It is important to remember that the airlines can only be profitable if they are able to cover their operational costs by selling tickets. Nearly all of their costs are somewhat predictable, and can be pro-rated into future transactions except one: the short term costs of fuel.
To protect themselves, and sometimes to even take advantage of the situation, airlines commonly hedge their fuel costs. They do this by buying or selling the expected future price of oil through a range of derivatives, thus protecting them from rising prices. In this article, we look at four ways airlines hedge against fluctuating oil prices.
- Airlines can employ several hedging strategies to protect their bottom lines from fluctuating oil prices.
- One simple strategy is to buy current oil contracts, which lock in fuel purchases at today's prices. This is advantageous if you expect prices to rise in the future.
- Call and put options are other tools to hedge against moving oil prices.
- If an airline buys a swap contract, it is obligated to fulfill the terms of that contract.
Purchasing Current Oil Contracts
In this hedging scenario, an airline would believe that prices will rise in the future. To mitigate this, the airline purchases large amounts of current oil contracts for its future needs.
This is similar to a person who knows that the price of gas will increase over the next 12 months and they will need 100 gallons of gas for their car during that time. Instead of buying gas as needed, the car owner decides to purchase all 100 gallons at the current price, which they expect to be lower than the price of gas in the future.
Purchasing Call Options
A call option gives the buyer the right (though not an obligation) to purchase a stock or commodity at a specific price before a specific date. If an airline buys a call option, this means it is by buying the right to purchase oil in the future at a price that is agreed upon today.
For example, let's say the current price of oil is $100 per barrel, but an airline company believes prices will increase. It could purchase a call option for $5 that gives it the right to purchase a barrel of oil for $110 within a 120-day period. If oil prices increase to above $115 per barrel within 120 days, the airline will end up saving money.
Implementing a Collar Hedge
Similar to a call option strategy, airlines can also implement a collar hedge, which requires a company to purchase both a call option and a put option. Where a call option allows an investor to purchase a stock or commodity at a future date for a price that's agreed upon today, a put option allows an investor to do the opposite: sell a stock or commodity at a future date for a price that's agreed on today.
A collar hedge uses a put option to protect an airline from a decline in the price of oil if that airline expects oil prices to increase. In the example above, if fuel prices increase, the airline would lose $5 per call option contract. A collar hedge protects the airline against this loss.
Purchasing Swap Contracts
Finally, an airline can implement a swap strategy to hedge against the potential of rising fuel costs. A swap is similar to a call option, but with more stringent guidelines. While a call option gives an airline the right to purchase oil in the future at a certain price, it doesn't require the company to do so.
A swap, on the other hand, locks in the purchase of oil at a future price at a specified date. If fuel prices decline instead, the airline company has the potential to lose much more than it would with a call option strategy.