Airlines divided on hedge benefits as oil volatility surges
US giants defend their no-hedging policy while accounting rules help keep Europeans in the pro-hedging camp.
Oil prices have whipsawed this quarter, passing $76 a barrel in early October before plunging to nearly $50 a barrel. The volatility has been a challenge for airlines, which have differing strategies on hedging against fuel costs.
In one camp are the three US giants, American, United Continental and Delta Airlines which have adopted a no-hedging policy. That helped them when oil prices were low but hit them this year when the rise in fuel costs hit revenues and profits.
With $750 million additional fuel expenses in the latest quarter, American Airlines was contrite with investors about the impact. “Unfortunately, rising fuel prices outpaced [our] increase in revenues”, CEO Doug Parker said on a 25 October earnings call. “The declining earnings has been met with a declining stock price, which neither we nor our investors are happy about.”
At the other end of the spectrum are avid hedgers such as Southwest Airlines. Hedging more than twice its annual fuel consumption, Southwest kept its increase in fuel costs to just 9%, compared with 33% at American. “Our fuel hedging gains have offset a significant portion of higher market jet fuel prices so far this year and will continue to provide protection, especially if prices continue to rise”, CFO Tammy Romo said on a 25 October earnings call.
Most European airlines also belong to the pro-hedging camp, although for them the challenge is more complex because they also need to protect against currency swings in order to buy fuel, which is always priced in dollars.
Lufthansa, the largest European airline by revenues, hedges about 100% of its annual fuel consumption but in recent years has paid a higher average price for fuel than Southwest or the non-hedging US giants. Even after including hedging benefits, Lufthansa reported that fuel costs rose by 23% in the latest quarter, a result closer to American than Southwest.
One reason for the decline in hedging popularity among the big US players is the accounting treatment under US generally accepted accounting principles (GAAP). These rules set stringent hedge effectiveness tests that require derivatives to cover a minimum and maximum proportion of underlying risk exposure. Companies whose hedges fail these tests must report mark-to-market swings on the derivatives in their income statement. In 2016 Southwest reported paying $1 billion to counterparties when oil prices fell below $40.
Rather than expose investors to such impacts, airlines like American prefer to let shareholders take their own view of oil prices, focusing their energy instead on improving non-fuel related efficiencies in their business. Delta Airlines went a step further, buying a Pennsylvania-based oil refinery allowing it to produce a proportion of its jet fuel consumption.
“We’re not pursuing any hedging and think that we’re in a very good position”, Delta’s CFO Paul Jacobson said on an 11 October analyst call. “The refinery helps us as does our integrated fuel strategy in which we continue to deliver results that are materially better than the industry average.”
By contrast, European airlines are covered by International Financial Reporting Standards which allow more hedge accounting leeway than US GAAP. Mark-to-market changes in derivative values can be kept out of income statements, and buried in footnotes to the annual accounts. Recently adopted IFRS 9 rules increase this leeway further, especially with regard to option contracts.
In this environment, airlines are more concerned by the risk of insufficient hedging, particularly in the low-cost sector. Ryanair, Europe’s biggest airline by passengers carried, recently highlighted the exposure of its competitors to increased oil prices.
“Norwegian is 85% unhedged for the next 12 months and Wizz is about 60% unhedged and I therefore much prefer our hedging position to theirs given where oil is at the moment and where it is likely to go to” Ryanair CEO Michael O’Leary told investors on a 22 October call. “We are now hedged up to 90% out to September 2019 at about $68 a barrel. That is a much stronger position than most of our competitor airlines.”
O’Leary made these comments just before oil plunged back to $50, meaning that Ryanair may now be committed to paying $18 more than the spot price. Fortunately for Ryanair, IFRS 9 will keep the mark-to-market hedge valuation impact out of the company’s fourth quarter results. Ryanair didn’t to respond to a request for comment.