Guest columnist Tom Bacon thinks so, and here he tells us why

Airlines have touted fuel hedges for over a decade now. As fuel prices spiked in 2008 – driving another period of losses for most airlines – airline finance departments all investigated fuel hedges more seriously and, over the past five years, have implemented various caps, collars, and other exotic hedge techniques to reduce their exposure to rapidly escalating fuel prices.

Although this is typically portrayed as a financial function, fuel hedges at airlines fundamentally respond to a perceived revenue problem. If airlines could quickly pass higher fares commensurate with higher fuel prices onto to their customers, there would be less need for a financial hedge.

In fact, for decades post deregulation US airlines could do just that: fuel price increases could be passed onto airline travellers.  Of course, for a number of reasons there is a time lag before higher fares have their full effect. First, customers buy tickets up to a year in advance, so there is a phase-in period for higher fares. Also, given the volatility of fuel prices, carriers are reluctant to move too quickly to respond to fuel price changes. Finally, higher fuel prices often translate into a weaker economy so airlines are slow to push up fares as demand slacks off. Nevertheless, over time the carriers collectively adjust fares to try to make money whether fuel prices are relatively high or relatively low. Many US airlines reported strong profitability in 2013 despite fuel prices that were still averaging $100 a barrel.

Of course, as select airlines have embraced hedging, fuel increases have a differential impact across carriers. In 2008 in fact, Southwest was largely hedged and was therefore much more insulated from market changes; they refrained from the fare increases necessary to offset the fuel price impact on other airlines.

Bonanza time

Now, we suddenly face a period of very low fuel prices. Whoops. Airlines that are significantly hedged will find they are paying higher-than-market prices for fuel. They will want to keep fares high commensurate with their high locked-in fuel price. Meanwhile, carriers that haven’t hedged will be the ones getting a profit bonanza if industry fares don’t change.

Thus, hedging can represent shifting risk as opposed to actually reducing risk. Hedged carriers are more vulnerable in a low fuel price environment and less vulnerable in a high fuel price environment. With fuel equally likely to increase or decrease, hedging often represents just a change in the risk profile. In effect, if carriers hedge they are really speculating on fuel price – betting that they can outguess the market. As USAirways management took over American, they eliminated fuel hedges early on, arguing that it didn’t make sense to pay hedge fees for what largely amounts to speculation.

How will airlines with different hedge positions now respond to lower fuel prices? In the past, select airlines with the competitive advantage on fuel (Southwest in 2008) may have responded in their own self-interest, seemingly taking pleasure in the pain they caused other carriers.  Also, lower fuel prices may have driven short-term, potentially non-sustainable, capacity additions. With the new consolidation of large airlines in the US – and a laser focus of all carriers on earnings -- these reactions are less likely. Airlines collectively will be very slow to reducing fares and adding capacity in response to the lower fuel prices. This will result in significantly higher profits for non-hedged airlines in the near term. In the longer term, driven by higher capacity growth on the margin, fares will decline and a new equilibrium will be established.

If airline finance departments were to ask revenue management, I would argue that there would be less hedging going forward, particularly out longer than six months. More carriers would adopt the American Airlines policy. If fuel hedges represent speculation on fuel prices, we will see carriers lose as often as they gain from them – less the transaction costs of the hedges. And the consolidation of the industry translates into even greater likelihood that fuel price increases can be passed onto customers through fare increases. 

Yes, avoid hedges and reduce your risk!

Tom Bacon is a 25-year airline veteran and industry consultant in revenue optimisation. Questions? Contact Tom at tom.bacon@yahoo.com or visit his website