The Effectiveness and Value of Fuel Hedging by Airlines

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Table of Contents

Summary Overview
The Procurement Methods
Considerations Relevant to the Hedging Strategies
Evaluation of the Relative Effectiveness of Each Airline’s Approach to Hedging
The Most Successful Method and Lessons Learnt from the Hedging Efforts
Conclusion
References

Summary Overview

In the airline industry, fuel consumption is one of the most significant challenges companies have to deal with. Therefore, controlling fuel costs can give an airline a relatively high competitive advantage in the market. One such move to counter this problem is the hedging program derived from the implemented financial risk procedures (Liu et al., 2016). As such, they have saved substantially from the earlier anticipated losses through the strategy.

It depends on purchasing contracts to acquire oil at a relatively lower price than that in the market when demand goes high. The principal challenge to the agreement is when there is a drastic decrease in oil market prices, such as the one experienced by China Eastern Airlines and Southwest Airlines (Liu et al., 2016). It warranties a response or a different type of agreement to handle such scenarios due to uncertainties. The case study is conducted to analyze the effectiveness and value of fuel hedging by airlines and the potential adjustments that can be made for higher profitability.

The Procurement Methods

Various airlines have designed a strategy to successfully apply the hedging technique to control their fueling prices, hence staying competitive. Several challenges face the industry, such as its sophistication, excessive government regulation, high capital intensive with fixed revenue requirements, destructive competition, and a volatile working environment. China Eastern Airlines has substantially benefited from the hedging strategy by turning to the financial derivatives market. It has continuously utilized option contracts instead of oil futures contracts (Manuela et al., 2016). Thus, it secures prices at their desired level by buying long-term options while simultaneously selling significant amounts of put options. On the other hand, Southwest Airlines used the futures option and were substantially affected by the fall in fuel prices.

Considerations Relevant to the Hedging Strategies

Various internal and external factors affect airlines’ decisions to hedge fuel prices. One such consideration is the fluctuation in fuel prices, mostly due to the limited energy source, jet fuel. Every company has to purchase jet fuel regardless of the current market price, which is continually varying. Thus, it makes the industrial complex and unpredictable necessitating counter mechanisms to manage the issues. A company cannot compete with prices since they risk losing clients in ensuring stability and predictability of transport charges (Turner & Lim, 2015). The solution to gaining a competitive advantage over other firms is through cutting jet fuel costs, thereby minimizing expenditure.

Airlines also consider the decision because of stiff and uneven competition ground within the industry. The robust global economies have created a great demand for consumer travel; hence, firms invest in more routes and options for travelers. However, competition stiffens, and some companies are forced to choose between flight prices, sacrifices in customer experience, and other cost-saving moves versus losing clients to other companies.

Moreover, global carriers are established and hence have an advantage in the market. Similarly, airports are facing congestion as demand rises higher, raising other concerns for carrier companies (Dafir & Gajjala, 2016). The data-driven tech world is equally transforming, potentially undermining the almost outdated infrastructure of most airlines. Other companies opt to merge with others, such as Southwest and Air Tran coming together to cut costs (Manuela et al., 2016). The technique prompts others to utilize counter moves such as fuel hedging.

Evaluation of the Relative Effectiveness of Each Airline’s Approach to Hedging

Hedging approaches can result in different outcomes, either predictable or unpredictable. In the case of Southwest, it risked a three-year contract which could potentially result in either profit or loss depending on market fluctuations. The logic behind the decision is based on the notion that the hedge price will remain lower than market prices (Swidan & Merkert, 2019). It was an effective means which sustained it through the Great Depression while other firms experienced massive losses.

It successfully adopted the futures contract alternative throughout the period while absorbing shocks in the market. On the other hand, China Eastern chose an approach commonly referred to as “suspicious like speculation” (Liu et al., 2016, p.76). It signed a contract with an international investment bank agreeing on certain conditions subject to predictions, which was a considerable risk had there been a shift in oil market price.

The Most Successful Method and Lessons Learnt from the Hedging Efforts

The two cases provide an overview that helps to understand the logistics required to balance the situation. One of the most critical lessons is the need for flexibility. A strategic sense and effective risk management can result in high value, although any bias toward the risks can have fatal outcomes. Thus, it is necessary to have an efficient information processing unit to analyze such strategies to minimize losses (Abbey, 2016). The most effective hedging plan was done by Southwest China Airlines, although they all failed during the drop in fuel prices. They did not prepare for the decrease because of their success which generated bias. They could not determine any potential risks in their cost reduction efforts.

Conclusion

The airline companies will be likely to continue using fuel hedging in the coming months and years. They survived the previous decades through the technique and beat their competitors while making consistent profits. It essentially implies that although it has proved to be risky as well, the methodology can still work to minimize losses in the future effectively. However, it is critically noteworthy to recognize that such moves should be carefully evaluated. The market price volatility is a factor that is out of the control of most firms; thus, the only speculation is best suited to inform the decision-making process. Consequently, the focus should not be on cutting down costs; instead, it should be about limiting the effects of price fluctuations.

References

Abbey, D. R. (2016). The Relationship between Fuel Hedging and Airline Profitability. Northcentral University. [Master’s thesis, Northcentral University]. ProQuest Dissertations Publishing.

Dafir, S. M., & Gajjala, V. N. (2016). Fuel Hedging and Risk Management: Strategies for Airlines, Shippers and Other Consumers. John Wiley & Sons.

Liu, Chin-Yen A., & Jones, K.J. (2016). Integrated risk management on fuel hedging program: A case study on Southwest and China Eastern airlines. Academy of Business Research Journal, 2, 74-85.

Manuela Jr., W.S., Rhoades, D.L., & Curtis, T. (2016). An analysis of Delta Air Lines’ oil refinery acquisition. Research in Transportation Economics, 56, 50-63.

Swidan, H., & Merkert, R. (2019). The relative effect of operational hedging on airline operating costs. Transport Policy, 80, 70-77. Web.

Turner, P. A., & Lim, S. H. (2015). Hedging jet fuel price risk: The case of US passenger airlines. Journal of Air Transport Management, 44, 54-64. Web.

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