ATF price risk key to airline industrys growth

Updated: Nov 21 2005, 05:30am hrs
The recent surge in air turbine fuel (ATF) prices has raised concerns about the domestic airline industrys ability to sustain the 18% growth it managed in the past two years by launching low-cost carriers and discounted prices. With increased dependence on price-sensitive customer segments, the fate of airlines would significantly depend on managing fuel prices.

In absolute terms, ATF prices in India have gone up by around 75% since 2003, with surging global crude prices causing fuel costs to go up from 15% to 25% for major carriers. The impact has been greater for low-cost airlines, since fuel costs are as much as 35-40% of revenues. Rising prices hit the bottomline, since competition and price-sensitivity of customers limit airlines from passing on the additional cost through higher airfares.

Globally, airlines manage fuel cost impact through hedging of price risks in derivative markets. KPMG research indicates that most global airlines hedged 40-65% of their projected annual volumes during 2003-04, with low-cost US carriers Jet Blue and Southwest recording hedge ratios at 40% and 83%, respectively.

Fuel hedging has been a key component of their low-cost strategy and they look at efficient fuel price management for competitive advantage. The effectiveness of active hedging is evident in their actual ATF costs per gallon. In 2003, the largest fuel hedgers (Southwest, JetBlue, Delta) achieved fuel costs below the average New York and US Gulf Coast ATF spot prices.

The Indian government recently allowed Air India to hedge ATF in international markets and is in the process of allowing private operators to do so. The challenge for airlines here would be managing a host of residual risks arising out of hedging operations, since ATF is not being traded in most leading exchanges. Implying that airlines would either have to hedge through OTC ATF contracts or use proxy hedging in exchanges with a more liquid commodity, such as crude.

Fuel hedging has been a key component of some low cost US carriers
The government recently allowed Air India to hedge ATF in global markets
Domestic markets can help airlines effectively hedge their ATF price risks
While OTC markets provide sufficient flexibility of structuring contracts, they would expose companies to credit risk. Alternatively, proxy hedging through close commodities such as crude and heating oil would entail an element of basis risks. Which, if not managed properly, might lead to untoward results.

Also, airlines would be exposed to foreign exchange risks, since ATF is traded in dollars internationally. Considering the multiple risks, the regulator could allow a breadth of risk management options, rather than limited activities on managing only the pure commodity risks. However, it is unlikely that the regulator would allow airlines to build multiple risk portfolios on their books straightaway, given that instruments such as credit derivatives are not allowed for most Indian corporates.

A solution would be to grant auto approval to all airlines to undertake hedging of their basic ATF exposures, while gradually allowing them to manage the residual (credit and basis) risks over a period of time. Airlines would need strong risk management capabilities for hedge programmes. Usually, the most difficult part is to develop an appreciation within the organisation of the risks posed by multiple exposures. And the need to manage these through proper systems and risk management tools, rather than exposing hedge programmes to the market perceptions of a few executives and brokers.

The key is to develop a dynamic hedging strategy, by varying the hedge ratio and instruments over the oil price cycle. When oil is at a low point in the cycle, fixed price swaps could be used to allow the airline to lock in a relatively low price. During the middle range of the cycle, collars could be used to lock in a range of prices, compensating potential savings from price depreciation with probable losses from price increases. At a high point of the price cycle, caps could be used to prevent losses from further price increases, while holding on to gains in case of price decreases.

This strategy needs constant monitoring of market movements and hedge portfolios. For which a strong decision-making and reporting framework needs to be developed, using various risk metrics to enable the hedging desk and senior management to take appropriate decisions.

In the long term, market participants, with government support, develop an indigenous hedging market. Currently, domestic exchanges such as NCDEX and MCX have launched rupee-denominated crude contracts. But liquidity is low for any active hedger to meaningfully participate in the market. With build-up of liquidity, domestic markets could play an important role in allowing airlines to effectively hedge their ATF price risks.

The writers are with KPMG Advisory Services, India