You do not have to spend long in airline boardrooms to realise that the oil price hike has been a painful experience for carriers everywhere. Already the fuel hike is being cited as a real threat to industry financial performance this year. Although there are welcome signs that the oil price could finally start to tumble as and when production constraints are removed in the Middle East, the damage already done in the first quarter of 2000 is all too clear.
And if the price of oil is the boardroom preoccupation of the moment, then it is not long before the conversation turns to the airline's strategy for hedging. But does hedging really represent a long-term solution? Given that fuel prices have more than doubled over the last year, having a hedge in place against the rise would seem to make eminent sense - even a necessity. Yet hedging can produce losses as well as gains.
Hedging is, after all, a gamble on a future unknown price. While it will tend to delay the full impact of a price hike, at times, it is almost inevitable that a hedging strategy will produce what amounts to a wrong bet and equally delay a price fall. A simple rule of thumb would suggest that any such bet would have to be right more than half the time to produce an overall benefit. Some airlines are beginning to wonder whether the costs of hedging may actually be greater than the benefit, at least in the long term.
Since the highs of the early 1990s, there have been a couple of periods when the fuel price fell and airlines with hedges in place have not fully benefited from that fall. In the present climate of soaring prices, however, there has been comfort to be gained from putting more hedging in place rather than less. Indeed a number of airlines already have far greater hedging activity than normal. A case, perhaps of perfect hindsight.
In reality, hedging is there to provide a little certainty and stability in an input price - not to cancel out its impact altogether. The same goes for hedging against currency fluctuations for non-US airlines, which can suffer from variations in US dollar rates even against the backdrop of a stable fuel price. For example, the 15%movement in the Deustche Mark against the dollar in the mid-1990s.
What is of more interest is the importance of fuel as a swing factor on profit. Of course, the world is not so simple that a single factor like oil price or the dollar exchange rate can explain away the variation in an airline's profit.
However, to use that well-worn economist's phrase "holding all other things equal", it is possible to see a clear swing effect of the change in the fuel price on profit. There are a number of qualifications that have to be made - not least that using averages can often be dangerous.
Nevertheless, looking at the fluctuations of fuel and profits there is a reasonably clear pattern for both US and European airlines. The conclusion is hardly startling: fuel rises have tended to depress profits, but in some cases the impact has been worse than in others. What is also visible, however, is a degree of what could be described as "profit illusion", with fluctuations in the fuel price obscuring the industry's underlying profit performance. So while, at times, it is clear that the impact of a fuel rise has masked an otherwise healthy improvement in underlying profitability, it is equally clear that at other times the gain from falling fuel costs has helped hide an underlying deterioration in the operating result.
Neither is this effect exactly unexpected. Its scale and power to illude, however, are surprisingly significant. Take the case of the major US airlines over the last decade (see chart). In 1990 and 1991, their operating losses appeared to be spiralling out of control, yet stripping out the impact of a fuel hike, results would have remained flat until the upturn in 1994. Four years into the recovery and the gain from fuel prices, no doubt carried over through hedges, helped produce an apparent $725 million improvement in year-on-year operating profits for 1998. But without that $2.2 billion gain from fuel, profitability would have been down by nearly $1.5 billion. And when industry profits appeared to tumble last year, the fuel cost was responsible for at least half the fall.
The pattern in Europe is a little more mixed, further complicated by factors such as currency fluctuations. However, the difference is one of degree. The relative influence of fuel is a function of the underlying level of profitability and the swing in the fuel price. If the underlying profitability is poor, then by definition, a move in the fuel price has a far greater impact either hiding or hurting more.
What then of the future? The decisions made within OPEC over the next few weeks will clearly be fundamental, though hedging may postpone any good news for some. In the meantime, fuel surcharges (under whatever guise) are now a feature and it will be interesting to see what happens to these if and when the fuel price falls back to more normal levels. There are already renewed deliberations over fuel taxation in Brussels. So watch this space - it could get hotter from here.
Source: Airline Business
