34 Airline Economics January/February 2012 www.airlineeconomics.co

FUEL HEDGING

It goes without saying that com-mercial airlines are constantly faced with managing their expo-sure to volatile fuel prices. A variety of instruments – futures,

swaps, options and other derivatives – can help reduce the impact that volatile fuel prices have on your company’s revenue, cashflow and earnings. However, before you develop a fuel-hedging plan, you need to create an official fuel risk management policy. This process will help you examine your risk tolerance and goals as well as the financial and accounting implications of a fuel risk management programme.

A fuel risk management policy should be a streamlined document that is easy to read and provides practical guidance to your management team. Fuel risk man-agement policies are generally tailored to the specific needs of the company,

although all policies should provide a framework for corporate decision-mak-ing, while giving specific guidance for implementing your fuel risk manage-ment programme. Upon completion, your company’s board of directors should approve the policy. It is vital to remember that your fuel risk manage-ment policy is a living document, and should be reviewed on a semi-annual basis to ensure it meets current corpo-rate objectives.

Most fuel risk management policies include these four common components:

1. ObjectivesObjectives should be clear, concise and relevant. They should include the finan-cial goals, risks to be hedged (that is, price and basis), your company’s tolerance for risk, and the minimum and maximum

amounts to be hedged. Certain questions should be addressed, such as whether to hedge cashflow or earnings.

2. ResponsibilitiesThis section should specify which individual(s) in your organisation have authorisation to enter into hedging trans-actions on behalf of your company. You also should identify:I) the members of the your fuel risk man-

agement committee, and when and/or how often they will meet to discuss your fuel hedging programme;

II) who reviews your hedge positions and when; and

III) what levels of management approval are needed before entering into vari-ous fuel hedging transactions (that is, short-term hedges versus long-term hedges).

How to manage your hedges

Mike Corley at Mercatus Energy Advisors sets out the keys to a successful jet fuel price risk management programme and provides a written example of an effective fuel hedging policy

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www.airlineeconomics.co Airline Economics January/February 2012 35

FUEL HEDGING

agement programme is to minimise, to the extent possible, the impact that the fluctuation in jet fuel prices has on Green Airlines’ cashflows and earnings, with-out exposing Green Airlines to any risks associated with transactions that could be regarded as speculative trades.

Fuel price risk management includes the identification of jet fuel price expo-sures, risk measurement and the actions employed to mitigate such risks. Fuel

use basis swaps or crack spreads to hedge your exposure to basis risk? It should also address what commodities can be used, such as jet fuel, gasoil, heating oil or crude oil. All of these parameters must be defined and explicitly approved. Specify whether you will employ a passive approach to fuel hedging or whether your authorised individual(s) may employ a more active approach to fuel hedging.

Example:Fuel risk management policy for Green Airlines (a fictitious airline)I. Statement of PurposeThe purpose of this policy is to establish parameters for Green Airlines’ fuel price risk management programme. Green Airlines is exposed to jet fuel price fluctu-ations in the normal course of its business. The objective of the fuel price risk man-

3. ControlThis is an operational issue that typically should define operational aspects such as reporting responsibilities, mark-to-market results, when and who should inform management of your compa-ny’s fuel risk management activities, how transactions are confirmed and by whom, and whether your company is within credit limits with counterparties. You might also include documentation requirements for accounting purposes, for example, IAS 39.

4. StrategiesThis section typically includes the types of instruments your company can use to hedge your jet fuel price risk. Can you only use options? Can you purchase fixed price swaps? Can you use a combination of options to reduce premiums? Can you

How to manage your hedges

“This process will help you examine your risk tolerance and goals as well as the financial and accounting implications of a fuel risk management programme”

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36 Airline Economics January/February 2012 www.airlineeconomics.co

FUEL HEDGING

price risk management also entails using fuel hedging instruments to protect against cashflow volatility as well as the volatility of earnings.

II. ScopeThis policy applies to Green Airlines and its subsidiaries (hereinafter referred to as ‘the Company’).

III. Policy Guidelines1. The Company uses derivatives instru-

ments, primarily swaps, call options and call option spreads, to hedge jet fuel price risks. Other hedging instruments such as costless collars, three-way collars, four-way collars and participating swaps will be used with prior approval from the board of directors. The maturity of the derivatives instruments used by the company should be no longer than 18 months.

2. The Company will hedge its known exposures to jet fuel prices if it is deter-mined that changes in jet fuel prices might have a material impact on cash-flows.

3. The Company does not use deriva-tives instruments for speculative trading purposes.

4. The Company applies hedge account-ing based upon the criteria established by IAS 39.

5. The Company estimates the fair value of derivatives based on quoted market prices and records all derivatives on the balance sheet at fair value.

6. For derivatives instruments that are designated as fair value hedge, the Company recognises its gains and losses, as well as the offsetting gains or losses of the hedged items, in earn-ings in the current period.

7. The Company will hedge exposures to the variability in jet fuel prices as it relates to anticipated cashflows. These exposures arise from fore-casted jet fuel consumption. For derivatives instruments that are designated as cashflow hedges, the after-tax gain or loss from the effec-tive portion of the instrument is reported as a component of ‘Accumu-lated other comprehensive income (loss)’ in stockholders’ equity, and is reclassified into earnings in the same period or periods in which the hedged

8. Provide all contracts-related infor-mation to the accounting and legal departments within five days of the last business day of the month.

The CFO, treasurer and assistant trea-surer shall individually have the authority to enter into fuel price risk management transactions in the Company’s name and on its behalf based on the guidelines set out in this policy. The corporate treasurer will authorise any other individuals to be able to enter into fuel price risk man-agement transactions in the Company’s name. Any exceptions to this policy must be approved, in writing, by the FPRMC. The CFO shall issue a signed mandate to all the Company’s counterparties stat-ing that the CFO, treasurer and assistant treasurer have the authority to transact on behalf of the Company.

V. Responsibility of the Board of DirectorsThe board of directors has the following responsibilities with respect to the man-agement of the Company’s fuel price risk management programme:1. Review and approval of the Com-

pany’s fuel price risk management policy.

2. On a quarterly basis, review the fuel price risk management report to determine whether the fuel price risk management activities are adher-ing to the established fuel price risk management policy, and whether the performance of the hedging strategies are reasonable given the objectives of the Company and the current environment.

VI. Responsibility of the CFOThe CFO has the following responsibili-ties with respect to the management of the Company’s fuel price risk manage-ment programme:1. Review and approval of the Com-

pany’s fuel price risk management policy.

item is recognised in earnings.8. The Company will establish proce-

dures for measuring and predicting the Company’s entire jet fuel price risk exposure on a periodic basis. The results will be reported to man-agement so they are aware of the potential exposure and can choose to take steps to limit these exposures.

9. The fuel price risk management pol-icy will be generally implemented, reviewed and monitored by the Fuel Price Risk Management Committee (FPRMC), which shall consist of the chief executive, chief financial officer (CFO) and treasurer.

10. The Company will only enter into derivatives contracts with financial intuitions that have a Standard & Poor’s issuer credit grade of BBB or better.

IV. Treasurer Responsibility and AuthorityThe treasurer will be responsible for the execution of fuel price risk management transactions for the Company.

This policy recognises that the treasury department is not a profit centre and any activities that might be perceived as specu-lative trading is in violation of this policy.

The treasurer will:1. Execute transactions in accordance

with this fuel price risk management policy.

2. Monitor results of all hedging activi-ties.

3. Report results of all hedging activities to the FPRMC at least monthly, based on gain/loss thresholds.

4. Provide mark-to-market (MTM) information to the FPRMC and the accounting department on a monthly basis, within five days of the last busi-ness day of the month.

5. Provide information on realised gains and losses to the FPRMC and the accounting department within five days of the business month-end.

6. Perform a MTM report of outstand-ing fuel derivatives on a weekly basis. If any MTM report shows a change in unrealised losses of greater than $500,000, this report will be sent to the FPRMC within 24 hours of the MTM report being generated.

7. Send all trade confirmations directly to the assistant treasurer for entry into the risk management system.

“Fuel hedging without the required expertise can quickly turn into a nightmare of epic proportions, as evidenced by the failed hedging initiatives of numerous airlines”

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2. Approval of all relationships with counterparties established by the treasurer for the purpose of con-ducting fuel price risk management transactions.

3. Review of all fuel price risk manage-ment contracts and monthly reports for compliance and performance.

4. Approval in advance of all fuel price risk management transactions that are not consistent with the guidelines prescribed in this policy. The CFO must notify the board of directors of such transactions.

5. The CFO will implement control sys-tems and procedures that provide for an appropriate level of segregation of duties related to conducting and accounting for fuel price risk man-agement activities.

VII. Responsibility of the TreasurerThe treasurer manager has the following responsibilities with respect to the man-agement of the Company’s fuel price risk management programme:1. Conduct fuel price risk management

activities that have been authorised and approved by the Company. This includes buying and selling swaps, call options and call option spreads on jet fuel, heating oil, gasoil and crude oil.

2. Conduct monthly reviews of fuel price risk management positions and enter into new contracts as necessary.

3. Preparation of the reports specified in this policy for management review.

VIII. ReportingThe treasurer will prepare, and the CFO will review, a monthly fuel price risk management report on exposures that contains the following information:1. The net fuel price exposure of the

Company by region and recom-mendations of appropriate hedging actions.

2. Specifics of all fuel price risk manage-ment transactions (purchases and sales) made during the month.

3. Summary of the current open fuel price risk management positions and explanation of the strategies employed for all positions.

4. Results of positions that have been closed or expired during the month.

5. Reasons for and amounts of viola-

tions of or exceptions to the fuel risk management policy.

6. Status of any fuel price risk manage-ment positions that might require management attention.

7. The fuel price risk management report will contain information for all transactions occurring during the month whether or not they have been fully settled as of the end of the month.

8. The fuel price risk management report shall contain a management summary that will describe the status of the positions and significant trans-actions made during the previous month. The management summary should be presented in a manner that will allow the FPRMC and the board of directors to determine whether fuel price risk management activities during the month have adhered to the Company’s fuel price risk manage-ment policy.

9. The treasurer will prepare and the chief financial officer will review a monthly report that measures eco-nomic and volumetric exposure to fuel price risk.

10. The monthly fuel price risk manage-ment report will be distributed to the FPRMC every month. The report will be sent to the board of directors for review on a quarterly basis.

VII. Review of Fuel Price Risk Manage-ment Programme1. Policy Exceptions: This fuel price

risk management policy provides guidelines for fuel price risk manage-ment. In some circumstances, fuel price risk management transactions that are appropriate for the Company and entirely within the spirit of this policy as described in the ‘Objectives’ section might not fall within the prescribed quantitative guidelines contained in this policy. When the treasurer determines that a fuel price risk management transaction is in the best interest of the Company and is consistent with the objectives of this policy, the transaction is permitted even though it is not consistent with the quantitative guidelines, subject to the following controls:a. Whenever a transaction is

made that is an exception to

the quantitative guidelines, the CFO must approve the transaction in writing prior to execution.

b. The transaction must be reported to the chief execu-tive and the board of directors within 24 hours.

2. This policy will be reviewed semi-annually, at a minimum, to ensure it remains consistent with the over-all objectives of the Company. The policy may be reviewed and updated more frequently if conditions dic-tate. Proposed amendments to the policy should be prepared by the treasurer, and should be reviewed and ratified by the FPRMC and the board of directors.

Clearly, a sound fuel risk manage-ment programme requires a significant amount of time as well as expertise. If your company does not have the in-house resources to properly carry out all the above-mentioned functions, it is highly recommended that you engage experts who do have the necessary expertise, as fuel hedging without the required expertise can quickly turn into a nightmare of epic proportions, as evi-denced by the failed hedging initiatives of numerous airlines.

FUEL HEDGING

www.airlineeconomics.co Airline Economics January/February 2012 37

Mike Corley is the founder and president of Mercatus Energy Advisors, an energy hedging and risk management advisory firm. He can be reached via telephone at +1.713.970.1003 or the firm’s website at www.mercatusenergy.com.

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