Our flagship national aviation company is making huge losses and is on the brink of insolvency. And the reason attributed to the mediocre performance. Well, you guessed it right, hedging gone wrong. But the other main reason put forward is the depreciation of the Euro, the currency in which Air Mauritius receives most of its revenue. Given the increasing interaction between countries (globalisation), the uncertain economic environment and the uprising of war-prone nations, a company operating across borders is constantly exposed to risks and faced with intricate complexities to deal with in managing its book of business profitably.
The ideal situation for such a company is to be able to protect itself from any uncertainties affecting its markets and shield its revenues as well as costs. Imagine being able to ascertain future cashflows with a known degree of certainty, determine future costs, plan forthcoming business strategy with more reliable data and discern future profits without being at the total mercy of the whims of the market, exchange rate fluctuations and manipulations by organisations like the OPEC. Being in such a sweet spot is actually possible for an institution… Through nothing else but hedging.
But, what exactly is hedging? Why is it that when we hear this word, the mention of losses is not far behind? Why is it portrayed in such a negative light? And, if it is such a byzantine and dangerous concept, why are we still having recourse to it? Why would an airline company engage in hedging and risk making losses? These are fair questions and let us take a shot at answering them.
Hedging is actually a simpler concept than is portrayed. It is a double-edged sword that if used correctly and in the required scenarios will slash most risks (mainly financial) faced by a company. Hedging essentially means risk mitigation, that is, decreasing the uncertainty of a particular outcome to make it more predictable. It is nothing to be feared; virtually all companies in the world practise it today and there exists widely published literature surrounding its dynamics. It is instrumental to the survival of an airline company in today’s volatile globalised markets. Hedging for an aviation company means that the company knows roughly the price it will pay for its fuel and the exchange rate at which it will receive its revenue.
The correct use of hedging by Air Mauritius, for example, would not only have allowed them to lock in a price for the jet fuel needed but equally enabled them to shield the company’s revenues from the depreciation of the Euro.
Hedging for an airline company can take various forms and is mostly carried out with the use of derivatives (contracts between two or more parties). However, care should be taken to separate the process from speculation. Conversely to speculation, hedging aims at making neither a profit nor a loss. Instead, it exists to materialise, with a certain degree of certainty, the future cashflows of an institution. The mechanics of hedging can best be understood through a real case scenario, in which we look at one type of hedging strategy.
Locking in the price of jet fuel
What does locking in the price of jet fuel mean? It means that irrespective of the movement in the price of jet fuel, the company will pay a known price with which it is comfortable. Say for instance, the price of a barrel of oil available on the market currently stands at $75 and there are fears that the price of oil will shoot up due to increased geopolitical pressures in the Middle East. To protect itself from a dramatic and potentially damaging increase in fuel bills, Air Mauritius will try to lock in the price of its jet fuel at a price close to $75 (the price available will usually be slightly higher than this due to several reasons, like storage costs incurred by the seller, amongst others). This process is known as hedging. The company is effectively protecting itself from an increase in the price of its jet fuel. As mentioned before, there a number of ways in which a hedging strategy can be constructed, but let us consider the most common and widely used one; entering into a contract which entitles the airline company to buy jet fuel (or a very closely correlated substitute to jet fuel) at a specific price (c.$75) at a future date. This means that the company knows the price at which it is going to pay to acquire its required fuel. Now, what if the price of a barrel of jet fuel:
Increased to $100
This essentially means that the company will benefit from its hedging strategy because it can acquire fuel at less than $100, that is, at $75. However, in reality, Air Mauritius does not know which party it entered into a contract with. It did so through an intermediary. Therefore, to save on costs and any red tape, it cancels the contract by doing an opposite transaction. Even if the company knew who it entered the contract with, carrying out an opposite transaction is deemed as the best thing to do. The opposite transaction allows the company to make profits – it is analogous to think of this as if Air Mauritius bought jet fuel at $75 and immediately sold it for $100. Now, although the airline has made a profit from its hedging strategy, it has not bought any jet fuel yet. So, it now goes to the market to buy its required jet fuel. The higher price it has to pay is offset by the gains it made on its hedge. Thereby, effectively paying $75 for a barrel of jet fuel.
Decreased to $40
Instead of the anticipated increase in jet fuel, say the price went down due to unforeseen supply increases by the OPEC to compete against shale gas. The hedging strategy put in place by Air Mauritius means that it has to buy jet fuel at $75 while the market price is considerably lower. Does this mean that the company is making a loss? Not quite. Infact, the company will enter into an opposite contract that is analogous to buying and selling oil at $75 and $40 respectively. Although this leads to a loss on the hedging strategy, the company can now go to the market and buy oil at the cheaper price of $40. The hedging losses will be offset by the actual lower price at which oil can be purchased; effectively meaning that Air Mauritius paid $75 for its jet fuel. As planned.
Sounds too simple? To be honest, hedging is a simple concept to understand. The key aspect to grasp is that a hedge is intended to make neither a profit nor a loss; it allows a company to pay a known price for its future purchases/receive a known amount for its future sales. However, although being a straightforward concept, it does not mean that hedging is without any downside. The main risks are the possibility of the counterparty (the other party in the transaction) defaulting, basis risk (hedging using something other than jet fuel), the wrong number of contracts being bought, to name a few main downsides of hedging. While the downsides of hedging raise eyebrows, these risks seldom materialise in reality. Hedging is not a free lunch but the benefits far outweigh the drawbacks in the case of a company like Air Mauritius.
As mentioned earlier, another reason put forward for the worsening of Air Mauritius’ results is the depreciation of the Euro. What could have been done in such a case? Unsurprisingly, a well-effected hedging strategy would have protected from any fall in revenue due to a depreciation of the Euro. To be more precise, a hedging strategy would have resulted in a known exchange rate in which revenues would have been received.
Although hedging has both its proponents and opponents, it is a practice that is becoming increasingly necessary to allow companies to protect themselves and better plan for the future. There is no escaping the fact that hedging is a necessary evil, especially in the case of an airline company. Portraying hedging for what it is instead of associating it with losses is key to highlighting its benefits.