Delta Is Right In Hedging Jet-Fuel Prices

Most U.S. Airlines barring a few, such as US Airways (NYSE:LCC), hedge their fuel requirements. Fuel hedging is the process of fixing the purchase price of jet-fuel in advance by the airlines with oil companies or financial institutions. This is done to avoid the impact of any sort of volatility in the spot-market price of jet-fuel. The impact from high volatility, particularly a sudden and large increase in the price of jet-fuel, is pretty severe on airlines as jet fuel constitutes 30-40% of the overall costs of an airline, and is also the largest cost head for most airlines. However, in recent times with Delta (NYSE:DAL) posting a net loss in the second quarter on account of hedging losses, the debate between the advantages and disadvantages of jet-fuel price hedging has resurfaced. Today we present a deeper analysis on the same.

Advantage of hedging jet-fuel price

A pre-determined price of jet-fuel for an airline protects it from a sudden increases in oil prices. For instance, if an airline fixes 50% of its fuel requirements for a particular year at a price of $2.80 per gallon, and in case the spot-market price of jet-fuel remains above $3.00 per gallon for most of the year, then the airline would benefit from lower costs. On the other hand, the counter party – an oil company or financial institution that entered in to this transaction with the airline would bear the cost above $2.80 per gallon for 50% of the fuel consumed by the airline in that year. Thus, airlines which hedge effectively often end up saving alot of money from any spikes in fuel prices. 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, had to incur the entire rise in fuel prices and posted lower earnings in 2011 compared to in 2010. Delta, on the other hand benefited from its hedging transactions, which prevented its earnings from getting impacted to the same extent in 2011.

Disadvantages of jet-fuel price hedging

During the second quarter of 2012, when the price of jet-fuel declined steadily from $125 per barrel in April-start to $95 per barrel by the end of June, Delta was forced to incur higher average jet fuel prices of $3.95 per gallon as a result of its hedging transactions, excluding which the average price would have stood at $3.37 per gallon. As a result, the company posted a GAAP net loss of $168 million in Q2. On the other hand, US Airways which did not hedge any fuel, incurred an average jet-fuel price of $3.18 per gallon, as it could fully realize the benefits of lower oil prices. As result, it posted a GAAP net profit of $306 million in Q2. ^[1] Thus, in this case the absence of fuel price hedging benefited US Airways.

To summarize, we believe that hedging benefits airlines as it prevents them from oil price shocks. And, with an increasingly uncertain international political environment, particularly in the Arab world, sudden oil price increases cannot be ruled out. However, the amount of fuel to be hedged and the accuracy in predicting future oil prices are critical in realizing the benefits from the hedging transactions. Even though smaller airlines such as US Airways may consider the expenses related to hedging transactions to outweigh its potential benefits, this leaves them vulnerable to a sudden and large increase in oil prices. Thus Delta, which is one of the largest airlines in the U.S. is right in hedging jet-fuel prices.

We currently have a stock-price estimate of $10.92 for the airline, approximately 10% above it current market price.

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1. US Airways Reports Highest Quarterly Profit In Company History, www.usairways.com, July 25 2012 [↩]