August 7, 2009 / 7:10 PM / 8 years ago

Airlines focus on fuel hedging as price inches up

CHICAGO/LONDON (Reuters) - Top U.S. and European airlines, groping for a toehold on recovery amid economic downturns, are adjusting their fuel-hedge strategies to control that huge expense, which has been climbing higher.

It's a tricky business for the troubled industry, whose top costs are labor and fuel.

While labor costs are largely fixed and predictable, volatile fuel prices track crude oil, which has traded in a $100 range since last summer.

Even when fuel prices are falling, they can still be detrimental to carriers, who can lose money on useless hedges.

"Rising fuel costs during the second quarter and now into the third quarter are a huge concern," Southwest Airlines (LUV.N) Chief Executive Gary Kelly said on a conference call last month.

"We do have hedging in place to provide some protection. But, of course, it couldn't be absolute protection," Kelly said. "So our outlook for the next three quarters is cautious given the economic and fuel price outlook."

U.S.-based Southwest unwound its hedges somewhat in 2009 after its fuel-hedge portfolio lost money when oil prices tumbled 80 percent in late 2008. But it was Southwest's thorough fuel hedges that insulated it from soaring energy costs that ravaged rivals in the first half of 2008.

Other airlines like US Airways Group LCC.N also scaled back their fuel hedges after plummeting oil prices led to large quarterly charges.

But NYMEX crude oil has climbed some 64 percent this year, trading near $71 a barrel on Friday, and carriers are slowly ramping up their hedges again.

The NYMEX heating oil contract, which is used as the benchmark for jet fuel trades, has shown surprising strength as have the cash differentials. Along the U.S. Gulf Coast, where most U.S.-made jet fuel is produced, the wholesale price of jet fuel has gone from $1.79 a gallon in June to $1.92 a gallon earlier this week.

Nevertheless, some analysts believe airline fuel hedges are perpetually insufficient. [nN04368459]

"They have increased a little bit but not as much as you would have expected," said Basili Alukos, airline analyst at Morningstar. "Just given that fuel was so low, I would have preferred for them to have gone all in."

U.S.-based airline consultant Robert Mann agreed.

"They'll all go out of their way to hedge interest rates and foreign exchange, but they seem reluctant to take on fuel," Mann said.

"None of them have done very much on the natural hedging side, which is bringing in newer, more fuel-efficient aircraft," Mann said.


European airlines also stepped up hedging in the last quarter to protect themselves against the risk of a sustained crude price rally.

Budget airline Ryanair (RYA.I) has hedged up to 90 percent of its fuel needs for the remainder of 2009 in a move that it hopes will cut expenses by 460 million euros over the fiscal year.

The oil price spike to $147.27 a barrel last July prompted the carrier to freeze its hedging program, and this strategy allowed it to enjoy wider profit margins when oil prices sank to under $33 a barrel last December.

German flag carrier Lufthansa (LHAG.DE) is maintaining an extensive hedging policy that covers up to 85 percent of its fuel purchases. The airline said it would start making money on its hedging program if crude prices reach $90 a barrel this year.

"We have strengthened our assumption that our hedging policy is right after last year's oil-price volatility because we are eventually expecting higher prices again," said Lufthansa spokesman Stefanie Stotz.

The airline reported a net loss of 216 million euros in the first half of 2009, down from profit of 318 million euros a year earlier. Air France-KLM (AIRF.PA) said it lost 252 million euros on its fuel hedging program alone between April and June.

In addition to crude oil, airlines also use gas oil futures traded on the IntercontinentalExchange (ICE) as a hedging proxy for jet fuel. Traders said weak gas oil prices in July -- the main component of the jet fuel price -- had encouraged airlines to fix future costs.

The premium of gas oil futures to crude oil, known as the crack spread, traded at a five-year low of less than $5 a barrel on (ICE) in early July because of huge supply overhang in the European middle distillates market.

"Airlines have been looking at the structure of the gas oil cracks and thinking it is pretty attractive and are looking to lock in positions," said a London-based middle distillates trader. "There is probably also some fear of oil prices running away."

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