Like many airlines rocked by high fuel costs and poor economic growth, Qantas Airways has hit turbulence in recent years. In December 2013, however, the Australian flag carrier reached something of a nadir. That month, the airline was forced to issue a market update that warned of "accelerated cost reductions" and a strategic review – a response to "fundamentally changed market conditions". The airline lost its cherished investment grade rating from New York-based credit rating agency Standard & Poor's (S&P), slipping from BBB- to BB+. Shortly after that, it was also downgraded by New York-based Moody's Investors Service, dropping from Baa3 to Ba2.
That month, Qantas embarked on a massive cost reduction exercise, as the airline posted a half-year pre-tax loss of A$252 million ($198 million). A three-year transformation programme was unveiled, including plans to reduce the group's net debt by A$1 billion, cut costs by A$2 billion and cull 5,000 jobs. A wage freeze would be imposed on many of the airline's staff until the firm became profitable again, while over 50 aircraft would be deferred or sold. "This is an unacceptable and unsustainable result," declared Alan Joyce, Qantas's chief executive, in a statement. "Comprehensive action is needed in response."
That transformation programme is now under way. Even the airline's Sydney-based group treasury has not gone untouched, losing five staff – or 20% of its headcount – as part of the transformation programme. Nonetheless, the unit – which is responsible for the treasury function of Qantas, as well as low-cost airline Jetstar – has played a critical role in turning the company around.
Reversal of fortune
After a full-year pre-tax underlying loss of A$646 million for the year ending in June 2014 – the worst in its history – Qantas swung to a half-year A$367 million pre-tax profit in December 2014. The turnaround is in no small part thanks to the efforts of its treasury – in particular, the five-strong risk management team led by Cecilia Ho, Qantas's treasurer, risk management.
Granted, the team has enjoyed some assistance from lower oil prices, which collapsed during late 2014 and early 2015. From a high of $115.06 a barrel (/bbl) on June 19 last year, front-month Brent North Sea crude oil futures traded on Atlanta-based exchange Ice slumped to beneath $50/bbl in January this year. By May 29, the contract had recovered slightly, closing at $65.56/bbl.
We’re forecasting at least a half-a-billion-dollar benefit from lower fuel costs this year
Those price dynamics mean that if Qantas had entered the 2015 fiscal year with no fuel hedges in place at all, it might still have reaped handsome gains. Yet the airline, which is known by counterparties for its careful risk management, actually began the year more highly hedged than in previous years. And throughout the entire period, its downside risk was carefully limited.
"We came into this financial year with a highly hedged profile," says Ho. "That was to make sure that we allowed the business to focus on the transformation initiative, and so that fuel didn't become noise the business had to worry about, or that fuel diluted any of the cost savings the company achieved."
The airline's hedge portfolio consists of a small number of jet fuel forwards, with larger hedges executed using a combination of outright options and consumer collars. Consumer collars typically involve buying out-of-the-money calls and selling out-of-the-money puts, capping both the potential gains and losses from fluctuations in fuel prices. That strategy gave Qantas the flexibility to adjust its hedges as oil prices hit their mid-2014 peak and subsequently dropped.
For instance, when oil prices stood at around $110/bbl in June last year, Qantas decided to restructure some of its collars into outright call options by buying back the out-of-the-money puts. By February 2015, the repurchase of the puts, which originally cost A$5 million, had allowed the airline to benefit from plunging fuel prices to the tune of about A$280 million.
For much of 2014, the risk management team gradually improved the airline's best-case scenario by buying back put options. At the same time, they also cushioned the firm's worst-case outcome by ratcheting down the strike prices on its calls. This means that even if fuel prices were to skyrocket over the coming months, the airline would be even better protected than it was back in July 2014.
"One of the focuses of our hedging strategy this year has been to ensure that our slippage back from current prices is capped at a lower price outcome than at the beginning of the year," says Greg Manning, the airline's group treasurer. "We've done that."
As of May this year, Qantas's group treasury was expected to deliver the airline a worst-case fuel cost of A$3.95 billion for the 2015 fiscal year. That compares with an actual fuel cost of A$4.5 billion for the 2014 fiscal year. "We're forecasting at least a half-a-billion-dollar benefit from lower fuel costs this year, and that's after the option premium that we've spent," says Manning.
The savings will go some way towards the airline's target of slashing net debt by A$1 billion, he adds. "That's A$500 million that Qantas doesn't have to go out and fund – in fact, it's A$500 of free cashflow that we have to put towards another aspect of the transformation programme, which is to reduce net debt by $1 billion in 2015."
Qantas's nimble hedging strategy compares favourably with rival carriers that have endured nasty losses in the past year, such as Hong Kong-based Cathay Pacific and Singapore Airlines. For the most part, Manning says it boils down to one key decision – the recommendation of a hedging strategy based largely on options, as opposed to "the easy way" of fixed-price forwards.
"As fuel fell to $90/bbl – levels that we had not seen for a number of years – it was tempting to simply lock these prices in using forwards," Manning says. "However, the group chief financial officer and chief executive agreed with the strategy put forward by treasury to invest in option premium and cap the airlines' worst-case outcome, whilst allowing for further participation, should fuel prices continue to fall."
Since the dark days of December 2013, things have got better for Qantas. Although the transformation programme is still ongoing, the oil price environment looks more favourable and passenger numbers have been improving. The airline's share price stood at A$3.45 by May 22, having traded at close to A$1.00 at the time of its downgrade by S&P. And if Qantas delivers a full-year profit for the year ending in June, its group treasury can rest assured that it has made a tangible contribution.
"Airlines are capital-intensive, low-margin businesses," says Manning. "They're in a cyclical industry. It's about protecting the business, not trying to guess which way prices may go. Ours has been a consistent and disciplined approach and one that's shown its value this year."
The week on Risk.net, December 2–8, 2017Receive this by email