Jet Fuel Swaps Ground Risk
Schap, Keith, Modern Trader
Faced with unpredictable fuel price and currency moves, airline hedgers can package both in a simple-to-manage commodity swap and leave the risk management to the swap dealer.
Frequent fliers know, to their distress, that weather conditions at a point of departure form only part of the travel story. Thunderstorms or sleet at the destination can ground them on what seems a sunny day.
Airlines face a similar economic situation. They must fuel wherever they land planes, so variations in the price of jet fuel comprise a major risk. For U.S. passenger carriers, for example, fuel costs comprise roughly 30% of the cost of doing business. Worse, exchange-rate risk can magnify the fuel price risk for international carriers.
Because traditional risk-management approaches often work imperfectly and may even magnify the risk problem, airlines and other commercial fuel users are turning increasingly to commodity swaps that allow them to bundle several risks and manage them as one convenient unit.
In effect, those who have chosen the commodity swap approach are following the advice of Puddin' Head Wilson's Calendar: "Put all your eggs in the one basket and -- WATCH THAT BASKET."
An important part of the fuel hedging problem stems from an imperfect fit between exchange-traded hedge vehicles and the actual products companies must use (see "Hedging the wet barrel").
The litany of energy hedging difficulties is long, especially among those trying to use futures. And it starts with the contrast in the makeup of wet and paper barrels.
When refiners process crude oil, the chief products are gasoline, middle distillates (heating oil, diesel fuel and jet kerosene) and residual fuel oil. And oil traders often refer to those products in terms of whether they come from the top, middle or bottom of the barrel, respectively. Because products "from the same part of the barrel" share physical characteristics, heating oil futures seem a logical hedging vehicle for protecting against jet fuel price risk.
In practice, that hedge has caused companies to suffer huge losses. Referring to the memorable cold snap in early 1990 and the Iraqi invasion of Kuwait in August 1990, Julian Barrowcliffe, director of global commodity swaps at Merrill Lynch in New York, says: "Some of the largest hedging losses have resulted from the assumption that heating oil and jet kerosene were essentially the same product and heating oil futures could hedge jet. At times, they haven't tracked each other at all."
As a result, when jet fuel prices spiked during those crises, the heating oil futures prices didn't move enough to protect the hedgers (see "Marching to the beat of different drummers"). That enormous basis risk can make the results of having hedged worse than the results with no hedge in place.
Also, New York Harbor (NYH) price behavior often differs from that in other regions of the United States, to say nothing of the rest of the world. Because of that, a futures hedge can create unwanted geographical basis risk.
Beyond basis risk, hedgers must cope with margin funding which creates an accounting problem for many corporate market users.
In addition, all those "payouts" are anathema to upper management people who often fail to consider the futures side of a hedge in context and see only losses and expenses. The burden of explaining and justifying can seem an endless distraction.
Managing those extra risks requires personnel and funding, and there's always the chance the corporate hedger will inadvertently take delivery. Having to dispose of #2 heating oil in New York Harbor when the target is jet fuel in Cleveland is indeed an unneeded liability.
And for a company based outside the United States, the additional problem of exchange rate risk can be an important consideration. Separately hedged, that can only increase the cost of establishing protection. …