As we head into the middle of financial reporting season, it is once again "open season" on the world's airlines for equity analysts who are getting ready to take pot shots at flight operators for how they hedge their jet fuel.
Why is it that the world holds airlines to such absurd standards? Especially equity analysts. Airlines are expected to have protection in place against any major rise in their jet fuel prices -- those costs nowadays represent as much as 65% of total costs for some airlines. Whenever the price of jet fuel goes up in the world markets, analysts rip into any airline that hasn't bought futures or options contracts that limit its exposure to rising prices.
But at the same time -- and this is where airlines must rue their fate -- analysts expect airlines to fully benefit from any fall in the price of jet fuel. Any airline that has a hedge in place that goes to maturity above the prevailing spot market price for jet fuel is roundly roughed up by the analyst community for "losing money" on their hedges.
A Reuters article carried in Singapore's Business Times Wednesday quotes Brian Nelson, an equity analyst at Morningstar, as saying "Given some of the hedging mechanisms they are using, they are going to be subject to significant losses on those portfolios (...) They're going to see significant losses if crude oil continues to fall."
Well, yeah. We are surely about to see a hefty round of exactly this kind of criticism. With jet fuel prices down around the world about 20% from their peak in July, major Asian airlines like Cathay Pacific, Singapore Airlines, Qantas, Malaysian Airlines and others can expect to get a healthy dose of vitriol from commentators for hedges they took out in the past three months.
But most of these airlines have been following sensible risk management practices. Southwest Airlines Co., the US airline that famously hedged much of its jet fuel purchasing at $61 per barrel or so (jet fuel is still $140/barrel, even with its recent depreciation), has been held up as a role model for airlines. But Southwest Airlines Co. was in equal measure following responsible risk management practices, and just plain lucky.
Analysts should remember that they are reviewing airline results with the benefit of hindsight. And if they can't keep that in mind, they should remember that any responsible hedge is always offset by losses and gains made in the physical purchasing of jet fuel.
So red ink on the hedge should be balanced by unexpectedly cheap jet fuel bought in the real world. All hedging is, when done responsibly, a simple balance sheet exercise.
Looking at the net loss of a hedge without looking at the physical offset is as bizarre as looking at a net gain in a hedge while forgetting that costs in the real world have soared.
Even worse, measuring a hedge on its own book value reinforces bad habits, and a poor understanding of derivatives in general that so often leads to real catastrophe down the road.
The low cost carrier referred to in the article that has done the phenomenol job of hedging is Southwest Airlines (LUV). Not Southwestern.
Yes, thanks Steve. I will update the post.
Good insight Dave. The analyst criticism could be valid, if the airlines were in the business to speculate on fuel prices. Yes, in hindsight the hedge doesn't make sense if the company wanted to take advantage of fuel price volatility. But if I were investing in an airline, I'd want it to focus its efforts on its core business -- filling seats and providing high-quality, reliable and safe air travel. Not trying to time the movement of a commodity as volatile as jet fuel.