Bloomberg had a news article earlier this week that highlights the practical problem of implementing a hedging strategy even in one of the largest commodity markets, jet fuel. Many airlines attempt to hedge some portion of the anticipated cost of jet fuel purchases over the coming year. In large part, they do this by purchasing futures contracts on either crude oil, the feedstock for producing jet fuel, or heating oil, another refined product that is slightly different from jet fuel. The prices of the three commodities are correlated, but only imperfectly. In the long run, if the price of crude oil goes up significantly, the price of the refined products must also go up. But in the short run, the relationship is very erratic. The price of crude and jet fuel can even sometimes move in opposite directions as they have recently. Here is a graph of the crack spread over the last number of years:
The spread graphed is the difference between the price of the refined products produced from a barrel of oil and the price of the barrel of oil. The graph shows the most widely quoted version of the crack spread, the 3:2:1 spread–i.e., 3 barrels of crude oil yields 2 barrels of gasoline and 1 barrel of heating oil. Clearly this spread swings significantly through time.
This is a classic case of basis risk, which is just the volatility in the differential between two related commodities or between one commodity for delivery at different locations or different delivery dates. Basis risk undermines the effectiveness of a hedge built using a related commodity. Airlines that used crude oil futures to hedge their jet fuel prices are finding that the hedges are losing money at the very same time that jet fuel prices are going up. This is exacerbating the cash flow volatility that the hedge is designed to reduce.
What can be done about this?
Most airlines have already done what they are supposed to do. Basis risk is a familiar fact of life, and not a new feature of the oil market. Knowing that a hedge built using crude oil futures contracts contains basis risk, the right hedge strategy involves a smaller hedge ratio. If, absent basis risk, the optimal hedge ratio were to buy forward 75% of next year’s anticipated fuel purchases, then, including basis risk, the optimal hedge ratio is smaller. Perhaps the company should buy forward only 40% of next year’s anticipated fuel purchases. How to figure out the percentages is a complicated exercise. Of course, reducing the size of the hedge limits the amount by which the hedging strategy is reducing the volatility of the company’s cash flows. But that reduction in effectiveness is just a reflection of the reality that the feasible hedges are imperfect. Perfect hedges just aren’t available. So achieving a deeper reduction in volatility is just not possible.
Why hedge using crude oil contracts? Why not hedge using the real thing, jet fuel contracts? If jet fuel contracts were available at the same ‘cost’ as crude oil contracts, then clearly this would be a better alternative. The Bloomberg article mentions that Delta and JetBlue include jet fuel contracts as a part of their hedging strategy. The problem is that the jet fuel market is smaller than the crude oil market, and constructing a financial contract indexed to the jet fuel price is ‘costlier’ than constructing a financial contract indexed to crude oil. By ‘cost’ here, we mean the real expenses incurred by financial institutions who manufacture the financial product—including any profit they can extract. Identifying this ‘cost’ is difficult. It is built into the bid-ask spread, which itself may be volatile. When airlines choose the mix of contracts that make up their hedging strategy, they have to factor in the ‘cost’ paid for each type of contract and find the cheapest mix. They then have to weigh the total ‘cost’ of hedging against the benefits of hedging in order to arrive at their chosen hedge ratio. According to the Bloomberg article, US Airways has decided the ‘costs’ are too high, and the optimal hedge ratio is zero.
How about simply abandoning hedging completely, and switching to a ticket pricing policy that includes a pass through of fuel costs? This is another alternative mentioned in the Bloomberg article. While it always makes sense to review assumptions about pricing and the pass through to consumers, it is a dangerous illusion to imagine that a company can reduce its exposure to zero just by willing it so with a simple pricing rule. Even if an airline were to explicitly price its tickets in two parts—a base airline fee, plus a fuel surcharge tied to the daily market price of jet fuel—the airline would still be exposed to fluctuations in jet fuel prices. This exposure has at least two parts. One has to do with the delay between the date on which the typical ticket is purchased and the date on which the passenger flies. The cost of the jet fuel can fluctuate between these dates. The second has to do with demand elasticity to price. If customers respond to an increase in jet fuel prices by cutting back on the number of flights they take, the airline will take a hit. It still has to pay for the airplanes it owns or rents. It still has to pay its labor bill. It still has costs tied to gate fees and other structural expenses. Re-optimizing the airline’s operations in response to changing factor prices takes time. In the meantime, cash flow is made volatile by the change in the jet fuel price. Instead of trying to imagine away exposure by force of will, an airline needs to realistically assess its industry, its flexibility, customer flexibility, and so on, and arrive at a comprehensive strategy. Financial hedging is almost certainly a part of that strategy. How large a part depends as well upon a realistic assessment of basis risk and the ‘cost’ of hedging.
Related posts on airline hedging here and here.