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  • airlines
  • commodity derivatives
  • counterparty risk
  • Hedging

Airline hedging travels new route


As airlines start returning to the skies, their treasurers are updating risk management strategies after the $1trn industry’s 2020 crisis. The new formula: less fuel hedging, more revenue protection.

by Julian Lewis

Published: 9 March 2021

As airlines start to move on from their 2020 crisis, they are changing hedging strategies significantly. Having suffered badly when lockdown and derivatives left them long of a commodity no longer required, treasurers are approaching fuel risk management more cautiously. At the same time, the $1trn industry is looking to benefit from a novel revenue hedge.

With the Airbus venture Skytra now authorised by UK regulators, carriers who have long struggled with almost 90% of revenues being booked 90 days or fewer before take-off are relishing the prospect of protecting their flight yields.

The big question, though: will corporate buyers of air travel take the other side of the trade?

Annus horribilis

Although some airlines suffered even greater losses on their hedge portfolios in the 2008 global financial crisis, 2020 challenged their risk management as never before. They faced an unprecedented combination of operational shutdown, the need to unwind derivatives in a one-way market and oil futures trading at negative prices for the first time.

They ended up reporting enormous ineffective hedge losses. These reached $4.7 billion in Europe and $3.2 billion in Asia.

Airlines had to scale back their hedging strategies aggressively. Air France suspended its programme, which was based on covering 60% of the nearest three quarters’ exposure, 50% of the next-nearest’s and down in 10% steps. Finnair reduced the lower bound of its permitted hedged exposure to zero from 10%.

While treasurers insist 2020’s uniqueness means the experience doesn’t invalidate hedging’s long-term value, they acknowledge its difficulties.

“While you cannot look only at one year, last year was terrible, for sure – something no one predicted,” comments Bruno Lecerf, Director of Financing & Treasury at Air France, which reported a €221m decline in the fair value of its fuel hedges in 2020. He stresses, though, that the portfolio is significantly less in the red now after oil’s recovery this year and some hedges having matured.

“The underlying commodity exposure didn’t materialise. That’s a tail risk, really,” judges Christine Rovelli, Group Treasurer & Head of M&A at Finnair, where the fair value of its commodity derivatives fell by €29.4m in 2020.

As the oil price plunged and banks stepped away, the difficulty of finding bids exacerbated the situation. Some carriers took as long as two quarters to fully unwind their positions.

Cautious comeback

Christine Rovelli, Group Treasurer & Head of M&A, Finnair
Christine Rovelli, Group Treasurer & Head of M&A, Finnair

Now, though, with the industry set to resume much of its flight schedules, many hedges now expired or unwound and oil back at pre-pandemic prices, airlines are cautiously returning to hedging.

Their strategies are different this time round, though. Finnair has moved to what Rovelli describes as a much more agile approach that features regular review of its programme every other month and more dialogue with the audit committee and senior management.

In light of its financial situation Air France expects to pursue a “less ambitious” approach. This is likely to feature shorter tenors, lower hedge ratios and, in consequence, a smaller portfolio. To reduce downside risk, the carrier (already an active hedger through zero-cost collars) also expects to increase its use of options.

Counterparty risk appetite is also still notably limited. Even financial institutions that have returned to oil derivatives are reluctant to trade maturities much beyond 12 months.

Treasurer enthusiasm

Against this background, airline treasurers are unsurprisingly enthusiastic about the prospect of managing their revenue risk through derivatives on Skytra’s new price indices.

“The concept is great. It will be fantastic once the liquidity is there to allow us to trade the instruments,” says Rovelli. The prospect of lowering ticket price volatility – always high, even before the pandemic – is attractive, while Skytra’s “massive trove of historical data” will aid gaining auditor approval for hedges under IFRS 9.

“It is the first time since a long time that we’ve seen something so inspiring in terms of risk management,” adds Lecerf. He regards Skytra as potentially “a breakthrough for the industry”.

Airline appetite for the new indices seems assured. The big uncertainty is over major travel buyers’ appetite to use Skytra.

“To ensure a robust, true marketplace, we need to find willing counterparties to animate the market”, comments Lecerf. In view of the lower risk appetite for hedging instruments, he fears counterparties may be in limited supply at first.

It doesn’t help that airlines’ credit ratings declined badly last year. After the industry added over $200bn in debt, fewer than 15% of carriers now carry investment-grade ratings and 60% have fallen into the speculative category.

airlines credit rating distribution

Collateralisation through credit support annexes (CSAs) could address the ratings disparity with counterparties, though this requires cash or cash-equivalents at a time when the industry is struggling. Some carriers also refuse to use CSAs.

In the longer term, reducing earnings volatility and financing costs by hedging revenues with Skytra products should help raise airlines’ ratings again. A recent white paper by Toulouse Business School professor Regis Huc suggests that an overall one notch rise in ratings could save the industry up to $8bn a year.

Skytra itself is confident in the outlook for both corporate and financial participation. “The first wave of counterparties will be multi-national corporates and investors,” CEO Mark Howarth affirms.

The venture anticipates the greatest initial demand being on regional routes. It foresees long-haul markets taking longer to regain volume after the pandemic.

Readying for take-off

Skytra expects derivatives on its indices to begin trading in H2 this year. Forwards/futures, swaps and options are all likely to feature.

These derivatives will eventually trade both over-the-counter and on-exchange, though confirming a listed venue has been delayed to next year. “In the longer term we see OTC being used for larger block trades or customised settlement, and listed being for continuous trading in smaller sizes,” Howarth suggests.

If Skytra derivatives attract the anticipated two-way flow between ticket buyers and airlines, hedge funds and other financial players are likely to be attracted into trading them too – just as they do the Baltic Exchange Dry freight benchmark.

Skytra sees strong prospects of participation. “A diverse set of investors will be healthy for liquidity,” Howarth believes.