards, such as a rigorous regime that goes up to top management before airlines can take new positions to mitigate loss-making hedges, also slow their reactions and limit options when prices spike or fall dramatically.

This is unlike traders and banks which take daily positions — entering or exiting the market when necessary to limit losses or maximize gains — but also do so for speculative purposes.

One lesson some airlines did learn was not to hedge too far forward and to cut back on hedging volumes in order to manage premium costs when markets stabilize.

This has helped carriers such as Singapore Airlines, Cathay Pacific and Qantas, which managed a turnaround after the losses in 2008 and reported net hedging gains last year.

Their recovery could have been partly achieved by managing hedging volumes, which were reduced to pre-2008 levels of 20-40 percent of fuel consumption and limited their hedge to just 12 months ahead.

An SIA spokesman said the airline was now hedging 20-60 percent of its fuel requirements, down from 30-60 percent, and had stopped hedging on diesel, after a review last year.

“The objective of our fuel hedging program is to smoothen volatility in fuel prices. We hedge on a declining wedge profile, where the hedged volume is progressively built up over time,” he told Reuters. “We use a combination of hedging instruments, namely swaps, collars and call options.”

In the July-September quarter last year, SIA showed a net hedging gain of about $45 million, recovering from net losses above $200 million for financial year 2008/09.

It cut hedging volumes to 22 percent of fuel consumption, or about 3.5 million barrels of jet fuel, at an average of $100 a barrel versus current prompt jet swap levels of

$75.00-$85.00.

Hong Kong’s Cathay Pacific reported unrealized mark-to-market gains of HK$2.1 billion ($270 million) for first-half 2009, rebounding from losses of $978 million in 2008.

RISKS OF REDUCED HEDGING

However, traders cautioned that reducing hedging to as low as 20 percent could again expose airlines to volatile swings, especially if fuel demand rises with a recovering economy.

Traders said the market was at its most volatile in 2008, when prices rose from below $100 a barrel to a record above $140 in July. Prices then sank to below $40 by end-2008, marking the worst year for most regional airlines.

For graphic showing volatility of Brent futures and physical jet fuel prices, click:

http://graphics.thomsonreuters.com/gfx/RSW_20102101200022.jpg)

Reflecting this, the 30-day-at-the-money implied volatility for U.S. crude, which gauges the expected price movement based on options premiums, was the highest-ever above 100 percent in December 2008, when oil nosedived. Volatility was around 45 percent in July.

The monthly value for January this year stands at about 34 percent, the lowest since 12 months earlier, and has been rangebound between 30 and 50 percent since May last year.

“It all boils down to making the correct call on the market and being nimble and flexible enough to act on that,” a Singapore-based Western investment banker said.

“In short, they have to think like traders.”

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(Additional reporting by Ryan Siew; Editing by Ramthan Hussain)

Asia-Pacific airlines wobble over fuel hedging