Does Fuel Hedging Add Value? Quantitative Analysis but Qualitative Conclusion in the Case of the US Airline Industry.

This empirical analysis uses daily data sets to study hedging activity of major US airlines during 1996-2005 to examine whether hedging is a value added activity as perceived by the investors. The US airline industry presents a good environment to measure the risk exposure due to changes in jet fuel prices. Fuel price risk is omnipresent across the industry. Given jet fuel price volatility, airlines have an incentive to find value in hedging future prices of jet fuel. The research does not find a reason that would contradict the economic fundamentals of hedging; airline stock returns are negatively related to percentage changes in jet fuel prices, on average. However, looking at daily returns of jet fuel and stock prices, we do not find a significant correlation that can be used to support the theorized sensitivity. This result is consistent with the assertion that the benefit of hedging is of a limited value to the investors who seek a combination of stocks that will reduce the overall risk exposure of the portfolio rather than the risk inherent in this or that individual firm. This article is available in Undergraduate Economic Review: http://digitalcommons.iwu.edu/uer/vol5/iss1/9 1 Jet fuel prices have been substantially volatile throughout the last decade. Between the years 1996 and 2005, a barrel of crude oil was traded at a price range between $10.82 and $69.91. The fluctuation in crude oil prices certainly has an impact on airline industry operations as fuel costs on average represent 16.29% of total airline operating expenses (See Table One). A recent article in The Wall Street Journal lists the airline industry as the likely beneficiary of oil price decreases. Because the airline industry’s operations depend heavily on crude oil, major airlines’ profits could climb when their own cost drops, as fuel prices fall. Furthermore, according to a study of trading patterns by Bianco Research LLC, the airline sector is most inversely correlated to oil prices. Thus, the drop in commodity prices pushes investors to search airlines’ stocks. To mitigate the risk of fuel exposure, some airlines have used derivatives to lock in the price. As such, this temporary protection will shield airlines from high energy costs, but also might keep them from enjoying lower costs when the crude price falls. This paper investigates the fuel hedging behavior of major airlines in the US during the 1996-2005 period to examine whether such hedging has an effect on stock prices of these airlines. Since airline jet fuel prices are hedgeable, some investors might find value in an airline’s attempt to hedge future prices of jet fuel. That will be the truth only if the use of a hedging strategy is positively correlated with a firm’s value. As a result, the underlying price of the airline stock that has a hedging program in place would have higher intrinsic value, as its underinvestment cost is reduced. By the same token, the variability of the stock should be reduced as the price of jet fuel is fixed. Thus, the stock of airlines that engage in hedging is perceived as less risky. The research, contrary 1 Wall Street Journal (2006) 2 Wall Street Journal (2006) 1 Trempski: Does Fuel Hedging Add Value? Quantitative Analysis but Qualitativ Published by Digital Commons @ IWU, 2009 2 to the notion of a positive relationship between hedging and value, shows that hedging is not valued by the investors as reflected in the price of a stock. While using derivatives to hedge jet fuel costs might increase firm value, it is of little importance for investors as their returns do not depend on whether the airline implements the hedging strategy. Individual shareholders are primarily concerned with the cumulative risk exposure of their portfolios rather than with individual stocks.