May 1, 2003
Consultant relates how market speculation can help airlines better manage costs

The volatility in the oil industry in recent months demonstrates how susceptible air carriers can be to large price swings with jet fuel. Some airlines use hedging — buying future supply at today’s prices — as a way to smooth out volatility in the market. AIRPORT BUSINESS recently recently interviewed Raj Mahajan, president of KIODEX. Here is an edited transcript.

KIODEX, based in New York, provides a web services platform for CFOs, purchasing managers, chief risk officers, and others to help them determine percentages of supply to hedge; instruments to use; and how far out they should hedge. It can run simulations of oil prices and test various programs.

AIRPORT BUSINESS: Earlier this year, oil prices per barrel were reaching record levels; lately they’ve been dropping. What is it that hedging brings to an airline when looking at the volatile jet fuel market?

Mahajan: The fundamental issue that airlines are facing is profitability. Right now, a lot of these airlines are bleeding cash. Now, what are some of the drivers on the expense side of an airline’s income statement? The number one expense is labor; yet it’s really rather fixed. The second expense is jet fuel, and jet fuel can be 15 percent of revenues. So if I run a billion dollar airline, I will spend $150 million on jet fuel. However, that jet fuel could cost anywhere from $100 million to $300 million — oil prices can fluctuate that wildly.

When it cost $150 million, that might have been when jet fuel prices were at 60 or 70 cents [a gallon]; but if jet fuel prices go to a dollar, then it can cost $300 million. When talking about those kinds of swings, and you see airlines that are not profitable and they’ve lost $100 million or $200 million in a year, what if you didn’t have as much volatility in the jet fuel price? Would they be profitable?

So, a fundamental driver for an airline’s profitability is jet fuel.

You’ve got a situation where the performance of an airline has degenerated down to whether or not oil prices are 30 bucks or 20 bucks [a barrel]. That’s a problem, because what they tell investors is, what we do really well is we buy the right planes; we get them from A to B in the most cost-effective manner; we hire the right pilots. But a primary risk to the business is jet fuel prices, something they know almost nothing about.

There are a lot of people who know a lot about that on Wall Street. As an investor, I want predictability. And the one thing that is not giving me predictability when I buy an airline stock is jet fuel prices.

AB: Is it fair to say airlines don’t have a good handle on how to manage jet fuel prices?

Mahajan: It’s absolutely fair to say. Now it’s not fair to make a blanket statement; some airlines do it extraordinarily well — Lufthansa, Southwest, Virgin Atlantic. They are industry leaders, and all are active hedgers. Their main goal with hedging is not to minimize the cost per gallon. Their main goal is to minimize the volatility.

Hedging is not a tool to guarantee you that you’re going to buy jet fuel at 50 cents a gallon. Hedging is a tool to give management comfort that they won’t pay more than ‘X’ per gallon, or that they will pay in the range of 65-70 cents per gallon. If you can give management that tool, you’re removing a source of uncertainty from their income statement and they can make better decisions on how to run their airline. It’s getting your hands on the wheel so that you’re driving instead of being subjected to the whims of OPEC.

AB: It would seem that airlines, in their current state, would lean toward gambling on a price drop.

Mahajan: If I’m CFO of an airline, I’m going to calculate how many gallons we’ll consume this year; I’m going to figure out all the other things in my income statement that are relatively fixed. Then, say, based on my revenue forecast, if I don’t get jet fuel at less than 73.6 cents per gallon, my airline won’t be profitable. I’m going to tell my purchasing department: Here is your mandate; get jet fuel within a tolerance band around that price. Have a hedging program that’s going to be generating a cost around that band.

Also, there’s a relationship between fuel prices and ticket prices. If it looks like we’re going to be spending a dollar a gallon for fuel, what are my choices? I can raise ticket prices, but then we get into an interesting situation. If you raise ticket prices and other airlines don’t, then naturally you’re going to lose business or have to bring them down.

Now, if six months ago I gave the purchasing department a mandate to hedge at less than 80 cents and they could have, I would have known that I could manage my fixed cost for jet fuel so I could be profitable. I’m not looking to be greedy; I’m just looking to get profitable. When jet fuel prices spike, because I have the benefits of a hedging program, I don’t have to raise my ticket prices. Let’s say Delta did not hedge six months ago and I did, they’re going to have to raise ticket prices. You then force Delta into a very competitive situation.

AB: Why use hedging when the price per barrel is going down?

Mahajan: Let’s say 6 months ago, the fuel purchasing guy came and said we could put a hedging program in place for between 65-75 cents, but he thought it was going down to 50 cents. I’m faced with the option of the certainty of getting jet fuel at 65-75 cents, or waiting and hoping prices will go down. The responsible thing to do in my view is not gamble; the likelihood of it going down is equal to the likelihood of it going up.

Raj Mahajan can be reached at [email protected].