Does Hedging Against Fuel Price Movements Increase Airline Value?

Michael Giberson

Platts reports an airline financial analyst as telling an industry group that hedging fuel costs is a waste of time.

The world’s airlines should stay away from trading oil derivatives and hedging in general because the exercise had proven to be “a waste of time,” the head of Asia transport research at Swiss bank UBS, Damien Horth, told a meeting of the world’s airlines in China late last week.

“I would be of the view that hedging is a waste of time,” said Horth. “Most of the hedging I have seen in the last two to three years has been speculative.”

Horth, who was speaking to delegates at a jet fuel meeting hosted in Shanghai by the International Air Transport Association, said that few airlines seemed to be using oil derivatives simply to manage cost. …

“If you are simply price-setting, fine … what they have been doing has been non-speculative. Every other airline has been taking a view on oil, and once you do that, you are speculating.”

Horth dismissed academic studies that suggested there was a positive correlation between share prices for listed airlines and those that have hedging programs in place.

One such study, a joint 2003 report by the US’ Oklahoma State University and Portland State University, said airlines that hedge generally received a 12-16% bump in equity value — and represented conventional wisdom in the airline industry for much of this decade.

“I’m sure I could find a positive correlation between a lot of things,” said Horth.

As reported Horth seems a little hasty in his dismissal of the academic study mentioned. But more significantly, it seems like he is mixing his assessment of hedging and speculating – first saying hedging is a waste of time, then saying if the airline is not speculating then it is okay, then saying airlines mostly are speculating, then dismissing the academic study on hedging.

Horth apparently understands the difference between hedging and speculating, and I assume the Platts reporter or editor also understands the difference, so it is unclear why the argument presented is so mixed up.

Evidence from the US Airline Industry

The academic study referred to would be David Carter, Daniel Rogers, and Betty Simkins, “Does Hedging Affect Firm Value? Evidence from the US Airline Industry,” Financial Management (Spring 2006.). In the study, the authors show that jet fuel hedging is positively related to airline firm value, and that most of the hedging premium is attributable to the interaction of hedging with investment.

Not all empirical studies of hedging find a relation between hedging activity and company value. The general intuition from financial economics is that investors can optimally hedge their own price risk and won’t benefit from company activity to further hedge. In fact, an investor may be seeking exposure to the price risk as a hedge to other positions held. Since investors don’t benefit, under this explanation, the costs of hedging represent pure waste to the investor.

Exceptions to that general logic arise when (a) the company faces a complex risk exposure which an individual investor could not readily hedge against, such as a multi-national company facing many different currency risks; (b) effective corporate tax schedules are “convex”, meaning the average tax of a volatile stream of income is higher than the tax on the average of that volatile stream of income; or (c) when investment opportunities in the industry are correlated with adverse price movements.

Carter, Rogers and Simkins suggest that airlines benefit from hedging because of this last factor. When fuel costs are high, unhedged airlines may be forced to reduce routes and sell assets into a buyers market. A hedge, by preserving airline capital at times when fuel costs are high, makes it easier for the hedged airline to take advantage of the investment opportunities presented.

Note, on the other hand, that Yanbo Jin and Philippe Jorion, Firm Value and Hedging: Evidence from U.S. Oil and Gas Producers,” Journal of Finance (April 2006), find that although hedging does reduce oil and gas producer’s stock price exposure to oil and gas prices, it does not seem to add to the company’s market value. A survey of such studies by Charles Smithson and Betty Simkins tentatively suggests that hedging may be more valuable to commodity users than to commodity producers. (Overall, Smithson and Simkins find that most of the surveyed articles suggest hedging adds value, but with important exceptions.)

Is the “Broad Backlash Against Hedging” just Hindsight Bias?

Platts states that Damien Horth’s remarks reflect a “broad backlash against hedging in the airline industry, where the relationship with trading derivatives has historically been tenuous at best, and usually troubled.” The article reports that “shareholders have long tended to punish airlines that don’t have hedging program in place when fuel prices are running up — and are equally critical of airlines caught holding expensive fuel derivatives when fuel prices fall.” With fuel prices down significantly from earlier this year, airlines that were well hedged against price increases have found those hedges to be expensive.

It isn’t obvious that this is any more than hindsight bias, but with the recent volatility in petroleum prices it may be more important than ever to figure out the benefits – or lack thereof – of an active company hedging program. In coming to a conclusion on this issue, I’d rather rely on the conclusions of published academic articles than trust an analyst who would dismiss such research offhand.