Crude oil prices (Brent) have risen from $90 per barrel in June to around $110-$115 per barrel currently.  It breached the $105 mark in mid-July and has remained above that level since. This rise in crude oil prices will impact the margins of airlines severely as jet-fuel costs constitute 30-40% of their total costs. It also represents their single largest cost head. However, in order to guard against such rises in crude oil prices, airlines effectively use jet-fuel price hedging. However, for US Airways (NYSE:LCC), margins will be impacted from the rise as the airline does not hedge jet-fuel price.
We currently have a stock price estimate of $11.43 for US Airways, approximately 5% above its current market price.
Jet-fuel price hedging and its advantages
Jet-fuel price hedging is the process under which airlines fix the purchase price of jet-fuel with oil companies or financial institutions in advance. Most U.S. airlines, including Southwest (NYSE:LUV), Delta (NYSE:DAL), United Continental (NYSE:UAL) among others, hedge a certain percentage of their jet-fuel requirements. And this protects them from any sudden and large increases in prices of crude oil. For example, in 2011, the price of Brent crude remained above $105 per barrel for most of the year, climbing significantly from a range of $70-$85 per barrel in 2010. As a result, US Airways, which does not hedge fuel prices, had to incur the entire rise in fuel prices and posted lower earnings in 2011 compared to 2010. On the other hand, Delta and other airlines benefited from hedging transactions, which prevented their earnings from being impacted to the same extent as it did for US Airways in 2011.
Absence of fuel hedging leaves US Airways margins vulnerable to fuel price rises
US Airways, which is relatively smaller in size compared to its peers, considers the expenses related to hedging transactions to outweigh the potential benefits. But, this also leaves the company vulnerable to fuel price shocks. And, with oil prices rising again in the third quarter, the airline’s margins will likely be impacted severely.Notes: