4 Ways Airlines Hedge Against Oil

By
EVAN TARVER

Updated January 29, 2022

Reviewed by CHARLES POTTERS

Fact checked by
MICHAEL LOGAN
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The largest operating cost for airlines is typically fuel expenses. Fuel costs
are such a large part of an airline's overhead that fluctuating oil prices can
greatly impact an airline's bottom line.

It is important to remember that the airlines can only be profitable if they

are able to cover their operational costs by selling tickets. Nearly all of their
costs are somewhat predictable, and can be pro-rated into future
transactions except one: the short term costs of fuel.

To protect themselves, and sometimes to even take advantage of the

situation, airlines commonly hedge their fuel costs. They do this by buying
or selling the expected future price of oil through a range of derivatives,
thus protecting them from rising prices. In this article, we look at four ways
airlines hedge against fluctuating oil prices.

KEY TAKEAWAYS

 Airlines can employ several hedging strategies to protect their

bottom lines from fluctuating oil prices.
 One simple strategy is to buy current oil contracts, which lock in fuel
purchases at today's prices. This is advantageous if you expect
prices to rise in the future.
 Call and put options are other tools to hedge against moving oil
prices.
 If an airline buys a swap contract, it is obligated to fulfill the terms of
that contract.

Purchasing Current Oil Contracts

In this hedging scenario, an airline would believe that prices will rise in the
future. To mitigate this, the airline purchases large amounts of current oil
contracts for its future needs.

This is similar to a person who knows that the price of gas will increase
over the next 12 months and they will need 100 gallons of gas for their car
during that time. Instead of buying gas as needed, the car owner decides
to purchase all 100 gallons at the current price, which they expect to be
lower than the price of gas in the future.

Purchasing Call Options

A call option gives the buyer the right (though not an obligation) to
purchase a stock or commodity at a specific price before a specific date. If
an airline buys a call option, this means it is by buying the right to
purchase oil in the future at a price that is agreed upon today.

For example, let's say the current price of oil is $100 per barrel, but an
airline company believes prices will increase. It could purchase a call
option for $5 that gives it the right to purchase a barrel of oil for $110 within
a 120-day period. If oil prices increase to above $115 per barrel within 120
days, the airline will end up saving money.

Implementing a Collar Hedge

Similar to a call option strategy, airlines can also implement a collar hedge,
which requires a company to purchase both a call option and a put option.
Where a call option allows an investor to purchase a stock or commodity at
a future date for a price that's agreed upon today, a put option allows an
investor to do the opposite: sell a stock or commodity at a future date for a
price that's agreed on today.

A collar hedge uses a put option to protect an airline from a decline in the
price of oil if that airline expects oil prices to increase. In the example
above, if fuel prices increase, the airline would lose $5 per call option
contract. A collar hedge protects the airline against this loss.

Purchasing Swap Contracts

Finally, an airline can implement a swap strategy to hedge against the
potential of rising fuel costs. A swap is similar to a call option, but with
more stringent guidelines. While a call option gives an airline the right to
purchase oil in the future at a certain price, it doesn't require the company
to do so.
A swap, on the other hand, locks in the purchase of oil at a future price at
a specified date. If fuel prices decline instead, the airline company has the
potential to lose much more than it would with a call option strategy.