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2012 Fuel Hedging at JetBlue Airways Case Solution
The case talks about various hedging techniques of JetBlue for the cost of its fuel. The case analysis the effects of hedging schemes, like why firms hedge, the distinction between futures and forward contracts, defective hedging, and a form of hedging with derivatives called cross-hedging. And by using this case study of JetBlue, the case explains why the airline industry had been exposed to the risk of unreliable jet fuel prices. By making use of the future contracts to simulate two cross-hedging strategies over the 2007 to 2011 period. Utilizing WTI and other various oil futures contracts available, the case has portrayed that hedging was beneficial to JetBlue as it decreased their jet fuel expenses and volatility. These reduced costs and lessened volatility can even further boost corporate value by illustrating the capacity to manage risks to creditors. And why it requires thorough planning and an effective understanding of the prices of the assets available before making any decision to hedge the costs.
Following questions are answered in this case study solution:
Why does hedging the fuel price so important to JetBlue Airways?
What percentage JetBlue hedges? How about other U.S. airlines, European and Asian airlines? Which airline had been a pioneer in fuel hedging and how much it saved from 2000 to 2010 due to hedging?
What’s the underlying of the derivates contracts JetBlue used to hedge? Why did JetBlue suffer losses because of hedge ineffectiveness?
According to Exhibit 5 Panel B, how did Brent-WTI premium change from 2007 to 2011? Could the Brent-WTI premium be a temporary phenomenon? Would JetBlue continue using WTI for its hedge, or would it switch to Brent or heating oil?
Why JetBlue didn’t use derivatives contracts with fuel oil as underlying to hedge? What are the differences between WTI and Brent?
Why did JetBlue choose crude oil futures contracts to hedge fuel oil prices and didn’t choose heating oil futures or gasoline futures?
What was “crack spread”? What was the trend of “crack spread” from 2007 to 2011? How did “crack spread” related to “basis risk”?
Historically, Brent was more likely to trade at a slight discount of $1 to $2 to WTI due to WTI’s relatively higher quality. Why did Brent trade well above WTI in 2011 (See Exhibit 5)? What did happen to ease the transportation constraints for WTI? Why did EIA have cast doubt on whether the situation could be resolved?
What kinds of derivatives contracts JetBlue used to hedge? Did it use over-the-counter contracts or exchange-traded contracts and why? What position did JetBlue hold in options? What did the protection it gets? When did the cross-hedging work the most effectively? What was the option payoff per barrel in 2011Q4 (not accounting for the premium)?
Please describe JetBlue’s USGC jet fuel swaps at October 26, 2011 (position, settlement, strike price, payoff).
According to Exhibit 3, JetBlue only hedged 9% in 2009. Why? And how this phenomenon related to its hedging strategy?
Please summary hedging strategies used by different United States Airlines and impacts of hedging ineffectiveness on them.
Case Study Questions Answers
1. Why does hedging the fuel price so important to JetBlue Airways?
In 2005, Jet Blue experienced its initial reduction in profits due to a hike in fuel prices. Airlines had the option to tack on additional charges to tickets, but only if all competitors agreed to the same terms. To protect themselves financially, airlines utilized fuel hedging, which included various options for instance, swaps, and other numerous contracts available on crude, and similar commodities. And this could cost millions in dollars, and there was a risk of the airline experiencing losses due to a drop in fuel prices.
The situation in oil markets, such as in Libya or other countries of GCC, caused the jet oil rates to exceed $3 - the greatest it had been since 2008. Hedging fuel prices was a common practice among airlines in the United States at the time. Fuel hedging involves airlines utilizing fuel derivatives to secure costs against the sudden increase in the cost of oil. This strategy can produce fairly consistent returns when the prices of oil remain stable, but if oil prices drop, airlines can experience economic losses. The oil prices and operational expenses of JetBlue have been on the rise since 2009, and the changes in its stock prices can be linked to the ups and downs of oil prices.
2. What percentage of JetBlue hedges? How about other U.S. airlines, European and Asian airlines? Which airline had been a pioneer in fuel hedging, and how much it saved from 2000 to 2010 due to hedging?
In the year 2004, JetBlue had hedged around 39% of the average fuel. Southern Airlines had hedged around 80% of its fuel costs in the same period, followed by Delta and US Airlines, which hedged 29% each, while United and Continental hedged 0% of their fuel costs in the same period. In general, airlines have been helpless when it comes to raising prices to cover any considerable increase in fuel expenditure. From 2001 to 2003, they needed to face a yearly compound rise of 25.9 percent in jet fuel costs. On top of that, during the period between February and May 2004, few airlines attempted to raise fares and surcharges by $5 to $10 to counterbalance the higher fuel cost. Nevertheless, their competitors did not follow suit, leading to the failure of the endeavor. Most recently, United Airlines, on May 23, tried to increase its fuel surcharge on certain flights and categories by five dollars, attributing the hike to the augmented fuel expense. Apart from the need to manage such a massive operating cost for airlines, the extent of fuel hedging could also enhance the value of the business.
3. What’s the underlying of the derivates contracts JetBlue used to hedge? Why did JetBlue suffer losses because of hedge ineffectiveness?
JetBlue used derivatives contracts to hedge against the risk of increasing fuel costs, which cost the company millions of dollars. If fuel prices continuously drop, this has a negative effect on the company. To illustrate, they had a WTI call option that meant the fuel price was capped at $92 per barrel. If the price went above that, they would benefit from the difference. But if it dropped below $92, they would have to pay a high premium. To solve this problem, they used a WTI, a combination of a call and put option, which provided protection by offsetting the cost of the call option with the sale of the put option. However, JetBlue's fuel hedging percentage declined drastically from 2008 to 2009, as they hedged fewer fuel costs. And, when fuel prices surged again in 2010 and 2011, JetBlue increased its fuel hedging percentage. This is because hedging can safeguard profits in the event of a fuel price hike, so airlines tend to opt for it. But hedging can be expensive in the long run, as the cost of derivatives rises with the demand for air travel, and each airline has to employ experts and bear the infrastructure costs. This means that this hedging decision was an ineffective one.
4. According to Exhibit 5 Panel B, how did Brent-WTI premium change from 2007 to 2011? Could the Brent-WTI premium be a temporary phenomenon? Would JetBlue continue using WTI for its hedge, or would it switch to Brent or heating oil?
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