Impact of Fue Hedging on Airlines Profitability Literature Review

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Fuel Hedging and Airline Profitability -- Literature Review

Airline operations are usually affected by several factors, especially the prices of oil and exchange rates since they have the capability of making things more complex. Fuel prices are some of the major risks that generate complexities in the operations of airlines and have considerable impacts on airline profitability. Consequently, airlines develop and adopt several measures for risk mitigation in order to enhance their profitability. Fuel hedging is one of the risk mitigation strategies adopted by airlines to help lessen operational risks and enhance profitability. The significance of fuel hedging as a risk mitigation strategy for airlines is evidenced in the volatility of fuel prices. As airlines constantly adopt this risk mitigation strategy, numerous studies have been carried out to examine its effectiveness. Existing literature examines the economic sense of fuel hedging with regards to the role and impact of this strategy in promoting airline profitability.

Theory and Practice of Fuel Hedging

The continued use of fuel hedging by airlines is an issue that has been examined by several researchers and well-documented in existing literature. This issue has attracted considerable attention because of the increased volatility of fuel prices across the globe. The volatility in fuel prices is brought by several economic factors that continue to affect countries across the world. Morrell & Swan (2006) contend that hedging fuel costs is widely practiced by many international airlines despite lack of strong theoretical justification (p.713). Airlines adopt fuel hedging to protect fuel costs since it involves locking in the cost of fuel purchases in the future. This strategy is used by airlines since it safeguards against unexpected losses from increases in fuel costs and prevents unprecedented gains from decreasing costs of fuel (Morrell & Swan, 2006, p.713). Therefore, airlines use of fuel hedging is geared towards stabilizing fuel prices given their volatility and the fact that fuel accounts for approximately 15% of an airline's operational costs.

According to Morrell & Swan (2006), the theory underlying fuel hedging by airlines is that fuel hedges enable an airline to lessen a significant source of swings in profits and subsequent higher prices for the airline's stocks (p.715). Carter, Rogers & Simkins (2004) support this theory by arguing that airline executives usually find it impossible to pass higher fuel costs on to passengers through increase in ticket prices because of industry competitiveness (p.3). As a result, airlines hedge fuel prices in order to prevent huge changes in operating expenses and changes in bottom line profits. Existing literature demonstrate that airlines that generated adequate return tended to be those that hedged fuel prices while those that did not do so registered unsatisfactory revenue or losses.

Simmons (2015) argues that the only purpose of hedging fuel prices by airlines is to lessen risk as they face an uncertain future in relation to volatility of fuel prices (p.1). The same view is held by Westbrooks (2005) who states that fuel hedging is one of the creative measures adopted by airlines to help reduce risk and cost (p.19). This is primarily because airlines usually struggle to cope with the numerous challenging economic conditions. Fuel hedging is adopted by airlines in order to enhance their bottom line through increasing their earnings or revenues (Westbrooks, 2005, p.19). The author also argues that the theory behind fuel hedging by airlines is that it's similar to an insurance policy that safeguards these companies against rising fuel costs or volatility of fuel prices. In this case, the author provides a different perspective of hedging by postulating that it's an investment that's similar to other investments because there are risks associated with it. This is primarily because fuel hedging by airlines requires them to predict the future of a product and make an informed decision that is correlated with its leadership's aversion to risk (Westbrooks, 2005, p.22).

Carter, Rogers & Simkins (2006) further contend that recent literature shows that the theoretical justification for fuel hedging by airlines is that it can increase value (p.55). This position is supported on the premise that most of the existing theoretical research in corporate risk management postulate that hedging is one of the measures through which companies can increase their value and profitability. Trempski (2009) concurs with this argument by stating that most of the recent literature on hedging emphasizes the notion that it enhances a company's value (p.2). In this case, one group of recent researchers state that hedging contributes to higher company value while another group contends that hedging is a non-value adding initiative and others contend that hedging adds value only under specific circumstances (Trempski, 2009, p.2).

Simmons (2015), states that there are different hedging strategies available for companies depending on their needs and goals (p.

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1). Some of these strategies include fixing the price of an input, set the input price below an upper limit, and establish the input price within a series defined by upper and lower limits (Simmons, 2015, p.1). Simmons (2015) concurred with Westbrooks (2005) who stated that there are various hedging strategies that can be utilized by financial managers. However, Westbrooks (2005) states that these strategies must incorporate three basic tools i.e. forwards, futures, and options or a combination of these tools (p.22). Airlines use forwards to hedge fuel prices through establishing a contract with fuel companies to purchase fuel at a specific price, amount, and date. Through futures contracts, airlines hedge fuel prices through entering agreements to purchase fuel at a future time though the airline is given an assurance that the contract will be acted upon at expiration (Westbrooks, 2005, p.23). Option contracts give airlines the option of hedging fuel prices by acquiring the right, but not the obligation to purchase the fuel at specified prices and date.

While agreeing that forwards, futures, and options are the major strategies airlines use to hedge fuel, Morrell & Swan (2006) contend that through options, airlines do not need a margin when hedging fuel costs (p.715). These researchers state that forward contracts for fuel hedging are usually over-the-counter agreements while future contracts establish standards and protect parties against counter-party risk. However, airlines have recently shifted towards using a mixture of a call and put option that is commonly known as a collar (Morrell & Swan, 2006, p.716). This combination protects the company against price increases beyond a strike price above the current future at a price of the option premium that must be paid immediately (Morrell & Swan, 2006, p.716). Airlines also prefer swaps, which are customized futures contracts that enable an airline to lock in payments at future dates depending on the current price of fuel.

Trempski (2009) provides a different strategy that airlines use to hedge fuel prices on the premise that this industry is most inversely correlated to fuel prices (p.1). In attempts to lessen the risk of fuel exposure, some airlines are currently using derivatives to lock in fuel costs. Consequently, airlines obtain temporary protection that protects them against high costs of fuel while also preventing them from enjoying lower fuel prices in case of decrease in the costs of crude oil (Trempski, 2009, p.1).

Cobbs & Wolf (2004) argues that there are several jet fuel hedging strategies that are available for airlines through an analysis of industry practices. These strategies include over-the-counter instruments like options (including collar structures and swaps), exchange-traded futures (which involves futures on crude and/or heating oil), and not hedging. Not hedging is a model through which airlines take on the risk of rising fuel prices into their existing business models and structures (Cobbs & Wolf, 2004). This is an available strategy given that some airline executives have claimed that the risk of rising prices of commodity continues to exist despite whether or not they choose to hedge.

Carter, Rogers & Simkins (2006) provide other strategies that airlines use for fuel hedging in addition to futures, forwards, and options. These researchers states that some of these strategies include swap contracts like plain vanilla, basis swaps, and differential as well as collars such as zero-cost and premium collars (Carter, Rogers & Simkins, 2006, p.5). Plain vanilla swaps is a simple and basic hedging instrument, which is an agreement in which a floating price is exchanged for a fixed price over an specific period of time. Unlike other swaps, plain vanilla swap is an off-balance-sheet financial plan that does not involve the transfer of a physical item though both parties settle the obligations in the agreement through transferring cash. When used in fuel hedging, plain vanilla swaps provides details regarding the volume of fuel, its floating and fixed prices, and the duration in which the swap matures (Carter, Rogers & Simkins, 2006, p.5). In essence, these swaps are based on variations between the fixed and floating prices of the same product such as fuel.

On the contrary, a differential swap is an agreement that is based on the difference between a fixed differential for two different products and their real difference over a certain period of time. These contracts….....

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