2012 Fuel Hedging at JetBlue Airways Case Solution

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?