Fuel Hedging and Risk Management by S Mohamed Dafir and Vishnu N Gajjala
Fuel Hedging and Risk Management by S Mohamed Dafir and Vishnu N Gajjala
A good introduction to hedging aviation and shipping fuels, especially when you don't exactly know much about the industries. It provides some good background, such as this map of China's two new oil import routes (Pakistan-Kashgar and Myanmar-Kunming).
A rule of thumb for selecting a simple hedge instrument that is based on the level of underlying commodity prices is as follows.When prices are low (relative to historical averages or hedger’s expectations), hedgers should enter into fixed-price swap contracts. At low prices, swaps can be very efficient for hedging due to the limited downside risk.
When prices are in line with historical averages or the expectation is that prices will be range-bound, a collar structure (a combination of a bought call option and a sold put option) helps manage commodity price risks better. Collar pricing may also be more attractive when the market expectations for prices, as indicated by the pricing of puts vs. calls, reflects a range-bound view.
When prices are at high levels, outright purchase of call options may be a safe option for hedgers. Although there is an initial premium outlay required, the potential loss is limited to the premium compared with potential losses on swaps or other zero-cost structures if prices were to drop.
Large European airlines maintain the highest hedge ratios, while data on hedge ratios is sparse for Asia Pacific airlines. This may be due to the prevalence of surcharges in the Asia Pacific region. In particular, airlines in China have not been allowed to significantly hedge fuel prices after 2008 and are compensated for oil price increases with a fuel surcharge schedule that is determined by the civil aviation authority. The actual percentage of fuel costs that are hedged by an airline would be understated as surcharges are excluded from our calculations of hedge ratios.
During the financial crisis of 2008, the sudden disappearance of market liquidity was accompanied by a sharp rise in fuel price volatility and a drop in fuel prices. The extreme market conditions at that time constituted a stress test for the exotic hedging structures that were very popular from 2006 onwards. Many fuel hedgers in Asia were party to leveraged exotic structures and suffered significant losses that went relatively unnoticed by the media as the world’s focus was absorbed by the colossal losses emanating from credit derivatives. The few fuel hedgers who fared better did so as they had competent fuel-hedging desks and hands-on senior management, who were alert to the regime change in global fuel markets and quickly restructured those exotic hedges that were no longer optimal under the new market order.
on Monday, September 15, 2008, the CEO of an Asian airline called in panic, seeking advice and requesting to meet urgently as the airline had tens of millions of dollars pledged with Lehman Brothers under a CSA. The airline tried contacting Lehman Brothers but no one was answering the phone, as many of the bank’s employees might have had other pressing concerns at the time. During the month preceding Lehman’s filing for bankruptcy, oil prices experienced a significant drop that led to huge negative MTMs on the airline’s fuel hedges. Many airlines had to post collateral as required by the CSAs in place. The issue in such a situation was that the secured party (Lehman Brothers in this case) might have reused or pledged the collateral before going bankrupt.