An air of simplicity

Australian airline Qantas aims to keep things simple when it comes to hedging fuel price and foreign currency exposure. Treasurer Steve Fouracre talks to Marion Williams

Qantas may have the most advanced 747s in its fleet, but when it comes to its hedging policy, Australia's flagship airline prefers the conservative to the complex. The company's hedging activities are mainly driven by balance-sheet protection, as well as minimising earnings volatility and the impact of fuel price spikes on its balance sheet.

Group treasurer Steve Fouracre says the hedge book is "very large", warranting a treasury department that is big by Australian corporate standards. The 20-member treasury team is responsible for funding, aircraft leases, accounts and settlements, and managing and hedging risk, which it deals with using SunGard's Quantum software, which most Australian corporates employ. Superannuation and insurance also fall in its domain, as does the day-to-day management of counterparty credit risk from its hedging activities and aircraft financing.

Of all an airline's risks, fuel prices have the greatest potential to affect profits, says Fouracre. "Fuel is certainly the most volatile (type of risk), especially in the past two years," he says. "It can move the quickest." Qantas does not automatically put hedges on as exposures arise, but "monitors the market daily and looks for periods when there is good long-term value", says Fouracre. Hence his current reluctance to lock in oil prices of $70+ a barrel three years forward.

Qantas tends to be highly hedged in the current financial year to protect against any big moves in fuel prices, says Fouracre, but is less inclined to fully hedge its exposures beyond 12 months. So far, 30% of the company's fuel bill for 2006/07 is hedged at an oil price of just under $60, and fuel costs are fully hedged for the remainder of the 2005/06 financial year ending June 2006. Savings will be significant again in the current financial year to June, with hedging having trimmed fuel costs by A$214.7 million ($165.9 million) in the first six months.

The airline treats treasury as a cost centre, not a profit centre, and makes a point of not engaging in speculative activities. Hedging comes into play in an environment of fast-moving prices, which was apparent in the 2004/05 financial year, when hedging cut Qantas's fuel costs by A$403.5 million, up sharply from savings made in the previous fiscal year of A$118 million. Fuel represented 19% of the airline's operating expenses in the 2004/05 financial year, and that figure is expected to approach 30% in 2005/06.

Hedging transactions must comply with a board-approved policy, another check that dealings in financial contracts relate purely to hedging and not to speculation, says Fouracre. The policy not only specifies the types of instruments that can be used, but also the various levels of delegation and minimum and maximum levels of hedging. That policy has changed little since its inception in 1994, a year after the government took the first step to privatising the carrier.

The hedging policy is reviewed formally every two to three years, and there are also reviews when market conditions call for them. For example, the policy was re-assessed after September 11, 2001 and again following National Australia Bank's revelation in January 2004 of A$360 million in losses from unauthorised currency warrants trading. "We continually make sure we feel it is appropriate and go to the board to seek changes if required," says Fouracre.

Foreign sales

The carrier's foreign exchange risk arises from overseas ticket sales that generate surplus foreign currencies, such as sterling, yen, euro and New Zealand dollars. Qantas collects billions of dollars in revenue from selling tickets in more than 80 countries, netting A$9.8 billion in passenger revenues in the 2004/05 financial year ended June 2005. At the same time, expenses on fuel and aircraft maintenance are mainly in US dollars. Last year, the airline spent A$1.9 billion on oil and fuel costs, and its annual capital expenditure over the past four years averaged A$2.3 billion, which chiefly related to aircraft and spare parts.

To manage this currency exposure, Qantas forecasts flows, develops a view on exchange rates and then decides which hedging contracts are most appropriate. In 2000, for instance, when the airline announced a A$9 billion fleet re-equipment programme over 10 years, the Australian dollar was trading at $0.55. Believing the Australian dollar was undervalued at that level, Qantas left most of the order unhedged. Now the currency is stronger, the airline has increased the size and length of the hedge, says Fouracre.

Qantas often orders planes five to 10 years in advance, creating substantial currency exposure. "In most cases, we won't hedge that far out, but we do look to hedge out a reasonable way," says Fouracre.

The carrier uses a combination of swaps and options to achieve a balance between certainty for the budget and scope to participate in any favourable movements. A weak US currency, for example, is positive because it means Qantas's surplus sterling and yen are worth more and its fuel bill is cheaper. "Our book will be structured to participate in US dollar weakness, where possible," says Fouracre. "Swaps give you a known outcome. We use a mix to provide some certainty and some participation."

As and when borrowings are made, the company would borrow in currencies such as yen and sterling where it has surplus revenue to service the liability, says Fouracre. Similarly, it does not borrow in US dollars where a revenue shortfall already exists. Qantas therefore swapped the proceeds of its $400 million Rule 144a bond issue in March 2006 into Australian dollars. All in all, the firm has A$5.2 billion equivalent of long-term debt denominated in a range of foreign currencies.

It is clear from talking to Fouracre that Qantas hedges with relatively vanilla contracts. "We don't allow leverage or net sold option positions," he says. "It comes back to us being a cost centre." In his opinion, there are no free kicks: "Anything that looks cheap normally has associated risk that is not being priced." Fouracre believes instruments such as the bonds linked to fuel prices that have been marketed to Qantas rarely add value and bring unnecessary complexity. Anyway, all hedging contracts used must be able to be marked to market properly, hence the conservative product range.

Qantas takes steps to avoid over-hedging or hedging at the wrong time. Looking at the high oil prices implied by the forward curve, Fouracre questions whether they are long-term levels or will ease back as the global economy inevitably slows. "The forward curve puts oil prices at $70 in three years' time," he says. "We would not want to be caught out there."

In this context, the natural hedge provided by the correlation of oil prices with the economic cycle should not be overlooked. Airlines tend to do well in periods of economic strength, the usual time of oil price increases - hence Qantas can mitigate some of the higher costs through fuel surcharges, because there is strong demand, says Fouracre.

The airline also uses options to prevent over-hedging. "It is helpful in a shock like Sars (Severe Acute Respiratory Syndrome) to have some optionality," says Fouracre. By incorporating oil and currency options into its hedging, Qantas avoids being over-hedged if it needs to reduce capacity quickly due to unforeseeable events, such as bird flu or Sars.

In the past, the company kept most of its liabilities on a floating-rate basis. But in the past year or two, it started to hedge interest rate exposure by swapping part of its liabilities to a fixed-rate basis. Qantas's strong credit rating - BBB+ from Standard & Poor's and Baa1 from Moody's Investors Service - ensures access to the widest possible sources of funding when required, says Fouracre. This became clear in September 2001, when Australia's floundering second carrier, Ansett Airlines, collapsed. Qantas bought the company and strengthened its position domestically, which meant raising capital just days after September 11. "An investment-grade credit rating means you can ride through these shocks and take advantage of opportunities when a lot of your competitors are simply struggling to survive," says Fouracre.

High ratings

There is no doubt that Qantas's high ratings stem from its fairly conservative financial policies, strong market position and breadth of routes around the world. The airline is steadily increasing the diversification of its business and recently bought a road freight company, Star Track Express. Fouracre expects this portfolio combination to further reduce earnings volatility and boost Qantas's ability to cope with swings in the economic cycle.

The investment-grade rating also helps reduce the airline's refinancing risk by enabling it to push out the term of its debt. Hence, Qantas has not tapped its commercial paper programme for more than five years, preferring to issue long-term debt, thereby avoiding having too much debt maturing in one year.

Events such as outbreaks of disease and terrorist attacks - which can halt air travel - compel airlines to have enough liquidity to refund tickets while continuing to meet their financial obligations. As of December 31, Qantas had A$2.2 billion in cash and short-term bank bills on its balance sheet. The airline is also entering more pure operating leases than in the past, because it does not want to carry too much residual risk from its expanding fleet. Its approach seems to be paying off.