Flying into a storm

Extreme volatility in oil markets has caused hundreds of millions of dollars in losses on airline fuel hedges. At the same time, burgeoning margin calls have forced some to get creative with collateral agreements. How is the airline industry adapting? By Matt Cameron

A irlines across the globe have had a year they would rather forget. The financial crisis has taken a heavy toll, with many companies reporting severe drops in domestic ticket sales as holiday and business travellers cut back on spending, while cargo traffic has also declined precipitously. To add to their woes, ticket sales declined further this year as the swine flu pandemic swept across the globe - and analysts estimate global air traffic in terms of passenger kilometres travelled will decline by around 4% in 2009.

With so much pressure on revenues, the last thing the industry needed was unprecedented volatility in fuel costs. Oil prices climbed steadily throughout 2007 and 2008, to reach their all-time high of $147/bbl in July last year. Believing prices would continue to climb, many airlines persisted with their hedging programmes, with some making use of cost-reduction option strategies. However, an abrupt and severe drop in oil prices in the second half of 2008 left many airlines staring at hundreds of millions of dollars in mark-to-market and realised losses on fuel hedges - and facing huge margin calls from dealers. So severe was the shock, one derivatives professional says it is amazing so many airlines have survived.

According to the International Civil Aviation Organisation (ICAO), global scheduled airlines incurred an estimated operating loss of approximately $9.8 billion in 2008, compared with a record $19.7 billion operating profit in 2007. The decline in profitability was due partly to a slowdown in traffic growth, but mostly to fuel hedging losses, the ICAO says. If fuel hedging losses are excluded from global airline balance sheets, the industry would have ended the 2008 financial year with an estimated provisional operating loss of just $3.8 billion.

Airlines point to the severe volatility in jet fuel and other oil markets over the past year as the key reason for the losses on hedges. The Bloomberg northwest Europe outright jet fuel front-month cargo swap price (cost, insurance and freight) started 2008 at $897.66 a tonne and climbed steadily to hit a high of $1,451.51 on July 3, 2008, a rise of 62%. Prices then plunged to $457.93 by December 24 that year, reaching a low of $401.54 by March 11, 2009, a total drop of 72%.

Crude oil and other refined products - often used as proxy hedges for jet fuel - experienced similar levels of volatility. The active-month West Texas Intermediate (WTI) oil futures contract on the New York Mercantile Exchange (Nymex) dived from $147.27 a barrel on July 11, 2008 to $45.99 by December 24. The active-month gasoline futures contract on Nymex, meanwhile, dropped from a high of $367.87 a gallon on July 14, 2008 to $111.97 on December 24.

 

Freefalling losses

For many airlines that put on hedges at the peak of the market, the freefall in oil prices proved devastating. Hong Kong-based Cathay Pacific suffered mark-to-market losses of HK$7.6 billion ($980 million) and sustained a realised loss on fuel hedges of around HK$300 million in 2008. Dublin-based Ryanair incurred a ‚Ǩ102 million ($142 million) loss on fuel hedges in the last quarter of 2008, while British Airways reported an operating loss on fuel derivatives of £220 million ($361 million) in its 2008/09 annual report, versus an £878 million ($1.4 billon) gain in the previous year.

Singapore Airlines posted S$341 million ($235 million) in hedging losses in the final three months of 2008, and reported a further S$287 million loss in the first quarter of this year. Atlanta, Georgia-based Delta also experienced hefty losses, reporting a $390 million hole in the second quarter of this year. Meanwhile, German airline Lufthansa had to write down €72 million in fuel hedges that were transacted with the now defunct Lehman Brothers.

Airlines employ a variety of strategies to hedge fuel costs, with many opting to pursue rolling programmes of short-dated hedges, covering a targeted proportion of their expected fuel purchases. Along with swaps, many choose to employ collars. And with many corporate treasurers reluctant to shell out premium, these are usually structured to be at zero cost, where the premium achieved from selling the put offsets the cost of the call option.

With oil prices on a steady upward trajectory in 2008 - and expected to continue rising - swaps became less popular among airline hedgers, compared to other more flexible structures like collars, while premium on call options became too expensive for many. Instead, more firms began using three-way collars. This entails the purchase of a call and the simultaneous sale of a call at a higher strike price, combined with the sale of a put. The additional premium from the sale of the call option means users can either afford to sell the put at a lower strike (therefore making firms less exposed to a minor fall in oil prices) or improve the strike of the purchased call (allowing airlines to benefit sooner from any further rise in oil prices). Others sold a greater proportion of put options in traditional collar structures to fund the purchase of call options with improved strikes, known as ratio collars.

"When oil prices peaked in July last year, most airlines were in a precarious position because if they were to just use swaps to lock in prices, they would have been locking in operating losses," says Steve Jones, head of corporate sales for commodities in Europe, the Middle East and Asia at Morgan Stanley in London. "This is why many airlines were using more leveraged structures such as ratio collars, where they sold more volume on puts than they bought on calls, which allowed them a lower entry level on the hedge (a lower call strike)."

Dealers say many of the puts were struck at between $80 and $100 a barrel (in the case of crude oil) - a level widely assumed to give airlines sufficient protection against any correction in the oil price rally. But as oil markets collapsed in the second half of last year, airlines found themselves facing huge losses.

Not all were hit to the same degree, however. Some firms started to take action to restructure hedges before the collapse of prices, while others had already attempted to protect themselves against a sharp drop in oil prices. One structure used by some was the four-way collar. This entails the purchase of a call (for instance, at 105% of spot) and simultaneous sale of a call at a higher strike (115% of spot), alongside the sale of a put (for instance, 90% of spot) and simultaneous purchase of a put at a lower strike (80%). This means the upside is capped, but the company has limited exposure if the market crashes.

"When the oil price began to climb to $120 a barrel, the risk to the equity of the group became tremendous," says one European airline treasurer. "We had been doing three-way collars, but as the oil price continued to rise, the put strike in the three-way transactions would become a lot higher, reaching levels we weren't comfortable with. So, we decided to trade four-way collars, which gave us downside protection and would limit our losses should the oil price fall. Obviously, we were negatively affected when the price did plummet, but it was limited. We didn't use plain call options because the premiums were far too expensive."

 

Up for renewable

Airlines point out that the derivatives contracts were part of their rolling hedging programmes and so are short-term in nature. As a result, many of the most troublesome contracts will expire within the next year. Nonetheless, the rebound in the oil market in recent months has eased much of the pain for some airlines. Cathay Pacific, for instance, has recorded an unrealised mark-to-market gain of HK$2.1 billion on hedges in the first half of 2008. Since hitting a low of $44.41 a barrel on February 18 this year, the active-month WTI futures contract on Nymex had recovered to reach $66.75 as of August 17.

Despite this, there will inevitably be a close re-examination of hedging practices in the wake of the losses. Some have already declared they will shy away from complex structures in favour of plain vanilla swaps and options. For instance, Keith Fung, Hong Kong-based general manager of corporate finance at Cathay Pacific, says the airline will continue to set its hedging policy based on market conditions, but will be more focused on vanilla instruments and will probably steer clear of collars.

Indeed, some dealers claim corporate treasurers will be more willing to fork out premium on plain vanilla call options, recognising the potential benefits outweigh the upfront costs. "Because of the leveraged effect of having the extra puts, people will naturally be drawn towards simpler swaps, collars and call options," says Morgan Stanley's Jones. "There will be a much greater willingness to spend the premium on a call option or collar with an improved put/call. There has been a general reluctance by airlines to spend the premium, but in hindsight the amount they would spend on an option premium compared with the losses experienced on selling puts and selling swaps is very minor. As a way to alleviate incurring the cost of an option premium, some dealers are offering terms where it can be amortised over the length of the option contract."

 

Collars still OK for some

Not everyone plans to shy away from collars, however. Dallas-based Southwest Airlines says it will continue to use collars alongside other derivatives - despite scrambling to restructure its hedge book during the volatility of last year. "We had a lot of collar positions on last year with a variety of different put strikes," says Scott Topping, treasurer of Dallas-based Southwest Airlines. "When the oil price dropped, our floors were at risk. So, we reduced our hedges across the curve to about 10%. It was a dangerous situation and we realised we needed to be less hedged. We executed a number of swaps and sold collars to offset the floors as the oil price dropped. This year, we have primarily rebuilt the hedge portfolio using more basic structures, such as vanilla calls, but we will likely still use collars in the future - it makes sense given the cost of call option premiums."

Alongside actual losses on their hedges, another issue came to the fore in the wake of the crisis. With mark-to-market losses on some derivatives positions mushrooming, those airlines subject to credit support annex (CSA) agreements were hit with massive margin calls from their dealer counterparties. With the airline industry struggling, this put severe pressure on companies.

"When the oil price dropped rapidly, airlines endured the double whammy of having a much greater mark-to-market loss exposure than they had envisaged, and then having to post collateral from the ensuing margin calls," says one derivatives dealer. "If you have a two- or three-year hedge book, it can amount to a lot of money. The margin calls were huge at a time when the business was not doing so well and people weren't flying as much. So those airlines that had CSAs in place struggled and it was a massive obstacle to circumnavigate."

As of December 31, 2008, American Airlines had $575 million of cash collateral posted with counterparties on derivatives contracts. Many of the contracts were settled in the first half of this year and, as of June 30, the airline had $59 million of collateral posted with counterparties. Meanwhile, Delta Airlines was required to post $1.2 billion in collateral as of December 31 last year. Most of these derivatives contracts were settled in the first half of this year.

 

Flying collateral

As of July 20 this year, Southwest Airlines had approximately $425 million in cash collateral paid to its derivatives counterparties. However, the company also amended counterparty agreements from January to allow it to post Boeing 737-700 aircraft in lieu of cash collateral. The amendment is in place until January 2010, and the company had posted approximately $310 million in aircraft collateral as of July 20.

"The dislocation in the markets created a lot of difficulty for the airline industry with respect to hedging positions," says Southwest Airline's Topping. "A huge liquidity issue emerged as many positions became negative and required collateral to be posted. Many airlines were scrambling to meet those cash calls. As a result of going through the crisis, we modified some of our credit support agreements to allow aircraft to be posted as collateral rather than cash. We are able to substitute unencumbered aircraft up to $900 million in place of cash. It gives us a lot more confidence in placing new hedges on the books."

Those banks willing to accept aircraft as collateral would probably be limited to those with aircraft financing businesses. Nonetheless, some believe the practice will become more popular throughout the industry. "By using pools of unencumbered aircraft as collateral, airlines will be able to free unwanted pressure on their balance sheets," remarks a treasurer at a European airline.

Certainly, the practice of posting collateral and daily margining will become more familiar to a wider range of airlines. The biggest firms still claim they are unlikely to be compelled by their banks to sign CSAs - and dealers point out the credit exposure can be hedged through the credit default swap market if necessary. However, with greater focus on counterparty credit risk management since the crisis, coupled with the poor performance of the industry, the signing of CSAs and frequent posting of margin will become more common. This could create problems for many corporate treasury teams.

"From the airlines' perspective, daily margining is impossible because your average treasury operation has a financial director, a treasurer and a few support staff. They can't cope with daily reconciling and cashflows on a daily basis," says one dealer. "But what people have been doing to allay this is amending the time frame for collateral posting to weekly or monthly."

Few would disagree the posting of collateral makes sense for the dealer from a counterparty risk management perspective. For the airline, however, the posting of collateral could put huge strain on already stretched balance sheets. "If you have a big hedge book, it can be the margin calls that can crucify you and send the company down," says the dealer. n