CoronavirusAirlines in hedging dilemma

Airlines in hedging dilemma

Hedged fuel prices may be hurting, not helping, the world’s airlines, writes Elizabeth Roscoe

The world has changed dramatically over the past three months.

Countries around the world have closed their borders and are asking residents to isolate at home. Whether you live in Amsterdam, New York, or Sydney, your daily life has drastically changed.

Arguably no sector is feeling the effects of the pandemic more deeply than in the travel and aviation industry. Since the advent of the jet age, airlines have worked tirelessly to mitigate risks such as this as best they can. From relatively minor scheduling mix-ups to major disasters like terrorism and financial disruption – all risk mitigation plans are currently being put to the test. Life for the industry is being made no easier by a drastic drop in fuel prices. Airlines with the majority of their fuel in hedged funds have very few options.

The pandemic, with restriction on flight operations combined with a drop in fuel prices, is presenting challenges never before faced by the industry. How each country, and indeed each airline, respond, will determine much about the future of travel.

There are very few risk mediation measures that the airlines can undertake to protect themselves against an endlessly volatile and fluctuating fuel market, aside from hedging.

Commonly, hedging has worked to the airline’s advantage. A shining example was in 2007 when Southwest Airlines in the US hedged its fuel contracts at $51/barrel through 2009. The value of oil rose during that time, and competitors were paying nearly $91/barrel. These hedges produced gains for Southwest of $439m during the first nine months of 2007, keeping the airline profitable at a time when many were struggling.

In recent weeks, crude oil prices have tumbled downward to a low not seen since the Gulf War. Brent crude is now $33 a barrel during a time when many carriers are hedged at a price closer to $70/barrel. By having a significant portion of their fuel hedged, airlines are spending money they don’t have. According to Bloomberg, a number of the largest carriers have hedged more than 70 percent of their fuel consumption.

Low demand for travel and oil

There is lessened – or in many countries, total – cessation, of demand for air travel. On March 24, the International Air Transport Association (IATA) released some devastating numbers. It predicts a 38 percent drop in global passenger demand (RPK) compared to 2019 and estimates that compared to 2019 the industry as whole will lose $252bn. This loss figure is revised from $113bn only a few weeks earlier in March.

The list of airlines that have temporarily ceased operations seems to grow by the day – and includes Emirates, LOT, Austrian and Etihad. The airlines that are not grounded are operating a minimal schedule- Lufthansa, for example, is operating just 18 long-haul flights per week, according to Business Traveller. In the US domestic market, airlines are faring slightly better, with Southwest operating 2,000 flights a day (down 1,700 from this time last year) according to Reuters, and American Airlines is operating at 20 percent capacity compared to May of last year.

While demand for air travel has dropped, in mid-March S&PGlobal reported that: “Global oil demand will contract by 2.8m b/d, or 2.8 percent, this year as worldwide measures to slow the spread of coronavirus pandemic continue to escalate.” Jet fuel has been the hardest hit, with demand falling by 12 percent year on year, and demand for global commercial air traffic to fall by 20 percent compared to 2019. Currently, bright spots are emerging as MarketInsider has reported April 30 that oil has surged 20 percent as small signs of recovery are emerging.

Cash is king

Many European and American airlines have cash reserves to fall back on, but there are limits to that, according to Bloomberg.

Of course, not all airlines hedge fuel, and that might help them through these turbulent times. The major three US carriers (Delta, American and United) do not hedge fuel. According to a recent report by Raymond James and reported on by The Points Guy, the US airlines have, in general, about enough cash reserve to survive for another eight months, before needing to file for bankruptcy or worse. American Airlines, they predict, has only 4.8 months of cash on hand, but other carriers like Southwest and Allegiant have upwards of nine months.

Despite this, having been the epicentre of the outbreak and reliant on heavy loads of international traffic, China is still looking at a bleak financial picture. India closed all domestic air travel on March 25, so demand in and from that market has all but ceased. Traditionally, airlines in these two countries have not used fuel hedging.

When it comes to European airlines, the Irish Times reports that Ryanair and IAG (the parent company to Aer Lingus and British Airways), may be best suited to ride out the coronavirus outbreak. The Times reports that, “if no aircraft fly for the next year, Ryanair has 18 months of available cash while IAG has 16 months,” according to the report. Ryanair’s main rival, easyJet, has about 10 months. At the same time, the Times reports that, “…Air France-KLM and Germany’s Lufthansa have three to six months in cash before they have to start borrowing against aircraft.”  For those airline groups, this trouble is compounded by their high investment in hedged fuel prices, according to Bloomberg.

Moving forward

When the world does start travelling again there is an argument to be made for pent up demand. People who have been separated from friends and family for months will want to reunite. Students will resume studies abroad and leisure travellers, having spent their time at home dreaming of exotic destinations, will put their plans into action.

Consolidation of airlines is something many are discussing as a fallout from the virus and concurrent fuel market drop. Much like a ‘survival of the fittest’, the airlines with the most liquidity and the most carefully considered hedging strategies will survive the downturn.

Government bailouts have also been a much-discussed option for many airlines. According to Reuters, Lufthansa is currently seeking a 10 billion euro bailout and The Telegraph reports that Air France-KLM has received a seven billion euro bailout from the EU. Elsewhere in the world, some airlines have been denied bailouts with catastrophic consequences. Virgin Australia, for example, was denied government assistance and therefore had to cease all operations at the end of April, according to Bloomberg.

A further repercussion of current market difficulties may be a return to smaller and more fuel efficient aircraft and a hastened retirement of larger ones. A number of airlines were already planning to scale down their use of the jumbo Airbus 380 and many, including British Airways, had plans to retire their Boeing 747 fleet in 2020, according to Simply Flying. Given the global situation, these dates could be moved forward considerably. Further, airlines will be pouring renewed focus into their most fuel efficient aircraft like the B787 Dreamliner and the A350- both of which are sure to receive a warm welcome back to skies when life rebounds.

The future could hold changes in fuel hedging, and airlines could think twice before entering futures markets. Once the industry begins to recover and travellers begin to spend again, many of the answers to these questions will start to reveal themselves. Until then, the world waits.

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