Cathay Pacific Airlines Case Study

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Figure 3 Crude oil prices and key geopolitical and economic events

After all, due to the global upsurging demand and a relatively stable supply of crude oil in past 20 years, we can see an overall upward trend of the oil price. This become the major reason that airlines tend to undergo fuel hedging so as to provide protection against sudden and significant increases in jet fuel prices, given the fuel costs is one of the major costs items of the airlines business. The use of commodity futures, options and other derivatives will be discussed in latter part of this report.

The impact of shale oil and shale gas to energy prices

The crude oil price is affected by the rapid technology development of shale oil and shale gas extraction. Crude oil and natural gas belong to the conventional energy. The oil reserve in the world is shrinking day by day. The price is supposed to move up naturally with no doubt. Starting from 2000s, US enterprises are working very hard to explore new technology to extract nonconventional energy, i.e. shale oil and shale gas. Technology breakthrough has given great impact to the price of crude oil. In recent years, new technologies called horizontal Drilling and hydraulic Fracturing have been applied in the industry. They are very efficient in extracting shale gas.

According to the Annual Energy Outlook issued by the Energy Information Administration (EIA), the shale gas will increase its importance in the future. EIA predicts that in 2020s, the supply of natural gas in US will be greater than the demand due to the rapid development of shale gas. EIA also estimates that US as a traditional energy importer will become an energy exporter by that time. The price of energy has been greatly affected. The OPEC is being challenged by new comers. Theoretically, the decrease in energy prices can slow down the development of shale gas and shale oil industry. The cost of extraction of shale gas and oil must be higher than the extraction of natural gas and crude oil because the formers require higher technologies. The game behind all the giants has led to high volatility of crude oil price.

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Figure 4 The projection of increase in Shale gas from 2010s to 2035s by EIA

Forward and future Contracts

There are no exchanged traded jet fuel futures in the US exchange market. Therefore, hedging strategies of most airline companies have been set up between crude oil and heating oil because they are actively traded in the futures market. They are not perfectly correlated with jet fuel but are still highly correlated. Therefore, the airline companies face basis risk when involving heating oil and crude oil in their hedging strategies.

Airline companies can work out with the specialists i.e. fuel management companies, large oil companies and financial services institutions to tailor-made forward agreements for jet fuel hedging purposes. Forward contracts are over the counter (OTC) agreements between two parties i.e. the airline companies and the specialists. The contents of the agreements are whereby one party purchases a fixed amount of jet fuel from the other at an agreed price at a future date. In reality, airline companies enter into a forward contract with fuel management companies such as Mercatus Energy Advisors, Pricelock, Global Risk Management and World Fuel Services. They can choose to deal with the Oil companies such as ExxonMobile, BP and Koch Industries etc. The role of Investment Banks i.e. Goldman Sachs, BNP Paribus, Barclays Plc, Wells Fargo, Morgan Stanley and Citigroup involves either in matching counterparties or speculating activities. Derivatives such as future, option and forward agreements are zero sum games. The counterparty may go bankruptcy and unable to meet the obligation. So, there is counterparty risk involving in forward contracts.

Example of Forward Agreements

The Finance Director of Cathy Pacific, Martin Murray has pointed out that they have hedged from 2015 to 2018. 60% of the hedged position is at USD 95. 37% of the position is hedging at an average of USD 82. Murray insists that Cathy Pacific is well protected against upward fuel volatility going forward. It was most likely that the hedging strategic team in Cathy Pacific has hedged jet fuel cost by entering into forward contracts of ICE Brent crude oil. The Brent crude oil price was peak in USD 115 in June 2014. It had dropped to nearly USD 45 in January 2015. The forward contracts are OTC contracts with underlying product of Brent crude oil between Cathy Pacific and the other counterparties at USD 95 and USD 82 at the future date of 2018. Cathy Pacific has locked the oil prices at USD 95 and USD 82 from 2015 to 2018. At the date specified in the contracts, both parties have the obligation to fulfill the transactions. Cathy Pacific will continue to enter into the forward contracts even the Brent crude oil price is USD 45 in January 2015. Once the oil price rises in the coming years, the hedge will really help a lot.

Options

Airline companies can use OTC and exchange traded options to build up hedging strategies. In reality, airline companies prefer OTC options rather than exchange traded options because they are customizable. In order to cope with counterparty risk, airline companies trade options with several investment banks to diversify the risk. At the same time, the diversification among different counterparties also keeps the secret of the underlying strategies. For example, airline companies can long a call from one investment bank protecting from adverse oil price increases above the strike price. The company can short a put to another investment banks receiving a premium to pay for the cost of longing the call. Shorting a put gives up the benefit of oil price reduction. This strategy is called collars. It is better not to reveal hedging strategies to individual counterparty since options contracts are zero sum game. One party’s lose will be the other’s gain.

Since jet fuel is not available in US exchange market, the option of it must be tailor-made by the investment banks. Exchange traded options with underlying futures of Brent Crude oil, WTI Crude oil and heating oil are commonly used. There are two reasons. Firstly, some financially weak airline companies find it very difficult to find counterparties. They will have to rely on exchange traded options for hedging. Secondly, exchange traded options of WTI Crude oil, Brent Crude oil are well developed with market depth. Although