Asian airlines' fuel-hedging losses down to collar strategies

Aviation companies struggle with volatile oil prices

A major contributor to the large fuel-hedging losses suffered by Chinese and Taiwanese airlines for 2008 were seemingly collar strategies - the purchase of call options and simultaneous sale of put options. But some Asian carriers, such as Malaysia's Air Asia and Guangzhou-based China Southern Airlines, profited from their fuel hedges for last year.

Many Asian airlines, like their counterparts elsewhere, suffered substantial losses on hedges put on before the sharp oil price drop in December. The West Texas Intermediate (WTI) crude oil futures price peaked at $147.27 a barrel on July 11, before falling to $45.59 by the end of the year. Swinging volatility continued in the first two weeks of January, with the price leaping from around $39 on January 1 to above $50 on January 6 and back down to $43 by January 12. The closing price was $41.23 on January 20.

Hong Kong-based Cathay Pacific says it has suffered mark-to-market (MTM) losses on its fuel-hedging contracts of HK$7.6 billion ($980 million) for 2008. That's more than double the estimated HK$2.8 billion MTM loss it had made as of the end of October. The airline also took net realised losses on fuel hedges of around HK$300 million for the year, it said in a statement to Hong Kong Exchanges and Clearing (HKEx) in January.

But Cathay Pacific added that it would have paid an extra HK$7.9 billion for its fuel, had prices remained at their July peak. Other carriers make similar points, adding that their fair-value hedging losses may rise or fall depending on future movements in oil prices.

Meanwhile, Beijing-based Air China recorded an MTM loss of 6.8 billion renminbi ($994 million) for the year and said its contracts are still structured as buying calls and selling puts. The carrier added in a January statement that it is assessing the effectiveness of its fuel-hedging positions as at December 31.

Shanghai-based China Eastern Airlines has posted a MTM loss of 6.2 billion renminbi on fuel hedges for 2008. In a statement on January 9, the carrier said its key hedging strategy was to buy calls and simultaneously sell puts, with the aim of offsetting the high current premiums of buying calls.

Taipei-based China Airlines, meanwhile, revealed an MTM fuel-hedging loss for 2008 of NT$20.9 billion ($629 million) in January, while its domestic rival Eva Air says it expects to post losses of NT$9.3 billion.

Chin Lim, an aviation analyst at Morgan Stanley in Singapore, says all those to have suffered losses were using collar strategies and that most of the hedging was probably done in the July-September period, when the oil price was highest.

The simplest way of hedging is buying a swap, and following that, buying a call, says Lim. "The problem comes where you buy a call and sell a put," he says. "Collars were very common when WTI crude oil was $120-130 a barrel in summer 2008. You're selling a put to fund the call you're buying. If oil goes up, you profit because of the call, but if it goes down you get hit on the flip side because of the put.

"If you'd done a simple call option, which was very expensive at the time (in mid-2008, because the expectation was that prices would rise), you would have lost the value of it (because the oil price dropped)," he adds, "but you wouldn't have had the downside risk."

But Lim concedes it is getting increasingly difficult to analyse airlines' fuel-hedging positions, because "they won't tell you what the strike price is; they won't tell you how much they've got exposed; and they won't tell you what structure they are using".

Meanwhile, some airlines in the region have been more successful in their hedging decisions. Kuala Lumpur-based Air Asia, for example, had no fuel hedges on for the fourth quarter of 2008, executive vice-president for treasury Megat Kamaruddin tells Asia Risk. It had hedged 35-55% of its fuel requirements up to the end of the third quarter, but not beyond, he says.

"Our group CEO felt that the extremely high oil price was unsustainable and that the US economy was in very serious trouble," Kamaruddin adds. "We did what we had to do and are currently enjoying the benefit of paying the current spot prices for oil."

China Southern Airlines reportedly made a $5 million profit on its fuel hedges, having also stopped hedging by the end of September.

As for the coming months, Morgan Stanley's Lim says it is very difficult to know which hedging strategy to adopt, if any. But he says that now may be a good time to add positions, especially for carriers with strong balance sheets, which are likely to emerge stronger from the current global financial crisis.

Cathay Pacific said in January that it will continue to hedge a portion of its fuel purchases over the next three years.

Joe Marsh