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Can Hedging Fly Airlines to Safety in Volatile ATF Markets?

This article attempts to assess the damaging impact of high volatility in Aviation Turbine Fuel prices on the domestic aviation industry, as well as the main factors that make ATF costly in India. While explaining the intensity of the rise and volatility in the price of aviation fuel, it examines if hedging can be a safe route for the domestic airlines to tide over the turbulent phase of the market, as is the standard practice across the world.

COMMENTARY

Can Hedging Fly Airlines to at Rs 4,000 crore. It is forecast to jump to Rs 8,000 crore in 2008-09.
Safety in Volatile ATF Markets? This article attempts to assess the damaging impact of high volatility in ATF prices
on the domestic aviation industry, as
well as the main factors that make ATF
Danish A Hashim, V Shunmugam costly in India. It suggests how this impact

This article attempts to assess the damaging impact of high volatility in Aviation Turbine Fuel prices on the domestic aviation industry, as well as the main factors that make ATF costly in India. While explaining the intensity of the rise and volatility in the price of aviation fuel, it examines if hedging can be a safe route for the domestic airlines to tide over the turbulent phase of the market, as is the standard practice across the world.

The views expressed here are personal and do not reflect those of the organisation to which the authors belong.

Danish A Hashim (Danish.hashim@mcxindia. com) and V Shunmugam (V.Shunmugam@ mcxindia.com) are economists with the Multi Commodity Exchange of India, Mumbai.

Economic & Political Weekly

EPW
february 14, 2009

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viation Turbine Fuel (ATF) costs much more in India than it does in the rest of the world, due to the tax regime. The base price – refinery gate price (excluding taxes and margins) – of ATF at Rs 30.21 per litre in November 2008 was found to be around 10% higher than in Singapore, Dubai and Kuala Lumpur. Once the taxes, duties and margins are added to the base price, the retail price of ATF turns out to be around 60% higher than that in the centres mentioned above.

The retail price of ATF in India is around 50% higher than the base price, whereas in other countries including Dubai and Singapore it is higher by only around 5%. Unreasonably high ATF price raises expenditure for an airline, thereby making aviation services costlier for users. It is argued that had the fuel price in India been on par with global standards, the operating expenses of the carriers would have been lower by around 14% (Hashim 2004a).

A rapid surge and high volatility in the price, especially in the recent years, has further hit the domestic aviation industry, grappling with other efficiency issues. From Rs 21,200 a kilolitre level in 2004-05, the price of ATF spiralled to Rs 36,000 during 2007-08 and went up to an all-time high of Rs 71,028 in August 2008. Notably, even though the ATF price has, as a trend, shot up over the years, it has experienced wide fluctuations all the while. The most recent example of such wide fluctuation exists in a tumbling of the ATF price by around 45% between August and November 2008. In other words, while a given period has seen a steep rise in the price, another has witnessed a softening, leaving the airlines guessing about their operating costs all the time. Not being able to pass on short-term volatilities to their consumers easily, the airlines in India have taken a large hit on their balance sheets. The cumulative losses for the domestic airlines industry in 2007-08 were pegged

vol xliv no 7

can be moderated. While explaining the intensity of the rise and volatility in the price of aviation fuel, it examines if hedging can be a safe route for the domestic a irlines to tide over the turbulent phase of the market, as is the standard practice across the world.

Need for Price Rationalisation

In the last few years, the price of ATF has escalated sharply in India, in line with the trends in markets elsewhere (Table 1). B etween 2004-05 and 2007-08, the price of ATF in the country increased at the a verage annual rate of around 21%. While other countries have also witnessed a similar spurt in price, it was more damaging for Indian carriers (and, of course, consumers) because the price of ATF in the country was already much higher than what prevailed internationally. As a result, the expenses on fuel for domestic airlines shot up to 40 to 50% of the operating expenses, compared with the global trend of around 20 to 25% (Nanwani et al 2008). This was a big increase from a level of 30% that existed in 2000. Even at that time, however, domestic airlines were incurring far higher operating expenses on fuel as compared to global average of 10 to 15% (Hashim 2004b).

Table 1: Comparative Price Levels of ATF (Rs /kl)
Year India Sharjah Kuala Lumpur Singapore Bangkok
2004-05 21,200 11,697 11,044 11,272 11,499
2005-06 27,400 16,349 15,589 15,816 16,069
2006-07 37,000 23,017 21,427 22,111 22,383
2007-08 36,000 21,700 20,874 20,799 21,272

Source: Federation of Indian Airlines.

There are two main reasons responsible for the high prices of ATF in India. First, high sales tax, averaging around 20% across states (varying from 4% in Andhra Pradesh to 30% in Gujarat), plus 8% excise duty and 3% education cess by the central government.

Second is the monopoly in supply of ATF. Monopoly allows ATF to be heavily used to cross-subsidise many petroleum products of mass consumption. The

COMMENTARY

state-owned oil companies – Bharat Petroleum, Indian Oil, and Hindustan Petroleum – enjoy the exclusive right of supplying ATF to the domestic airlines and, therefore, the domestic airlines have no other choice but to buy it at the quoted prices. In fact, this prompted the Naresh Chandra Committee (2003) to recommend allowing the airlines to source their ATF requirement from suppliers of their choice. If buying of ATF from the competitive sources is allowed, that would greatly ease the financial strain on the airlines.

Coping with Price Turbulence

Added to the high domestic ATF prices is the high volatility. Figure 1 reveals the dramatic increase in price volatility in aviation fuel that the domestic airlines have faced in the last few years. The price of ATF has fluctuated widely during the different quarters of years between 2003 and 2008. The year-on-year (y-o-y) change in the price during the January-March such volatility and have, in fact, converted this adversity into opportunity at the expense of those which do not do so, the airlines in India have suffered hugely. The domestic airlines lack awareness or skills to use hedging to mitigate their fuel price risk, a concept that is new to the Indian operators.

Now, more importantly, how can our airlines manoeuvre against volatility in ATF prices? One thing is obvious: it is not possible for them to control volatility as this happens owing to external forces that are highly unpredictable and, hence, c annot be managed just by participating in spot markets. Therefore, the best that the domestic carriers can do is hedge the risk arising out of the ATF price volatility by participating in a derivatives market. Neidl et al (2001) showed that the US c arriers that had hedged in fuel in the s econd half of 2000 produced better financial results than those that had not. Southwest Airlines, by way of its strong

2003 2004 2005 2006 2007 2008 January-March April-June July-September October-December
Figure 1: Volatility in Price of ATF in India (year-on-year price increase in %)

90.0

75.0

60.0

45.0

30.0

15.0

0.0

-15.0 October-December 2008 growth is for October-November only. Source: Office of Economic Adviser, Ministry of Commerce and Industry, government of India.

quarter has been in the range of plus 40% to minus 12%. In the next quarter (April-June), the volatility was even higher in the range of plus 66% to minus 7%. The r emaining two quarters also witnessed similar volatility in the price of ATF. It is not very difficult to make out that there is very little which suggests a pattern in the volatility of the price movement through the quarters or years.

What remains a reality is that the high volatility in ATF prices is something which not only the airlines in India but carriers across the globe have to live with in order to survive. While many leading airlines in the world have learnt to deal with preference to hedging, was able to ward off the adverse impact of spiralling crude oil prices to a great deal in recent times. It is believed that Southwest hedged oil at $51 a barrel for 75% of its requirement. As a result, when crude oil breached even the $140 a barrel level, Southwest still managed to keep its fares low, giving its competitors a run for their money. Malaysia Airlines is another among the beneficiaries of hedging in aviation fuel. Consequently, despite the fuel surging all through the last year, the carrier managed to post a profit of $262 million. Not s urprisingly, it again hedged 43% of its fuel requirement for 2008.

It is also contended that hedging enhances the ability of airlines to withstand an economic downturn when it becomes a pressing situation for the weaker players to resort to distress sales of their assets (mainly aircraft) or even the entire entity itself (Pulvino 1998 and 1999). Froot et al (1993) argued that if hedging improves the cash position of an airline during an economic downturn, the hedged airline would have to rely less on external sources of funds to make capital investments. It has been found that investment opportunities are generally positively correlated with the aviation fuel cost, whereas higher fuel costs are consistent with lower cash flow. Further, Carter et al (2003) contended that an airline with a desire for expansion may find value in hedging in future purchase of ATF. They showed, empirically, that hedging enhances an airline’s value to the extent of 12 to 16%, which in turn has a positive impact on its further capital investments.

While most successful airlines of the world have used the facility of hedging to convert price volatility into an opportunity, the Indian civil aviation industry has yet to take off in this respect. At present, their exposure to hedging in ATF is limited, as the Indian government a llowed hedging in ATF only from 2007. Obviously, the domestic carriers lack the expertise and enabling policy and institutional mechanism to make it a success. This perhaps was the reason why Air India, despite being the first airline in the country to have started hedging in ATF, could not really take advantage of this facility. When the state-owned airline had made its fuel hedging debut, it incurred losses with the oil prices dipping below the hedged prices, prompting the carrier to stop taking positions subsequently. It may be argued that if Air India had continued to hedge in ATF, it could have much better manoeuvred the skyrocketing ATF prices witnessed in 2008. An appropriate degree of exposure of the domestic a irlines industry to hedging against price volatility would have perhaps saved the entire industry from incurring huge fi nancial losses.

It is evident that the domestic airlines can benefit significantly by hedging fuel costs. Incorporating hedging, as an integral part,

february 14, 2009 vol xliv no 7

EPW
Economic & Political Weekly

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into their financial planning would not only enable them to withstand turbulent shocks in oil prices but also help in setting off consolidation of the aviation industry and an increase in investments even during the lean phase of the business cycle. While bringing down the differential between the prices of ATF in India and abroad is not in the hands of the Indian air carriers, they can definitely protect themselves from the volatility in fuel p rices by making the best use of hedging opportunities.

References

Carter, D A, D A Rogers and B J Simkins (2003): “Does Fuel Hedging Make Economic Sense? The Case of US Airline Industry”, Working Paper, Oklahoma State University, Stillwater, USA.

Froot, K, D Scharfstein and J Stein (1993): “Risk Management: Coordinating Investment and Financing Policies”, Journal of Finance, 48:1629-58.

Hashim, Danish A (2004a): “Why Is Air Travel So E xpensive: An Analysis”, Economic & Political Weekly, 21 August.

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– (2004b): “High ATF: Keeping the Airlines Low”, Business Standard, 21 October. Nanwani, N and P Mehra (2008): “Burning Coffers”, Businessworld, 1-7 July.

Naresh Chandra Committee Report (2003): Report of the Committee on a Road Map for the Civil Aviation Sector, Ministry of Civil Aviation, Government of India, November.

Neidl, Raymond E and Eric C Chiprich (2001): “Major US Carriers 2000 Results and 2001 Outlook”, Global Research, Ing-Barings.

Pulvino, T C (1998): “Do Asset Fire Sales Exist? An Empirical Investigation of Commercial Aircraft Transactions”, Journal of Finance, 53:939-78.

– (1999): “Effects of Bankruptcy Court Protection on Asset Sales”, Journal of Financial Economics, 52: 151-86.

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Economic & Political Weekly

EPW
february 14, 2009 vol xliv no 7

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