After the storm

Asian airlines and other heavy users of fuels received a sharp lesson about the risks associated with their hedges after fuel prices peaked in 2008 and then collapsed during a six-month period. How have they moved to improve their risk management strategies? Georgina Lee reports

The one-way, almost continuous upward momentum of West Texas Intermediate (WTI) front-month crude oil futures contract price from January 2007 to its peak of $147.27 per barrel on July 11, 2008, was only outdone by the subsequent crash in price to $35 by January 2009. The dramatic price moves in oil and correlated energy products caused acute stress for even the most sophisticated financial models and hedging strategies. And the situation was far worse for fuel users that – often operating on a tight budget with small treasury teams – had bought into complex, leveraged structures offered by investment banks that promised to reduce the premium of their hedges (against further price rises in mid-2008) down to zero.
The billions of dollars of losses reported by a raft of different fuel-intensive businesses, notably Asian airlines deploying ‘collar strategies’ where they would receive on options should the fuel price rise above a certain threshold and pay out a leveraged amount on options should they fall below a certain floor, made it painfully clear to treasurers and their boards that risk management is no free lunch. And these corporations are now re-examining their strategies.

Airline executives and their hedge-providing banks say the recent fall in implied volatility has partly led to more willingness from Asian airlines to pay upfront premiums to buy outright options, meaning that for the first time in many years, there are more net-buyers of optionality than net-sellers. This contrasts with 2007–08 when the market was dominated by net-sellers. Implied volatility of WTI at-the-money, front-month options dropped by 118.5 percentage points by press time from a peak of 158.76 on December 15, 2008.

 “Options get relatively cheaper as implied volatility decreases, and the market has looked a lot more attractive for buyers of options with the big sell-off in volatility,” says Sean Brecker, head of commodities trading at Nomura in Singapore. This contrasts with the trend seen in 2007 and 2008 when it was common for airlines to be selling twice the quantity of puts to partially fund the calls – and helped explain their mark-to-market losses in their 2008 income statements because they got too leveraged up on these positions.

“These days airlines are entering into less leveraged hedges. For example, they may do collar structures in which they are long the same quantity of calls as they are short puts. In the past, they may have done so-called ‘2-by-1’ structures, i.e. short twice as many puts as they are long calls in an effort to reduce strikes. We have also seen clients buying outright call options and paying a premium upfront in an effort to cap their potential mark-to-market losses,” Brecker says.

Chai Eamsiri, director of the petroleum and fuel management department for Thai Airways in Bangkok, says despite all the bad press on collar strategies, most airlines, including his own, use simple collars for at least part of their entire portfolio. A simple, one-for-one collar contract comprises the selling of a put and buying of a call at the same time over a determined number of referenced fuel. “Because in a collar we also have to sell a put at a lower strike level, which is our risk, the question for us becomes ‘how deep [in terms of the strike level of the put] are we comfortable with it?’” Eamsiri says, as long as the put strike is set lower than its estimated fuel cost projected for the next quarter, his team would be willing to accept that strike.

Thai Airways uses three-way collars that involve the selling of a call in a bid to enable the airline to either improve the strike levels of the long-call, or short-put for the airline with the premium generated from selling that call option. Clearly, the selling of a call would trigger another concern for his team so when determining that call spread, Eamsiri says his team works out how much dollar-per-barrel upside protection his company needs. “You have to accept that you can’t get 100% protection from any hedging, that hedging is just one of the tools to mitigate fuel price risks; so when we hedge we also look at fuel surcharge, so that if the market moves out of the call spread, we could compensate part of that risk through fuel surcharge,” says Eamsiri.

As Thai Airways hedges only up to a six-month horizon, he says the airline can directly reference jet fuel, which has good liquidity up to one year. The airline now wants to increase its hedge percentage within the 80% ceiling set by its board, from 50% currently. It expects total fuel consumption this year to be 20 million barrels.

For Qantas Airways, Sydney-based assistant treasurer of risk management, Craig Hughes, says while the decision over whether or not to use a swap or option is not straightforward, his firm would prefer using options and/or collars rather than swaps, as swaps do not allow the airline to participate in falling prices.

While hedged at 85% for remaining financial year ended June, Qantas maintains a 78% participation in falling prices from current level. Participation level shows the proportion of its total oil requirement over a period that enables an airline to take spot out during a period of falling prices, rather than take delivery of its hedge-book price.

“A swap alone doesn’t allow for any participation in lower fuel prices; it is just an agreement to pay a fixed fuel price at maturity, regardless of where the prevailing spot price is,” he says. “This contrasts with a call option which locks in a known worst-case price, but also lets the airline’s cost structure benefit if fuel prices happen to fall. Given the correlation between fuel prices and business cycles, it is important the group’s fuel bill falls as prices fall, as this is likely to correspond to a period when revenues are under pressure.”

Hughes adds that while higher implied volatility makes buying options more expensive, the airline’s appetite for options will not necessarily be reduced, as higher volatility implies greater uncertainty over future prices, making both protection and participation even more necessary. “Even though it is more expensive to buy options when volatility is high, options are giving us protection against higher fuel prices, while at the same time minimising potential hedge losses if fuel prices fall,” he says. “We view having a large proportion of hedging in swaps as simply too great a risk in terms of possible mark-to-market losses; [in terms of] the inability to benefit from lower fuel prices; and potentially putting the airline at a disadvantage if our competitors are able to take advantage of lower prices.” Qantas uses a combination of jet fuel and gas oil for its hedges.

Toeing the line

Air China, which reported a net loss of 9.26 billion renminbi ($1.3 billion) after recording realised and unrealised fuel hedging losses totalling 7.8 billion renminbi in 2008, says while the company is using derivatives to manage its fuel cost, it has not added any new exposure this year. Zhang Zhishun, vice-managing director in the finance department of the Beijing-based airline, says amid the fuel hedging losses reported in 2008 his team has since devised new hedging guidelines, but he stopped short of giving details. The company’s 2009 annual report states the company had settled some of its fuel contracts with a recovery amount of 5.41 billion renminbi. Air China used derivatives referencing to a combination of Singapore kerosene, Brent crude and New York crude.

“Our hedging strategy hasn’t changed, and we haven’t increased new exposure [this year]. But because we have a fuel surcharge mechanism it could mitigate the impact of rising fuel oil prices on our profitability,” says Zhang. Since November 2009, the National Development and Reform Commission, alongside the Civil Aviation Administration of China, have resumed allowing mainland airlines to collect fuel surcharge under a new pricing mechanism, after the authorities suspended fuel surcharges in January last year.

Based on the mechanism, mainland airlines are required to absorb at least 20% of the incremental operating cost caused by increasing domestic fuel costs, and they are allowed to collect fuel surcharges once domestic fuel price goes above 4,140 renminbi per tonne. For Air China, jet fuel costs accounted for 31.5% of its 2009 operating expenses.

However, China Southern Airlines’ chief financial officer, Xu Jiebo, admitted the company is still exposed to changes in the international portion of its fuel costs and that there is little his team could do to control this risk. “We are not engaged in any fuel hedging for the moment,” says Xu. “We do not have a clear perspective as to where the global economy is heading, thus we would prefer to have a conservative approach towards our fuel hedging.”

Indeed, the huge fuel hedging losses suffered by mainland airlines, which in China Southern’s case, had caused it to book 124 million renminbi loss on derivatives from selling crude oil put options of 7.8 million barrels at strikes that ranged from $40–54, against longing options to buy 3.3 million barrels at $42–64, all of which have expired, had led regulators to scrutinise state-owned enterprises’ (SOE) use of derivatives.

In February 2009, the State-owned Assets Supervision and Administration Commission (Sasac), the state shareholder of China’s 140-plus SOEs, issued a set of guidelines that sought to restrict SOEs’ use of derivatives. One requirement has subjected the relevant senior executives of these SOEs to administrative or criminal liability if the use of derivatives caused significant losses to the company.

Meanwhile, amid these large mark-to-market derivatives losses, some of the SOEs sent letters to six international investment banks stating they reserved the right to pursue legal action against these banks if these bilateral derivatives contracts were proven to be illegal. Sasac was believed to be behind the move that was seen as a warning shot to foreign banks to ensure fair play when conducting derivatives deals with SOEs.

The result is that SOEs, as well as financial intermediaries, are taking a cautious approach. China Southern Airlines, for example, is adopting a “conservative approach” by doing nothing about its risk exposure to international jet fuel prices. Indeed, it is not unusual to find that not hedging is the preferred default risk management position for many SOEs.

“Going forward, perhaps these airlines might choose to lock in long-term, forward contracts with the oil trading companies so that they could lock in future prices in the physical market, and account for it just like normal, physical fuel transactions expenses instead of derivatives,” says a banker in Beijing, who helps Chinese corporates manage their treasuries.

Hedge accounting

Hong Kong’s flagship airline, Cathay Pacific, made a net profit of HK$4.69 billion ($1.8 billion) in 2009, which partly reversed its net loss of HK$8.7 billion net loss the previous year. Like many other Asian airlines, Cathay Pacific’s 2008 net loss was blown out by fuel hedge losses – to the tune of HK$7.97 billion. “It got burned by seven out of eight exotic hedges sold by a US investment bank that year,” says a Singapore-based source. Cathay Pacific booked a fuel hedging gain of HK$2.76 billion for 2009. But executives in Cathay Pacific’s treasury declined to comment.

Air China has also shown similar swings in its 2008 and 2009 income statements, as the airline also reversed its 2008 hedging loss and booked a net gain of 2.76 billion renminbi in 2009, due to a sharp decline in mark-to-market loss in fuel derivatives contracts on the back of the rebound in international oil price.

To reduce this volatility, airlines have investigated converting certain physical purchases into purchases embedded with risk management products. They essentially want to convert physical jet fuel purchases into financial products, be they swaps or other instruments. This approach became attractive in 2008 and 2009.

Investment bankers and airline treasurers say their shift to new, fair-value accounting standards and their adoption of International Accounting Standard 39 (IAS 39) that deals with hedge accounting – which is supposed to bring more transparency to the reporting in derivatives and their use in risk management – has also caused swings in the profit and loss accounts of airlines, resulting in airlines giving up on hedging altogether.

Based on a matching concept, IAS 39 enables gains and losses on the hedging instrument (for which most derivatives would qualify) to be recognised in the same income statement period as offsetting losses and gains on the hedged item. To qualify for hedge accounting, companies must demonstrate that the hedge relationships meet certain criteria, one of which is that the effectiveness of the hedge must fall within a range of 80–125% over the life of the hedge.

What this means is that companies can only account for an instrument as a hedge if the movement of that derivative offsets the underlying exposure within a band of 80–125%. If, for example, the only available hedge instrument in the market offsets the underlying exposure only by 75%, the company would have to mark-to-market in its profit and loss as the instrument would then not qualify as a hedge for accounting purposes.

Additionally, if the derivatives and the underlying items being hedged use commodity prices in different markets, such a hedge is regarded as ineffective and any gains or losses on the derivatives are recognised immediately in the income statement.

Gregory Mannings, treasurer, capital markets at Qantas in Sydney, says this means that if an airline hedges its jet fuel exposure with a different fuel index such as a WTI crude oil derivative – which is often the case for many airlines due to it being a more liquid commodity than jet fuel – the basis risk between those two commodities will result in the derivative being deemed ineffective and the derivative being marked-to-market through the income statement. “What IAS 39 does not reflect is that this is a valid hedging strategy and arguably the most appropriate for shareholders; one reason being that there is no competitive market for jet fuel derivatives if you want to hedge further out, for example, past one year,” he says.

Because IAS 39 requires the hedge relationship is documented at the inception of the hedge, but companies hedge forward, the net effect of IAS 39 also resulted in airlines in 2008 having to book their mark-to-market losses on fuel contracts when fuel prices fell significantly – although those contracts were not hedging their fuel consumption for that same year, but often for 2009 and 2010 instead.

And since 2009, fuel prices have been rising again, meaning for many airlines the derivatives they have taken out are now making gains. For example, Air China and Cathay Pacific have mark-to-market gains in their profit and loss accounts for 2009 that are related to exposures that may have nothing to do with the current year.

An extra burden for airlines is they have to reflect mark-to-market changes every time they issue financial reports, usually every quarter for listed airlines. Before IAS 39, such changes would normally be spread over the life of the hedge, which usually cover airlines’ future two to three years’ fuel consumption.  “The key point regarding IAS 39 is that the economic reality of your hedge transaction is often not reflected in your accounting results,” says Manning. “As a consequence, the results investors and analysts are getting are meaningless, and for airlines in particular, the accounting view distorts the underlying performance of the business,” he adds.

From an investor relations perspective, such volatility would mean the decision to use a particular hedge or not boils down to how much the management feels it could explain to investors if they have a strong view on that hedge they want to put on also leaves them with big swing on the company’s profit and loss account, says a banker.

By being able to lock in the physical at fixed prices, companies do not have any mark-to-market exposure. In fact, by locking in fixed prices it goes in as an operating expense. It looks better on the balance sheet as it gives investors a degree of certainty about how their fuels costs will look and that they will not have large mark-to-market losses for derivatives hedges.