US airlines are taking the hedge off on jet fuel

— An old investing adage is to buy on the dips, a philosophy generally followed by US airlines in the hedging market over the years. This year? Not so much.

Jet fuel prices have declined in price and volatility so far in 2014. So has jet fuel hedging, at least in the US. What is essentially insurance on any airline's single-largest cost has become seen as less than necessary.

The world's largest airline, newly merged American Airlines, said it had sold off its hedging contracts by the end of the second quarter, an expected move as merger partner US Airways had gone without hedging since 2008.  

Traders and brokers who make money selling the calls, collars and other financial instruments questioned whether other airlines would pick up the slack, especially tempted by a flat-price drop over the summer.

"My sense is less hedging overall," one jet trader said. "Take AA. They've adopted the US Airways model so they are entirely out of it. Nobody wants to catch a falling knife, plus consolidation has created less demand for hedging."

Platts data showed that 2014 spot market prices in the benchmark Gulf Coast, where half of US jet fuel is produced, averaged $2.88 per gallon as of August 28.

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The average leaped from $1.67/gal in 2009 to $2.15/gal in 2010, $3/gal in 2011 and $3.05/gal in 2012, before dipping to $2.92/gal in 2013.

Standard deviation, a statistical measure in which a higher number means more volatility, went from 27 cents/gal in 2009 to 15-18 cents/gal in the next four years and only 6.2 cents/gal in 2014.

In 2008, when oil prices peaked and then crashed, Gulf Coast jet averaged $2.96/gal with a standard deviation of 78 cents/gal.

That volatility helped prompt mergers that turned American, Delta, United and Southwest into the world's four largest airlines by passengers carried in 2013.

Most other US airlines have not cut hedging altogether, but have cut back, according to an analysis of second-quarter earnings reports and other documents.

Sources said US airlines had already reduced hedging volumes and lengths in recent years to about 30-40% of fuel consumption no more than 18 months out.

But United Airlines reported hedging only 21% for the rest of 2014, 19% for 2015 and 1% for 2016 consumption. Southwest Airlines said it hedged only 25% of fuel cost for 2014.

It famously loaded up on hedges more than a decade ago and outpaced rivals more exposed to rising jet fuel prices. JetBlue Airways hedged only 15% of its second-quarter fuel consumption.

Delta Airlines may be the outlier, with an aggressive hedging strategy sources said helped deliver jet fuel prices 10-15 cents/gal below the competition last quarter.

Globally, other airlines appear to be either starting, increasing or reducing hedges, but still keeping a higher percentage of fuel costs hedged than US airlines.

"We have certainly seen some North American carriers reduce the overall percentage of fuel they are hedging," said Mike Corley, president of Mercatus Energy Advisors, an independent energy hedging advisory firm.

"One CFO told me that the primary reason he can justify it is that such a large percentage of their revenue and profits are now coming from baggage fees, change fees, etc., as opposed to actually operating planes," Corley said. "Another said that their board doesn't see it as being as necessary as it was a few years ago given the decline in price volatility.

"However, he also said that when volatility/prices rise significantly they'll ask him to start hedging aggressively right away," Corley said, adding that the chief financial officer "understands the absurdity of the situation" in that such protection is cheaper during times of low risk and best adopted during times of low prices.

Europe united on hedging

In Europe, the reaction to lower and less volatile prices has been mixed, at least in the short term. While Air France-KLM has reduced its hedging, Ryanair has left its unchanged, and EasyJet and Lufthansa have increased positions in certain years.

Despite these minor adjustments, there appears to be broad unanimity across Europe's biggest carriers that hedging remains an essential tool in managing fuel costs.

A source at one European airline cited a herd mentality for hedging. "Everyone looks at their peers," he said. "What are your competitors doing? You don't want to be an outlier."

Irish budget carrier Ryanair is hedged for 90% of its fuel for the year ending March 2015, EasyJet is hedged 80% for the year ending September 2014, Lufthansa is covered at 78% for 2014, and Air France-KLM is hedged at 65% for 2014.

Similar percentages for International Airlines Group, the parent of British Airways and Iberia, were not available on its website.

Ryanair, the world's fifth-largest airline by passengers carried, expects its fuel hedging strategy to deliver savings of Eur50 million ($66 million) for the financial year to end March 2015.

IAG saw fuel costs fall 9.1% over the first half of the year due to hedging and the introduction of a more efficient fleet, another common theme as airlines worldwide switch out aircraft.

The CIF Northwest European jet fuel cargo market has been remarkably stable since Q2 2013, as well as lower after several years of wild volatility.

In 2009, prices averaged $567.04 per metric ton, climbing to $724.08/mt in 2010 and $1,015.14/mt in 2011, before peaking at $1,027.24/mt in 2012.

The market then fell to $989.61/mt in 2013, and has averaged $969.53/mt since the beginning of 2014 , Platts data showed.

"Despite prices of fuel falling, we've not seen airline fares falling," one European jet fuel trader said. "It seems like they've got a buffer priced in. After the bad times they've had, no one's going to begrudge the airlines a bit of profitability."

Middle East, Asia divided

Hedging markets are less developed in other parts of the world.

Corley said his group is working with numerous airlines in Asia, the Middle East and Latin America that are looking to improve the quality of their hedging.

"Some are beginning to hedge for the first time ever," he said.

But at least some of the bigger Asian airlines remained well hedged. 

Singapore Airlines said it was 52% hedged for its fiscal year that started in April, compared with 57% for the previous year.

Hong Kong-based Cathay Pacific said this month it has increased volumes and extended hedging contracts to 2017 to take advantage of falling prices.

"I think lower jet fuel prices are prompting more forward fuel price hedging from airlines," an Asian market source said. 

Japanese ANA Holdings plans to keep its hedging at around 75% for the rest of the year, before reducing its exposure to 40% and 20% in 2015 and 2016, respectively.

One key exception is Emirates Airlines, which does not hedge at all. The flag carrier of the UAE incurred significant losses from hedging strategies drawn up before the global economic crash saw prices nosedive in 2008.

Sources said it has no intention of hedging in the near term.

American setting the pace

The same scenario also nearly bankrupted US Airways in 2008, prompting the hedging turnaround.

American, and US Airways before it, has said it would hedge if it saw an advantage. But some sources said its lack of hedging at a time of a rising stock price may has made other airlines more willing to avoid paying the high cost of buying hedges.

"US Airways used to not hedge and, basically, US Airways management took over American and they said they are not hedging," an airline hedging unit source said. "And yes, everybody is scaling back except Delta. It has been very stable over the last two to three years and it is pointing to a backwardated market and that's probably why."

"It's too expensive of insurance. They'd rather not mess with it," an airline fuel buyer added. "We're doing different things to bring down the cost of hedging."

For example, he said his airline might buy a call and sell a higher call, adding risk at the high end but defraying the overall hedging cost.

"There is a change in that sense where you do get more comfort where I'm willing to take that risk and not protect because I'm not afraid oil is going to $150/barrel," he said.