Case Jet Blue Fuel hedging PDF

Preview

Summary

Fuel hedging case of jetblue airlines, summery...

Description

UV6682 Rev. Mar. 1, 2016

2012 Fuel Hedging at JetBlue Airways

In January 2012, Helena Morales was updating her JetBlue Airways (JetBlue) research report. Morales, an equity analyst, followed major U.S. airline carriers. JetBlue was a low-cost airline that had distinguished itself by offering in-flight entertainment and other amenities. JetBlue had started its operations in 2000 and experienced a remarkable growth rate, leading the company to go public in 2002 (NASDAQ: JBLU). In 2005, JetBlue’s profits suffered a first hit due to rising jet fuel costs. Keeping an eye on jet fuel oil prices was essential for an airlines analyst. Although airlines had applied fuel surcharges to the price of tickets in the past, these surcharges were viable only when matched by competitors. Given the limited pass-through to customers, fuel hedging protected the airline’s cost structure from spikes in jet fuel prices and allowed airlines to follow their business plans. JetBlue entered into a variety of hedging instruments including swaps, call options, and collar contracts with underlyings of jet fuel, crude, and heating oil. Some of these derivatives could cost millions of dollars, however, and there was the risk that the airline would suffer negative effects from a sharp decline in fuel prices. Jet fuel prices passed the $3-per-gallon mark in 2011, the highest since 2008 (Exhibit 1 shows spot jet fuel prices at a major trading hub: the U.S. Gulf Coast [USGC]). These levels were the result of a dramatic year in the oil market due to the Arab Spring, civil war in Libya, and demand growth from China. In its annual report, JetBlue reported that fuel costs were its largest operating expense, approaching nearly 40% of total operating costs in 2011. Table 1 shows fuel consumption and costs for the previous three years: Table 1. Fuel consumption and costs for 2009–2011. Gallons consumed (millions) Total cost ($ millions) Average price per gallon Percentage of operating expenses

2009 455 $945 $2.08 31.4%

2010 486 $1,115 $2.29 32.4%

2011 525 $1,664 $3.17 39.8%

Source: JetBlue annual report, 2011.

Fuel costs had increased as a percentage of JetBlue’s operating expenses in the previous years (Exhibit 2—Panel A). One reason for the increase was the airline’s expansion and the corresponding increased fuel consumption (Exhibit 2—Panel B), but the main reason was the rise in the average price per gallon of jet fuel.1 1

Total cost and average price per gallon in Table 1 include effective fuel hedging gains and losses.

This case was written by Associate Professor Pedro Matos. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright ¤ 2013 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

This document is authorized for use only in Enrique SCHROTH's NI06-M2_CFB-5656-CORPORATE AND TREASURY RISK MANAGEMENT at EDHEC - Business School from Sep 2021 t Mar 2022.

Page 2

UV6682

Morales took a detailed look at JetBlue’s Investor Update report released on October 26, 2011. The company described hedging 45% of its fourth quarter 2011 consumption (Exhibit 3). She also looked at a Bloomberg report that kept track of jet fuel hedging positions of other U.S., European, and Asian airlines (Exhibit 4). With the exception of US Airways, all major U.S. airlines had hedged about half of their fuel needs for the last quarter of the year; however, the situation was quite different for European and Asian airlines. Southwest Airlines had been a pioneer in fuel hedging and had benefited from lower than average fuel costs (Exhibit 4). From 2000 to 2010, it saved an estimated $3.5 billion in fuel costs due to hedging.2 Many of these airlines relied on West Texas Intermediate (WTI) crude oil hedges. JetBlue had used crude oil derivatives contracts for more than half of its 2011 hedging (Exhibit 3). But there were concerns that airlines would suffer losses because of WTI’s hedge ineffectiveness, which had been caused by a major development in the oil market: WTI, the main U.S. oil price benchmark, had become less well correlated with the global crude oil market (Exhibits 5 and 6). In 2011, WTI started trading at a discount to the leading global price European benchmark Brent crude (Brent) due to an oil glut in Cushing, Oklahoma—the physical delivery hub for the WTI oil futures contracts for the Chicago Mercantile Exchange Group (CME Group). Cushing was known as the “pipeline crossroads of the world,” but it was facing a bottleneck. Brent’s premium to WTI reached a record level of almost $30 per barrel in September 2011. Jet fuel prices had tracked the price of Brent, instead of WTI, for much of 2011 (Exhibits 5 and 6). The WTI dislocation affected jet fuel hedging strategies because of basis risk (i.e., that the jet fuel price would not change perfectly in tandem with the value of the WTI derivative instrument used to hedge it). Could the Brent-WTI premium be a temporary phenomenon? The oil glut in Cushing was due to record crude oil production from the Bakken shale formation and Canadian oil sands. But in November, there were signs that transportation constraints were easing after news of the coming reversal of the Seaway Pipeline, and the price of the Brent-WTI premium fell almost $20 per barrel; however, the spread ended the year close to $10 per barrel, still high by historical standards. Morales knew she had to cover JetBlue’s jet fuel hedging strategy for 2012. Would JetBlue continue using WTI for its hedges, or would it switch to Brent or heating oil?

Figure 1. Typical mix of usable refined products.

Basics of Jet Fuel Data source: U.S. Energy Information Administration, “Oil: Aircrafts were powered by kerosene-type jet Crude and Petroleum Products Explained,” fuel, which was distilled from crude oil. The http://www.eia.gov/energyexplained/index.cfm?page=oil petroleum first extracted from the ground was _home. crude oil that was transported by pipeline or ship to be refined closer to consumers. Refineries used a process of distillation to separate crude oil into usable refined products. The typical mix is shown in Figure 1. A 42-gallon barrel (bbl.) of U.S. crude oil provided 2

Susan Carey, “Price Rises for Fuel Threaten Airline Net,” Wall Street Journal, January 13, 2011.

This document is authorized for use only in Enrique SCHROTH's NI06-M2_CFB-5656-CORPORATE AND TREASURY RISK MANAGEMENT at EDHEC - Business School from Sep 2021 t Mar 2022.

Page 3

UV6682

about 45 gallons of petroleum products, approximately 10% of which was jet fuel. In the spectrum, jet fuel was categorized as a middle distillate between light distillates (e.g., gasoline) and heavy distillates and residuum (e.g., asphalt). As of 2011, there were no exchange-traded futures contracts directly on jet fuel, and trading was concentrated in crude oil benchmarks (Exhibit 7). The first one was WTI oil produced in the United States and traded in the CME Group.3 WTI futures were the world’s largest-volume futures contract on a commodity, and the contracts were physically settled. The second major benchmark was Brent, produced in the North Sea and the underlying for futures traded electronically in the Intercontinental Exchange (ICE).4 Brent contracts were financially settled. Despite the small output compared to other grades such as Arab Light, Urals, or Iranian Heavy, trading was concentrated in WTI and Brent because their pricing was transparent. Exhibit 7 shows the exchange-traded futures contracts on other middle distillates such as heating oil futures and light distillates such as gasoline, but these contracts had much lower trading volumes. The process of distillation linked the prices of refined petroleum such as jet fuel to crude oil, as shown in the high correlation in Exhibit 5. The refining margin or “crack spread” was defined as the difference between the price of refined petroleum such as jet fuel less the price of crude oil. See Panel B of Exhibit 5. At the end of December 2011, oil refiners were getting more than $23 a barrel (or $0.5 a gallon) in profit for refining crude oil into jet fuel. From 2007 to 2011, the crack spread had oscillated from $3.9 to a maximum of $41.9 per barrel (from $0.09 to $1 per gallon). This variation constituted basis risk for any jet fuel hedging strategy based on crude oil derivatives. The term “basis risk” was used to describe the risk that the value of the commodity being hedged may not change perfectly in tandem with the value of the derivative instrument used to hedge the price risk. In this case, basis risk occurred because there was a mismatch in the quality of the underlying products because jet fuel and crude oil were different commodities.5 The Divergence between WTI and Brent Oil Prices

Brent was a low-sulfur (sweet) crude oil used to price two-thirds of the world’s internationally traded crude oil supplies, according to ICE. In contrast to Brent’s waterborne cargo market where crude oil arrived in discrete quantities, WTI was a midcontinent pipeline market where crude oil flowed continuously at nearconstant rates. Exhibit 8 shows the location of Cushing—the physical settlement point for WTI oil futures— and the Brent oilfield. As of 2011, Cushing was landlocked, and oil only flowed north to refineries in Chicago, not south to the USGC. Brent was a more flexible waterborne market, but oil production from the North Sea was expected to shrink. In 2011, Brent traded well above WTI (Exhibit 5). The widening of the Brent price premium to WTI was unusual. In the past, Brent was more likely to trade at a slight discount of $1 to $2 to WTI, due to WTI’s relatively higher quality. The rising crude production from the Bakken shale formation and Canadian oil sands that had created the oil glut in Cushing turned the typical discount of Brent over WTI into a premium, and the Brent-WTI spread reached a record of $29.70 per barrel on September 22, 2011.

3 The contract traded in units of 1,000 barrels (1,000 oil barrels = 42,000 U.S. gallons), and the delivery point was Cushing. See contract specifications at the CME Group’s website, http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html. 4 One contract equaled 1,000 oil barrels, and delivery was cash settled. See contract specifications at the Intercontinental Exchange’s website, https://www.theice.com/productguide/ProductDetails.shtml?specId=219. 5 Other types of basis risk are due to mismatch in time of the hedge and locational mismatch in delivery point between the derivatives contract and the product being hedged.

This document is authorized for use only in Enrique SCHROTH's NI06-M2_CFB-5656-CORPORATE AND TREASURY RISK MANAGEMENT at EDHEC - Business School from Sep 2021 t Mar 2022.

Page 4

UV6682

In October and November, there were signs that transportation constraints were beginning to ease, and the Brent price premium to WTI narrowed. On November 16, ConocoPhillips agreed to sell its 50% share of the Seaway crude oil pipeline to Enbridge Inc. The new ownership announced that it intended to reverse oil flows to run north to south starting as early as the second quarter of 2012 to partially alleviate the oil glut by allowing crude oil to move from the Cushing hub to refineries located on the USGC. Following the announcement of the reversal, the difference between the spot price of Brent crude oil and WTI fell to under $10 per barrel in December 2011. Yet in a report at that time, the U.S. Energy Information Administration (EIA) had cast doubt on whether the situation could be resolved: The reversal of the Seaway pipeline will not eliminate bottlenecks moving WTI’s crude oil to downstream markets. With crude oil production increases from Canada and the Bakken and other shale formations in the coming years expected to continue, the market will still be dependent on rail as the marginal mode of transportation, meaning some discount will be required to account for the costs of moving inland U.S. crudes to the Gulf Coast.6 Hedging Jet Fuel Price Risk at JetBlue

Fuel represented about 40% of JetBlue’s costs; thus the airline viewed its fuel hedging as an insurance policy. Airlines found it hard to apply fuel surcharges to the price of tickets if these were not matched by competitors.7 Given the limited pass-through to customers, fuel hedging protected the airline’s cost structure. But purchasing the derivatives could be costly, and there was the risk that the airline would suffer negative effects as a result of a sharp decline in fuel prices. In addition, there was the issue of basis risk between jet fuel and the hedging instruments based on crude oil prices because the crack spread fluctuated and added to airline costs. JetBlue’s fuel hedging book combined swaps and options. The company disclosed details of advanced fuel derivative contracts for each quarter in 2011 (Exhibit 9). Airlines preferred these over-the-counter derivatives to exchange-traded futures because they were customizable. The hedge positions were mostly negotiated with banks, which would normally offset their positions with contracts with other market participants (e.g., oil producers) or directly using CME Group or ICE exchange-traded futures and options. WTI calls were the right to buy a particular WTI asset or a fixed strike price at a time until a maturity date. There were some WTI exchange-traded options at the CME Group (previously called the NYMEX), but it was likely that JetBlue was using over-the-counter options where the settlement price was based on the average price over a given period (instead of the exact spot price at expiration). Buying the call option would protect the airline against a rise in the price of WTI crude oil. Of course, this would be a cross-market hedge involving some basis risk, as its natural position was in jet fuel, but it would work so long as WTI and jet fuel price changes stayed highly correlated. JetBlue would have to pay an option premium for these contracts, which were a form of insurance policy. For example, on October 26, 2011, the company had reported that it had hedged the equivalent of 7% of its 2011Q4 jet fuel consumption at a price of $92 per barrel (Exhibit 9). As the WTI spot price had increased and closed at $98.83 per gallon (Exhibit 6) at the end of December 6 U.S. Energy Information Administration, “Spread between WTI and Brent Prices Narrows on Signs of Easing Trans portation Constraints,” Today in Energy, December 5, 2011, http://www.eia.gov/todayinenergy/detail.cfm?id=4170 (accessed May 14, 2013). 7 Freight carriers UPS and FedEx did not hedge fuel. Almost a duopoly, they passed through fuel increases using fuel surcharges. For example, FedEx developed an indexed fuel surcharge policy based on the average spot price for jet fuel, which it published on its website.

This document is authorized for use only in Enrique SCHROTH's NI06-M2_CFB-5656-CORPORATE AND TREASURY RISK MANAGEMENT at EDHEC - Business School from Sep 2021 t Mar 2022.

Page 5

UV6682

2011, JetBlue had a gain on this hedge, which would keep JetBlue’s cost at $92 per barrel (not accounting for the premium). A WTI (or heating oil) collar was the combination of a put and call option whose underlying asset was the WTI crude oil (or heating oil) spot price. It involved the purchase of call options where a premium was paid up front, but if prices increased, JetBlue would be protected. If prices decreased, then it lost the premium cost. The cost of these call options was offset with the sale of put options. Using the collar strategy, JetBlue would create a hedged position whereby it would have a minimum (floor) and maximum (cap) price on the underlying commodity. For example, on October 26, 2011, the company had reported that it had hedged the equivalent of 9% of its 2011Q4 jet fuel consumption at a price with a cap at $100 per barrel and a floor at $81 per barrel (Exhibit 9). The WTI spot price had increased and closed at $98.83 per gallon (Exhibit 6) at the end of December 2011, so it had not gained or lost from this hedge. This did not account for the collar net premium. The relative cost of put and call options depended on strike prices and volatility levels. A “zero-cost collar” could be structured so that the premium from selling the put option could offset the premium for the call option. USGC jet fuel swaps were agreements to exchange the floating price of spot USGC jet fuel for a fixed price over a certain period of time. The differences between fixed and floating prices were typically cash settled. A swap can be thought of as a package of forward purchase agreements. JetBlue would be typically the fixed-price payer, thus allowing it to hedge the fuel price risk. For example, on October 26, 2011, the company had reported that it had hedged 12% of its 2011Q4 jet fuel consumption at a fixed price of $3.00 per gallon (Exhibit 9). The spot price of USGC jet fuel had fallen to $2.917 per gallon (Exhibit 6) by December 2011, so it had suffered a loss on this hedge. JetBlue’s fuel hedging strategy had evolved over the years (Exhibit 3). The company’s approach to fuel hedging was to enter into hedges on a discretionary basis without specific targets. It hedged less in 2009 when oil prices were low and increased the percentage hedged again in 2010 and 2011. Dynamic strategies were based on the idea that oil prices followed a mean-reverting process. Ideally, airlines wanted to lock in prices at the low point in the cycle while capping prices at the high end but take advantage of eventual price declines. It was not clear whether the airline stood to gain from adjusting its strategy. Additionally, JetBlue had switched between derivatives written on different oil products. It had moved its hedging from heating oil between 2007 to 2009 to crude oil derivatives in 2010 and 2011, but it recently reverted to heating oil derivatives and directly to jet fuel swaps. For derivative positions to be treated as cash flow hedges for accounting purposes, it was important that the hedges were effective. Testing for hedge effectiveness was ruled by the Statement of Financial Accounting Standards. In its annual report, JetBlue stated its procedures in this respect (Exhibit 10). Morales wondered whether hedge ineffectiveness of WTI derivatives contracts might become an issue for JetBlue’s 2012 fuel hedges and, if so, whether that would be another reason for JetBlue to consider switching to Brent or heating oil derivatives. The Way Forward

Most U.S. airlines used WTI as the basis for their fuel hedges; however, for most of 2011, jet fuel prices had been tracking Brent more closely than WTI, and the increase in the jet-fuel-to-WTI refining margin was disrupting hedging programs. Several airlines reported large markdowns for fuel hedge ineffectiveness in the

This document is authorized for use only in Enrique SCHROTH's NI06-M2_CFB-5656-CORPORATE AND TREASURY RISK MANAGEMENT at EDHEC - Business School from Sep 2021 t Mar 2022.

Page 6

UV6682

third quarter of 2011. United Continental reported a $56 million markdown. “During the quarter, WTI crude oil prices decreased while jet fuel prices remained high,” United Continental declared in a statement accompanying its quarterly results.8 In 2011, after many years of hedging gains, Southwest took a $227 million noncash markdown related to the hedge ineffectiveness of its hedge portfolio in large part due to the Brent-WTI divergence. The company was more optimistic for 2012. “To the extent we see WTI and Brent coming together, I think that the hedges we have i...