There are several arguments for and against airlines hedging fuel costs which constitutes a significant part of their operating costs.
Arguments in Favour of Hedging
Ingrassia et al. when examining arguments by proponents of hedging suggest that by failing to hedge, ‘a firm may reduce its expected cash flows and thereby diminish shareholder wealth’ (2006:p.9). Hedging is thus viewed as a risk management tool rather than an income stream. Airlines are exposed to fluctuations in oil prices as they do not typically have long-term contracts with their fuel suppliers (Morrell P. and Swan W. 2006:p.10). With hedging, the airline benefits from price certainty, predictability of its operational costs and invariably cash flows and profit margins. It also serve as a means of diversifying unsystematic risks for shareholders (Ingrassia et al. 2006:p.12).
Hedging advocates also argue that hedging enhances the flexibility of an airline’s investment policies and reduces transaction costs (Ingrassia et al. 2006:p.9). Specifically, hedging increases the airline’s ability to fund investment projects using internal funds alone since it can forecast its cash flows with more certainty. Also, with various hedging instruments, airlines are protected in the event of low or high oil prices. For instance, Barrington (2015) defines options contracts, for a premium, give the purchaser the right, but not the obligation, to buy or sell fuel in the future at a certain price presenting an advantage in the event of falling oil prices.
For some airlines, hedging may serve to assure a stable and affordable supply or output source. By hedging against fluctuations in the price of a given supply, a firm could realize the benefits of vertical integration without having to actually acquire a downstream partner. (Ingrassia et al. 2006:p.11)
Arguments against Hedging
The arguments against hedging view it as an expensive instrument to reduce unsystematic risk given that most shareholders have already reduced their exposure through diversification (Ingrassia et al. 2006:p.14). The wide fluctuations in crude oil and jet fuel prices (see Figure 1) are due to various economic, political factors and global events. Ryanair lists global events to include increases in demand, sudden disruptions in supply and other concerns about global supply, as well as market speculation. (Ryanair Annual Report. FY2017:p.54).
Consequently, airlines do not need to hedge since they can make adjustments irrespective of oil price movements. For instance, price increase due to economic growth will mean that the airlines can pass the increases to customers. On the other hand, oil price decline due to unfavorable economic conditions will lead to a drop in fuel costs. However, a hedging airline unable to benefit from an oil price decline will impact its ability to raise fares to counteract increased fuel and other operating costs (Ryanair Annual Report. FY2017:p.62).
Opponents of hedging also view it as a mechanism to manage accounting earnings – for instance through altering timing of profits – rather than to reduce exposure to economic fluctuations. This is practiced by distressed airlines with cash flow problems. A decline in the price of oil may expose hedging airlines to some risk of losses that could have negative effects on their financial condition and/or operations. Large hedges at prices significantly higher than the spot market can make airfares less competitive by forcing carriers to pass on the extra cost to passengers. In addition, it could adversely impact an airline’s short-term liquidity because hedge counterparties could require more collateral for active hedging contracts.
2. Based on this, would you advise Ryanair to continue on hedging its fuel price risk?
Yes. As a low-cost carrier, the success of Ryanair’s business model depends on its ability to control costs in order to charge low fares while driving its revenues up. With fuel costs constituting a substantial portion of Ryanair’s operating expenses (approximately 38% and 41% in 2017 and 2016 respectively), after taking into account fuel hedging activities (Ryanair Annual Report. FY2017:p.129), it has limited control due to the volatility (Figure 2). Thus, Ryanair estimates that if it is unable to further reduce its other operating costs or generate additional revenues in periods of high fuel costs, operating profits are likely to fall. (Ryanair Annual Report. FY2017:p.57).
However with hedging in place, Ryanair is able to lock in the prices against higher fuel prices.
Through hedging, Ryanair is able to predict its earnings and profits with more certainty while concentrating on other aspects of operations and growing the business. Also, if oil prices decrease, the “loss” made from hedging is offset by the savings from lower fuel costs. Similarly, if oil prices increase, Ryanair would make a profit on the hedge which may be used to offset higher fuel costs in the future (see Figure 3). This implies that they are better off with a hedge in place.
Hedging could also lead to decreased fuel costs as recorded by Ryanair between 2016 and 2017 when fuel and oil costs decreased by 8% after factoring fuel hedging activities demonstrating the effectiveness of its hedging activities. (Ryanair Annual Report, 2017)