How Airlines Actually Hedge Higher Fuel Prices

David Kang

US airlines hedge less after 2014-2015 losses and are structurally more exposed to fuel spikes than large international carriers.

Kang says US carriers hedge less than they used to after getting hurt in 2014-2015, and some dropped out because their balance sheets are too small to carry a sizeable hedge book. Smaller airlines simply pass fuel costs on through surcharges, leaving them structurally more exposed to fuel spikes than the large international carriers that have the balance sheet to hedge.

“some of The US carriers actually dropped out, right, because they don't have a hedge book big enough or rather they don't have a balance sheet big enough to maybe take on these risks of hedging.”at 11:06

David Kang

Airline fuel hedging works best when oil is low, as surcharges then pass through costs while hedges gain.

Kang argues hedging is mainly useful when oil is low, because fuel surcharges cannot be charged then and the weak economy depresses ticket prices. A hedge protects against a low level and pays off as prices rise, locking in cost while the surcharge is also passed to customers. Done well, an airline can effectively earn on both, but only while the economy is improving and travellers ignore surcharges. He stresses that an airline must stay situationally aware.

“hedging has its uses because it can protect you from a low level as it moves up, so you're making money and you've locked in your cost... because oil is going up... you can charge the surcharge as well.”at 27:00

David Kang

Large international airlines can earn roughly twice as much by hedging fuel while charging surcharges in a strong, high-demand economy.

Kang says international carriers with large balance sheets and revenue books can charge a fuel surcharge while also hedging fuel consumption. Passing costs to customers is possible when the economy is strong and demand is high, so travellers do not mind surcharges. He estimates the fuel surcharge is currently around 25% of the ticket charge, and says airlines can make roughly twice as much money in that environment.

“everybody wants to travel, people are paying up, they don't really care right now how much a surcharge is, you can make twice as much money while you can.”at 27:53

David Kang

Airlines wary of fuel hedging after big past losses are mainly passing higher fuel costs to customers through ticket prices.

Airlines today are wary of consumption fuel hedging because of large past losses (Delta over $1B, an Asian carrier near $2B in 2020), and with geopolitics making oil unpredictable they are mainly passing higher fuel costs through to customers via ticket prices rather than hedging. He doesn't know what they should do, but says pricing is the weapon of choice.

“I think they're very wary of the consumption hedging, and they're mainly passing it through to the customer right now because they don't know what to do.”at 53:18

David Kang

Airlines should favor swaps when oil is cheap and shift to calls or zero-cost collars as oil rises toward $70-80.

Kang says swaps are best bought when oil is cheap (roughly $25-35), because they are symmetric and cost money if prices fall. As oil rises toward $70-80, airlines worry about how long it stays elevated and shift to call options or zero-cost collars (funded by selling puts) to avoid paying full premium. His reasoning is that the hedge instrument should be chosen according to the oil price level.

“it's best to do swaps when I think oil is low... somewhere around 25, $35... But as it moves further up around 70 to $80... they'll try and do options. So they'll buy call options.”at 18:35

David Kang

Brent is an imperfect but better-than-nothing jet fuel hedge proxy for international airlines, leaving them with crack-spread basis risk.

Kang explains that international carriers use Brent as a hedge proxy because it is liquid with counterparties on both sides, while US carriers use heating oil or WTI. A Brent hedge is imperfect, since airlines burn jet, but he says it beats having no hedge at all. He cites the recent crack spread, with heating oil versus WTI blowing out to about $100, as the basis risk airlines carry.

“it is better to have a hedge on than no hedge at all. If you cannot hedge in jet, then you're totally exposed. Right? So for lack of a better proxy, alright, people use Brent because it's the international carrier.”at 22:15

David Kang

The jet fuel market is thin, opaque and subjective, so airlines cannot reliably hedge jet and face crack-spread blowouts.

Kang argues the jet fuel market is thin and opaque. Airlines are the only buyers, price agencies like Argus and Platts print numbers sometimes with no real bid or offer, and a few trading houses and oil majors dominate Singapore jet. He calls it subjective and open to coordination, so airlines cannot reliably hedge in jet and fall back on Brent, gasoil or heating oil proxies. This leaves airlines exposed to crack-spread blowouts like the jet spike earlier this year.

“There's no real open market for it... the numbers that they print sometimes have no offer on the back of that... So it's very arbitrary. So that's the reason why most people don't trust these agencies.”at 23:25

David Kang

The threatened US diesel export ban was mostly rhetoric, pushing US heating oil down while Europe's diesel shortage lifts London Gasoil.

He sees the threatened US diesel export ban as largely rhetoric, which pushed US heating oil down rather than up. Europe is already short of diesel because Russia, the second-largest exporter, has been removed from the market, which sent London Gasoil soaring; the US East Coast imports European diesel, which adds to Gasoil strength and weighs on US heating oil. US Gulf Coast refiners ('the kitchen') supply mostly Latin America and Asia, so actual flows to Europe are not very significant.

“This export ban, a lot of it was rhetoric. So because of that rhetoric, you had diesel or heating oil in The US come down instead of go up.”at 56:30