Jet fuel exposure, some airlines have used derivatives

Jet fuel prices have been substantially volatile throughout the last decade.Between the years 1996 and 2005, a barrel of crude oil was traded at a price rangebetween $10.82 and $69.91. The fluctuation in crude oil prices certainly has an impacton airline industry operations as fuel costs on average represent 16.29% of total airlineoperating expenses (See Table One). A recent article in The Wall Street Journal lists theairline industry as the likely beneficiary of oil price decreases1. Because the airlineindustry’s operations depend heavily on crude oil, major airlines’ profits could climbwhen their own cost drops, as fuel prices fall. Furthermore, according to a study oftrading patterns by Bianco Research LLC, the airline sector is most inversely correlatedto oil prices2. Thus, the drop in commodity prices pushes investors to search airlines’stocks. To mitigate the risk of fuel exposure, some airlines have used derivatives to lockin the price. As such, this temporary protection will shield airlines from high energycosts, but also might keep them from enjoying lower costs when the crude price falls.This paper investigates the fuel hedging behavior of major airlines in the USduring the 1996-2005 period to examine whether such hedging has an effect on stockprices of these airlines. Since airline jet fuel prices are hedgeable, some investors mightfind value in an airline’s attempt to hedge future prices of jet fuel. That will be the truthonly if the use of a hedging strategy is positively correlated with a firm’s value. As aresult, the underlying price of the airline stock that has a hedging program in place wouldhave higher intrinsic value, as its underinvestment cost is reduced. By the same token,the variability of the stock should be reduced as the price of jet fuel is fixed. Thus, thestock of airlines that engage in hedging is perceived as less risky. The research, contrary1 Wall Street Journal (2006)2 Wall Street Journal (2006)1Trempski: Does Fuel Hedging Add Value? Quantitative Analysis but QualitativPublished by Digital Commons @ IWU, 20092to the notion of a positive relationship between hedging and value, shows that hedging isnot valued by the investors as reflected in the price of a stock. While using derivatives tohedge jet fuel costs might increase firm value, it is of little importance for investors astheir returns do not depend on whether the airline implements the hedging strategy.Individual shareholders are primarily concerned with the cumulative risk exposure oftheir portfolios rather than with individual stocks.Literature ReviewRecent literature has made progress in understanding why firms may hedge. Mostof the research focuses on the notion that hedging increases firm value. Based on theresults, one can divide the literature into three distinctive groups. The first group ofresearchers concludes that hedging results in higher firm value. The second groupinterprets the hedging as a non-value added activity, while the others argue that hedgingcreates value only under some circumstances. The three distinctive groups and theirfindings are described in the paragraphs that follow.Smith and Stulz (1985) argue that firms can increase value by hedging. Theyfound that by reducing the probability of bankruptcy, hedging can increase firm value.This effect is larger for firms with higher costs of financial distress. Further, Stulz (1996)classifies the failure to invest in valuable projects due to debt as financial distress costs.Froot, Scharfstein, and Stein (1993) build on the Smith and Stulz model, illustrating thevalue of hedging for firms facing financial constraints. In his research, he found thathedging is more valuable to firms as investment opportunities are inversely correlated2Undergraduate Economic Review, Vol. 5 2009, Iss. 1, Art. 9http://digitalcommons.iwu.edu/uer/vol5/iss1/93with the risk factor’s cash flow. In the other words, hedging reduces the need to accessoutside capital during the periods it is most expensive.Carter, Rogers, and Simkins (2002, 2006) find that airline industry investmentopportunities correlate positively with jet fuel costs, while higher fuel costs are consistentwith lower cash flow. The results of their studies show that jet fuel hedging is positivelyrelated to airline firm value, as it comes from reduction of underinvestment costs.However, the model used by Carter, Rogers, and Simkins might not be applicable in thecase of the airline industry and it can yield inaccurate results. The standardized monthlymarket model used in their studies has been applicable to currency and gold priceexposure to risk. It has not yet been determined that this model can accurately predict theairline exposure to jet fuel price changes. Another potential problem in the Carter,Rogers, and Simkins studies can be found in the variables used in the model. The CRSPvalue-weighted market portfolio might be a poor estimate of the market return. Most ofthe investors base their financial decisions on more general indexes like the S&P 5003. Inaddition, using the change in jet fuel price might not adequately reflect the airlineindustry as jet fuel contracts do not exist in the United States4. In reality, futures oncrude oil are used to hedge jet fuel purchases. This relatively small change in thevariables might have an impact on the model. Also, the study done by Carter, Rogers,and Simkins does not address periods of low jet fuel prices. According to EnergyInformation Administration a gallon of jet fuel was traded at $0.62 on January 2, 1996,compared to $1.78 on December 30, 2005. It yet has to be determined that jet fuelhedging adds value when the jet fuel prices drop.3 Jin and Jorion (2004)4 Morell and Swan (2005)3Trempski: Does Fuel Hedging Add Value? Quantitative Analysis but QualitativPublished by Digital Commons @ IWU, 20094Jin and Jorion (2004) found that, although hedging reduces the firm’s stock pricesensitivity to oil and gas prices, it does not affect the market value of the firm. Contraryto Carter, Rogers, and Simkins, they use the S 500 as the stock market index and thefutures contract for oil in their model. Thus, the two factor model provides for a morerealistic approach in measurement of the price exposure. However, Jin and Jorionexclude credit rating as one of the factors in their studies. Since hedging requiresfinancial commitment, credit worthy firms are more likely to hedge. This can createsome distortion in the results as indicated by Allayannis and Weston (2001) who find apositive relation between currency hedging and Tobin’s Q. The difference between thestudies can be attributed to the commodity risk exposure itself. Some investors mightfind it relatively easy and inexpensive to hedge their own risk. It yet has to bedetermined how investors perceive the jet fuel exposure risk.Morrell and Swan (2005) find in their studies weak empirical justification behindhedging. According to the researchers, hedging on average smoothes or exacerbatesairline profit cycles, but it depends on the time period used in the research. The only timeit would create exceptional value is when an airline is on the verge of bankruptcy, atheory difficult to believe. Airlines close to bankruptcy simply are not creditworthy andcannot obtain funds for the margin requirement. In conclusion, Morrell and Swan statethat hedging is a signal to investors that management is technically alert. Although itcannot be explained by a mathematical or economic model, it can be just the psychologyof the market that pushes airline hedging. Thus, there is no clear link between jet fuelhedging and market value of the firm as there are too many simultaneously operatingfactors.4Undergraduate Economic Review, Vol. 5 2009, Iss. 1, Art. 9http://digitalcommons.iwu.edu/uer/vol5/iss1/95IndustryThe US airline industry presents a good environment to measure the risk exposuredue to changes in jet fuel prices. Fuel price risk is omnipresent across the industry.Because fuel prices are more volatile than other airline costs, hedging stabilizes overallcosts and profitability. Also, it is not possible in the short run to pass the higher fuelprices on to passengers due to the highly competitive nature of the industry. Theunderlying implications are that hedging reduces risk exposure due to changes in jet fuelprice and maximizes firm’s value. Maximization results in higher stock prices, becauseinvestors perceive risk as a cost. To mitigate the risk and prevent swings in operatingexpenses and bottom-line profitability, airlines engage in hedging using variousinstruments5.The plain vanilla energy swap is an agreement whereby a floating price is fixedover a certain period of time. This transfer does not require the physical item and is notreported on the balance sheet. The contract is settled by transfer of cash, which isdetermined as the difference between fixed and floating prices. Similar to plain vanilla, adifferential swap is based on the difference between a fixed differential for two differentcommodities and their actual differential over time. Thus, the airline can hedge by use ofa commodity other than jet fuel price. Differential swaps eliminate the risk that jet fuelprices will increase more than the underlying commodity.A call option is the right to buy the underlying asset at a predetermined price at atime up to the maturity date. Generally, over-the-counter options are settled in cash,while exchange-traded oil options on NYMEX are exercised into future contracts.5 Carter, Rogers, Simkins (2001)5Trempski: Does Fuel Hedging Add Value? Quantitative Analysis but QualitativPublished by Digital Commons @ IWU, 20096Oftentimes, the settlement price is based on the average price for a period. Because calloptions are relatively expensive due to the volatility of energy commodities, manyairlines use zero-cost collars instead.A collar is a combination of a put option and a call option, where the put option issold at the strike price below the current commodity price and the call option ispurchased at a strike price above the current commodity price. The collar optionprovides protection from upward movement in the prices of the underlying commodity.The premium received from the sale of put option helps offset the cost of the call option.Also, the airline locks the price between the minimum and maximum over the period oftime the options are outstanding. When the price received from the sale of a put optionequals the price paid for call option a “zero cost collar” results. Using a zero-cost collardoes not require upfront expense cost.A futures contract is an agreement whereby a buyer and seller commit to buy orsell a specified quantity and quality of a commodity at specified price at the future date.The seller who takes a short position agrees to deliver the commodity. The buyer takes along position and agrees to purchase the commodity. Forward contracts are similar tofutures, but with exceptions that they are standardized and traded on organizedexchanges. While futures might require daily payment of price adjustments, forwards aresettled at the maturity date. Thus, futures and forwards can be used by the airlines as atool that mitigates the risk exposure of jet fuel price changes6.Derivative Accounting6 Carter, Rogers, Simkins (2001)6Undergraduate Economic Review, Vol. 5 2009, Iss. 1, Art. 9http://digitalcommons.iwu.edu/uer/vol5/iss1/97To better understand how investors perceive hedging, it is necessary to discusshow derivatives are accounted for. The Financial Accounting Standard Board issuedStatement 133 that requires the recording of changes in the derivative’s fair value to berecorded in either the income statement when realized or as “other comprehensive”income. As a result, derivative instruments are presented at fair market value on thebalance sheet, but any unrealized changes in net market value are not reported on theincome statement. Also, hedging effectiveness takes into consideration historicalperformance of the airline and anticipated future performance. This helps to determine ifthe hedges are deemed to be effective. Although it is beyond the scope of this study toexplain in depth all the accounting behind derivatives, it is important to know that anyamount of jet fuel hedged that is not consumed by the airline in a given period willappear as a charge on the income statement. Thus, the airlines never hedge the entire100% of their fuel needs7.DataThe analysis is performed on publicly held US major passenger airlines betweenthe years 1996 and 2005. The 10-K filings of these firms provide the data regarding fuelhedging as a percentage of next year’s fuel requirements, fuel as