A close look at the role of fuel hedging in Kenya Airways’ Sh26bn lossThursday November 05 2015
A new era of alternative investments is dawning in Kenya as the capital market prepares for the exciting world of derivatives.
Derivatives are financial instruments which solely derive their value from an underlying interest.
They are used to manage risks, enhance returns and sometimes facilitate market entry and exit. The most popular derivatives are in commodities, currencies, stocks, bonds and interest rates.
As our capital market develops and more Kenyan companies become exposed to global financial market risks, derivatives will increasingly be used to manage risks.
The terms futures, forwards, options and swaps will become household names in our capital market, boardrooms and financial reporting.
The rise in jet fuel cost over several years has been putting pressure on Kenya Airways to maintain profitability and positive cash flows.
Most airlines have traditionally embraced hedging as the ultimate protection against fuel price volatility.
After all, fuel price is the highest cost of operating an airline. Hedging against rising fuel prices seemed smart until the trend reversed mid last year.
Hedges turned sour when prices started going south in mid 2014 as a result of increased oil supply from the US and decreased demand as the Chinese economy contracted. No one foresaw the rapid fall in oil prices.
Even hedge fund managers who are very good in predicting probable price movements using sophisticated quantitative models missed it.
As such, we should not solely blame KQ management and the board for bets that turned sour.
Their predictions were as good as those made by seasoned derivatives experts. After all, Kenyans are used to perpetually rising pump prices even when global oil prices are falling.
We have to appreciate that KQ is one of a few Kenyan companies which are significantly exposed to global financial risks, which are beyond their control.
The airline, compared to any other local company, has the biggest global footprint. As such, the company is exposed to not only fuel price fluctuations but also foreign currency and interest rate risks.
No wonder Safaricom, another Kenyan corporate giant, does not have any derivatives designed as hedging instruments. When Kenya Airways released its 2014 results, the huge loss of Sh26 billion shook the entire East African financial markets to the core.
READ: Kenya Airways reports record Sh26bn net loss
The loss was partly due to hedge derivatives, which accounted Sh7.5 billion. How did this happen and how could it have been avoided?
Kenya Airways’ use of oil hedge derivatives to protect it against sudden increases in prices is not new. The only probable change seems to have been a switch from oil future hedges to other hedge options.
It’s worth noting that the airline has in the past made massive profits from hedges. It did not make any losses related to oil hedges between 2012 and 2014.
The management got it right, their hedges worked effectively. The hedges returned a cumulative gain on fuel derivatives of Sh4.07 billion, with Sh2.5 billion realised in 2012 alone.
Prior to 2013, KQ seemed to have used hedging oil prices future contracts, a type of forward where two parties commit to do a transaction at a fixed price at a future date.
As in all markets where commodity derivatives are available, there is a choice of either using exchange traded derivatives which are contract specific but very liquid, or over the counter (OTC) derivatives which can be tailored to the client’s requirements.
Leading firms which trade in energy derivatives include Chicago Mercantile Exchange (CME), Intercontinental Exchange (ICE), and Dubai Mercantile Exchange (DBE).
Soon, Nairobi Securities Exchange will join this league once the Single Stocks Futures starts trading. It would be fair to assume that KQ had entered into energy future contracts instead of forwards since the majority of commodity trading has developed on exchange rather than OTC.
If future hedges go against the bet, a company’s liquidity is affected negatively due to intra-day profit or losses crystallising on a daily basis.
Future prices fluctuate from day to day and the contract buyers and sellers attempt to profit from these price changes.
This marking to market process means that if the long position loses money against daily settlement prices, losses must be paid following the close of the trade and vice versa.
These daily payments of variations margins can partly lead to liquidity issues if the bet goes against the buyer. In the case of KQ, the hedges worked in its favour in 2012 resulting in gains of Sh2.5 billion.
In 2014, KQ seems to have changed its tactics and started using options instead of oil futures.
It employed fuel options to supposedly hedge rising jet oil risk effectively .Unlike a futures contract, an option is the only derivative instrument which allows the buyer to walk away from their obligations.
In an option contract, the buyer is given a right but not an obligation to purchase or sell something at a later date at a price agreed upon today. This is how the option may have resulted in the loss.
In an option, if an airline’s management forecast rising fuel prices they will buy a call option. They will pay an upfront premium.
If their prediction comes true and the price increases, the airline exercises the option and buys the jet fuel at the lower price which was agreed upon at the inception of the contract.
This call option is said to be in the money since the airline will be buying fuel below the current market price.
If it were a vanilla call option and it turned out that the strike price is higher than the current fuel price, the airline lets the option expire and buys fuel at the prevailing market price.
This call will be said to be out of the money. The only cost that the airline will incur is what it paid at the inception of the call option.
Vanilla is the simplest form of derivative. It’s derived from ice cream; the vanilla type being the simplest and easiest to obtain. In some cases, jet fuel future contracts are not available to hedge against a rise in price.
Other underlying commodities like crude oil can be used to hedge jet fuel in such situations. That is why KQ has been using the Brent Crude Oil call and put options. KQ has scored big time for choosing the four ways zero collar options.
Unlike the vanilla call or put option where the buyer pays premium upfront, the four ways zero collar is an exotic option requiring minimal or sometime no upfront premiums cost.
This strategy is normally used in bullish conditions. KQ must have owned the underlying security which in this case is jet fuel or crude oil. Exotic is the opposite of vanilla.
Buying jet fuel derivatives was not the only choice the airline had to hedge rising oil prices.
In most cases, there can be no assurance that derivatives will provide adequate protection against unpredictable changes in jet fuel cost. If hedges are not working, the management can opt to do nothing and keep buying jet fuel based on the current market price.
This would have been the case with KQ had the risk management committee predicted that oil prices would fall.
KQ management didn’t want to take that route since going by history, their options were in the money in previous years.
As such, doing nothing to manage risks was out of question. After all, they had made money from hedging the previous year. This time round the management lost and bets went the wrong way.
As a former British Airways CEO said, you can run from high fuel prices briefly through hedging but you can’t run very long.
In this era of falling oil prices doing away with hedges may seem like the best route to take. In the US, American Airlines did away with oil hedges.
The no hedge policy has enabled the company to report decent profits while competitors like South Western and Delta are feeling the heat of oil derivatives gone sour.
Hedging is like insurance, if the cost of having a policy outweighs benefits the prudent thing to do is not to take one.
Now that low oil prices will persist for an unforeseeable future, breaking the hedge contracts may be cheaper for KQ in the long run instead of piling up losses.
One of the ways of getting out of the contracts is through novation. In novation the airline transfers all its obligations and rights under either the call or put option to a third party.
Derivatives markets are active and there is always a party willing to buy out contracts and bet in the opposite direction.
As a result of the hedges, the airline is currently buying fuel at $80 per barrel. This is $35 more than the prevailing market price.
The management should look at the cost of innovating from these hedges. The airline should discontinue the current hedges if the cost involved in revoking them is lower than the cost of buying jet fuel at the current inflated hedge prices.
The savings could be huge, given that the airline has fuel hedge contracts for 40 per cent of the anticipated usage.
Mr Kiragu is an accounting and finance professor at Mount Saint Vincent University, Canada.