Oil market: Why listed airlines in India must adopt hedging as standard practice
Air turbulence creates uneasiness among passengers, especially, those sitting at the tail-end of the plane, oil turbulence can create financial troubles to managers of airline businesses and more so for those sitting on thin financials. The uncertainty in oil markets would be evident from the sticky $50 per barrel oil prices despite the historic OPEC agreement to cut output by 1.8 million bpd in the first half of 2017. On the other hand, Asian demand has been showing an increasing trend in the last three months. Volatility, thus, is the order of the day and the stakeholders shall better remain protected. With 28 to 42% (current fuel prices) of their operational costs attributable to one of the crude derivative, namely the Aviation Turbine Fuel (ATF), Indian airline sector is no exception to it. While the good times (low oil prices) add value to the investors in the airline industry stocks, bad times (high oil prices) lead to vulnerable operators succumbing to cost pressures and exiting the markets besides leaving NPAs.
Typically, airline companies are expected to flock into hedging in a low but rising crude oil price environment. On the other hand, surging oil prices often lead to loss of consumer base and business confidence leading to slow-down of economic activity, and hence a reduction in demand unless it is compensated by competitive air travel costs. As fuel prices swell and travel demand falters at the same time it leads to a profit plunge. In such a scenario, hedging remains the inevitable recipe as the gains from having purchased oil futures provides not only for better cost control, but also for competitive pricing of tickets. With profits of the airline industry more dynamically linked to the overall economic situation, other modes of transportation, other than oil prices, the only factor that is under the control of airline businesses would be that of ATF which can be locked in through crude oil derivatives.
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The shape of the futures curve also catalyses the hedging behaviour of the exchanges. As ‘term structure’ strengthens—indicating higher future prices, the psychological impact of locking in the price of future fuel requirements below future possible spot prices encourage hedging. According to a Citigroup report, the consumers for crude oil are now returning to hedging as spot prices have rallied and futures curve has flattened out. The cost of jet fuel is not only the largest cost component (accounting for 30-40% of opex); it represents a component that is most volatile and its control lies in hedging. Additionally, as the airline industry seeks to sell tickets in advance, they have their income locked in before outgoing costs, and carrying months of risk lag on income versus costs can have massive cash flow issues. Hence, securing fuel costs would not only help airlines protect margins, manage cash flows, butride out the volatility. A simple example of the three airlines shows that with a 30% increase in ATF prices, both Jet Airways and Spice jet would be in the red.
Globally, risk managers quote Southwest Airlines’ long running (25 years) and successful corporate hedging programme, which makes up one-third of their costs. Ryan Air remains one of the latest examples of having hedged their exposures to the extent of 95% in 2017, having declared price certainty as their target than low prices. Singapore Airlines Ltd, remains another south-east Asian airline that has currently reported to have extended its hedging horizon from the previous 2-5 years hedging an average of 37% of its total fuel cost. Meanwhile, Malaysian Airlines has taken a prudent approach in the current oil price environment and has aggressively hedged 65% of their fuel oil requirements for 2017 at about a bit north of $60/bbl. While hedging is catching up as a healthy practice to protect the bottomlines among airline firms globally it is yet to catch up in World’s ninth largest civil aviation market—India, where the cost of fuel for an airline fluctuates widely from 28% to 63% of its total operating expense.
Analysis of crude prices reveal that, a major reason for losses reported by Indian airline companies during 2011-2014 could be largely attributed to the high cost of ATF and the higher volatility (%) in ATF prices as announced by the OMCs every fortnight. It indicates the underlying need for locking in fuel prices that would have helped the Indian airline firms provide pricing power, thereby keeping their margins well protected.
Further, with the current Listing Obligations and Disclosure Requirements (LODR) of Sebi becoming effective from the current financial year, it makes more sense for listed airlines companies in Indian exchanges to adopt hedging as a standard practice. Historically, analysts have rewarded firms that are well protected from all risks including commodity price risks. With the LODR and the adoption of Indian Accounting Standards would clearly differentiate firms that recognize risks and manage including airlines that have a larger risk arising out of ATF prices that represent more than a third of its operating costs.
– By V Shunmugam, Head—research and planning, MCX.