The Hindu Business Line : Hedging, the only logical option for airlines to control ATF cost

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Hedging, the only logical option for airlines to control ATF cost

With relentless oil price fluctuations, the only answer for Indian airlines is to take a leaf out of the book of their global counterparts and incorporate a sustained hedging programme to maintain fuel cost as a percentage of total expenditure.

Mr Hemal Shah, Associate Director, Risk Advisory Services, Ernst & Young.

In Greek mythology, you’d read about King Minos who held Icarus and his father, Daedalus, captive in the Labyrinth, a prison. “The Labyrinth’s original purpose was intended to hold the horrible creature, the Minotaur, a bea st that was a product of one of the King’s mistress’s affairs with a bull,” informs Wikipedia.

To escape from the prison, “Daedalus fashioned a pair of wings for himself and his son, made of feathers and wax…”

In the current story of Indian aviation, the Labyrinth may well be the high cost of fuel, even as the industry would like to fly high.

“The country is upbeat about the aviation boom, and airlines increase capacity to deal with an ever-increasing customer-base, but the growth has not reflected on the bottom line,” observes Mr Hemal Shah, Associate Director, Risk Advisory Services of Ernst & Young (E&Y).

“As fares and load factors head north, profits at major airlines are heading south as losses in the aviation industry continue to accumulate. Even though airlines bask in what is traditionally always a good third quarter, oil prices spiralling close to $100/barrel are the major dampener and are sending shockwaves across the industry,” he adds, during the course of an e-mail interaction with Business Line.

Considering the woes of the aviation industry, the Standing Committee on Transport, Tourism and Culture recommended on November 20 that the Finance Ministry should “sympathetically consider and give approval to the proposal of the Civil Aviation Ministry regarding notifying aviation turbine fuel (ATF) as ‘declared good’ under Section 14 of the Central Sales Tax Act on a priority basis”, and thus help contain the sales tax on ATF at 4 per cent.

While such a move would definitely help the industry, Mr Shah is of the view that hedging can help our airlines stay competitive and explore pricing options to corner market share in the crowded international skies.

“Hedging is the only logical option for airlines to deliver value to stakeholders by controlling ATF cost and adding to the ever-dwindling EPS (earnings per share).”

Excerpts from the interview:

How much is ATF as a cost component?

ATF continues to be the single largest cost factor for airlines constituting nearly 35 per cent of the total operating cost. The other constituents are: employee costs (13 per cent), selling, distribution and agent commission (18 per cent), and other cost factors (30 per cent). This can change if airlines lease aircraft instead of buying them outright.

Also, fuel costs as a percentage can vary between 35 and 40 per cent depending on whether the airline is a full service carrier or a low-cost one.

When ATF price rises, how do airlines react?

Airlines typically increase surcharges as and when ATF prices rise. Only Rs 225 of the surcharge is payable to AAI (Airports Authority of India); the balance goes to the airlines. Surcharges are in the form of fuel surcharge (as high as Rs 1,100) plus congestion surcharge (of Rs 150).

Not a viable strategy?

True. While this strategy ensured that airlines were partially compensated for rising ATF prices, the surcharges, which are eventually passed to the end consumer, have peaked to as high as Rs 1,250 for a one-way ticket.

Though full service carriers continue to see increased load factors in a busy travel and business season, low-cost carriers are likely to start bearing the brunt. They know that increase in surcharges beyond a point would make air travel a less preferred option to their target customer segment.

Are airline companies working on containing their costs?

They do. Airlines continue to concentrate on acquisition of fuel-efficient aircraft, and efficient routing.

And they even install blended winglets to reduce the cost of fuel. Yet, rising oil prices have offset any such initiatives.

We have the laws in place, to facilitate hedging?

With the Reserve Bank of India (RBI) relaxing regulations (through its landmark circular ‘Risk Management and Inter-Bank Dealings - Commodity Hedging’ dated May 31, 2007) and permitting Indian airlines to hedge their ATF exposures overseas even for domestic off-takes, the ability to use hedging as a tool to control spiralling ATF costs is further enhanced. Earlier, hedging was permissible for international off-takes only. Domestic off-takes required specific approval, which had not been sought by any airline in India with domestic operations only. Now automatic approval is available for international and domestic off-takes. While airlines procure from domestic refiners, pricing by domestic refiners to end-customers is based on international benchmarks.

Do airlines procure from non-domestic refiners too?

Airlines do not procure from non-domestic refiners as the import-parity and export-parity pricing ensures that domestic refiners are not put at a disadvantage against their international counterparts.

What is the key observation from the data on refiners’ pricing mechanism (table)? Will hedging make a difference to the pricing mechanism?

Nearly 74 per cent of ATF price contribution is directly linked to an international benchmark, while 19 per cent is indirectly linked to it, as the other components are computed as a notional percentage while pricing. This further creates a strong case for airlines to explore international markets for hedging.

And hedging will not change the situation portrayed by the table. Because, it’s the pricing structure of the refiners, not the airlines.

On the benchmarks in the industry.

There are multiple benchmarks for pricing crude and products. Internationally there are two benchmarks adhered to by countries which are into hedging operations. They are Mean of Platts Arab Gulf (MOPAG) and Mean of Platts Singapore (MOPS).

While MOPAG is not an actively traded benchmark, its closest benchmark MOPS is. MOPAG assessment is done by Platts, an international price assessment agency, based on netbacks computed from MOPS.

Netbacks are computed by deducting freight rates for 55,000 MT clean tankers assessed by Platts. Accordingly, a liner correlation can be established between MOPAG and MOPS.

Why?

This is the way international price assessment is done by Platts. The pre-decided parameters are based on shipping attributes and size of tankers for transporting fuel on the given shipping route for a clean tanker. ATF is a product that requires a clean tanker, unlike crude.

You see a clear case for hedging, for Indian airline companies?

Yes. Market liquidity is high for MOPS and active trading for MOPS happens during Singapore market hours that are suitable for hedging operations in India.

To further strengthen the case for hedging in international markets, the historical correlation monthly average price declared by Indian Oil Corporation (IOC) for the four metros and Sing Kero (which is the actively traded benchmark in the paper market) was as high as 0.96 (for data relating to the period January 2006 to August 2007).

Also the statistical correlation between monthly average price declared by IOC for the four metros and WTI Nymex Crude was as high as 0.91.

Means?

When you cannot get a direct hedging instrument, you need to look for a proxy that is tradable and liquid in the paper market. The statistical correlation for the proxy being between 0.8 and 1.25 proves that the proxy is a good hedging instrument. This is as prescribed by the US GAAP (generally accepted accounting principles) and IAS (international accounting standards).

What are the alternatives available for airlines that want to hedge?

Airlines have the option of using OTC (over-the-counter) markets as well as NYMEX (New York Mercantile Exchange) for hedging ATF price risk.

A wide range of instruments including futures, swaps, options and option structures provide airlines the flexibility to hedge their ATF procurement.

Popular hedging structures offered by OTC counterparts vary from plain vanilla forwards, swaps, and options, to zero-cost collars and three-way participation structures.

Any lessons from international experience?

Gleaning the experience of international airlines, one sees that those with robust hedging programmes have the ability to sustain oil price shocks.

For instance, as per the Morgan Stanley Airline Earnings estimates for 2004, increases in oil prices by up to $4/barrel would have little impact on the EPS of Southwest and Jet Blue, which followed an aggressive hedging programme, hedging up to 80 per cent of their consumption. (Recent numbers are not available, as this assessment was made when airlines initiated hedging activities.)

At the same time, airlines such as American, Delta and Northwest that did not have a sustained hedging programme were likely to report a negative EPS by virtue of rising oil prices.

The results of a sustained hedging programme followed by Southwest are still paying-off. As per US SEC (Securities and Exchange Commission) filing for 2006, Southwest paid an average price of $60/barrel of ATF while the average New York Harbour price for the same period was approximately $85/barrel.

In sum, therefore…

Accordingly, a sustained hedging programme for airlines is extremely critical to ensure that capacity growth and general aviation boom is translated into the bottom line. For low-cost carriers, given price elasticity, the need to hedge is even greater as customer inclination towards other modes of transport can erode their customer base and send load factors and market share south.

Are there takeaways for other industries too from the airline experience?

Yes, there are multiple other industries that consume fuel oil and naphtha. However, exposure attributes of each product are different and cannot be generalised with ATF.

Bio: Mr Hemal Shah has over 10 years of professional experience. He leads the firm’s financial risk services (FRS) group, offering financial risk management solutions to banks, corporates and government undertakings. A chartered accountant by qualification, Mr Shah has extensive experience in carrying out assignments in the areas of market risk, treasury profitability, policies and process improvement. He specialises in offering solutions related to commodity price, forex, interest rate, derivatives and investment management.

D. MURALI

http://InterviewsInsights.blogspot.com

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