IIIS Discussion Paper No.433 / August 2013 Fuel Hedging, Operational Hedging and Risk Exposure– Evidence from the Global Airline Industry August 2013 Britta Berghöfer School of Business, Trinity College Dublin 2, Ireland Lufthansa Aviation Center, Airportring, 60546 Frankfurt / Main, Germany [email protected] Brian Lucey (Corresponding Author) School of Business Trinity College Dublin 2 Ireland Institute for International Integration Studies (IIIS), The Sutherland Centre, Level 6, Arts Building, Trinity College Dublin 2 Ireland Glasgow Business School, Glasgow Caledonian University, Cowcaddens Rd, Glasgow, Lanarkshire G4 0BA, United Kingdom Faculty of Economics University of Ljubljana Kardeljeva ploscad 17 Ljubljana, 1000 , Slovenia [email protected] IIIS Discussion Paper No. 433 Fuel Hedging, Operational Hedging and Risk Exposure– Evidence from the Global Airline Industry August 2013 Britta Berghöfer School of Business, Trinity College Dublin 2, Ireland Lufthansa Aviation Center, Airportring, 60546 Frankfurt / Main, Germany [email protected] Brian Lucey (Corresponding Author) School of Business Trinity College Dublin 2 Ireland Institute for International Integration Studies (IIIS), The Sutherland Centre, Level 6, Arts Building, Trinity College Dublin 2 Ireland Glasgow Business School, Glasgow Caledonian University, Cowcaddens Rd, Glasgow, Lanarkshire G4 0BA, United Kingdom Faculty of Economics University of Ljubljana Kardeljeva ploscad 17 Ljubljana, 1000 , Slovenia [email protected] Disclaimer Any opinions expressed here are those of the author(s) and not those of the IIIS. All works posted here are owned and copyrighted by the author(s). Papers may only be downloaded for personal use only. Fuel Hedging, Operational Hedging and Risk Exposure– Evidence from the Global Airline Industry August 2013 Britta Berghöfer School of Business, Trinity College Dublin 2, Ireland Lufthansa Aviation Center, Airportring, 60546 Frankfurt / Main, Germany [email protected] Brian Lucey (Corresponding Author) School of Business Trinity College Dublin 2 Ireland Institute for International Integration Studies (IIIS), The Sutherland Centre, Level 6, Arts Building, Trinity College Dublin 2 Ireland Glasgow Business School, Glasgow Caledonian University, Cowcaddens Rd, Glasgow, Lanarkshire G4 0BA, United Kingdom Faculty of Economics University of Ljubljana Kardeljeva ploscad 17 Ljubljana, 1000 , Slovenia [email protected] Keywords: Airline, hedging, operational hedging, financial hedging JEL Codes: G32, L93 ABSTRACT The aviation industry is characterized by low profit margins and a constant struggle with skyrocketing fuel costs. Financial and operational hedging strategies serve aviation managers as a tool to counteract high and volatile fuel prices. While most research on fuel hedging has concentrated on the U.S. airline market, this paper is the first study to include airlines from Asia and Europe. We analyze 64 airlines over 10 years and find that Asian carriers are more negatively exposed than European airlines but less exposed than North American airlines. In contrast to Treanor, Simkins, Rogers and Carter (2012), this study finds less significant negative exposure coefficients among U.S. carriers. Using a fixed effects model we reject the hypothesis that financial hedging decreases risk exposure. One possibility is that the decreased volatility in jet fuel prices over the past few years has perhaps made airlines less exposed to fuel prices and hence, financial hedging less effective. However, operational hedging, defined by two proxies for fleet diversity, reduces exposure significantly. A one percent increase in fleet diversity, calculated with a dispersion index using different aircraft types, reduces the risk exposure coefficient by 2.99 percent. On the other hand, fleet diversity, calculated with different aircraft families, reduces exposure by 1.45 percent. Thus, aviation managers have to balance the fleet diversity between operational flexibility and entailed costs. 1. INTRODUCTION The airline industry has always been characterized by low profit margins. Decreasing airfares due to increasing competition have made air travel a commodity market (Button, Costa, Costa and Cruz, 2011; Carter, Rogers and Simkins, 2004). Deregulation in the world airline industry has led to greater competition since the 1980s (Oum and Yu, 1998). Especially the deregulation of the aviation sector in Europe has supported the intense growth of low-cost carriers (LCC). Traditional airlines in particular suffer from losing market shares to LCCs (Civil Aviation Authority, 2006). Besides increased competition, high and volatile fuel prices challenge airlines further. Fuel accounted for 33 percent of average operating costs in 2012, for 22 percent in 2005 and for 13 percent in 2001 (IATA1, 2012a). The overall fuel bill amounted to 177 billion U.S. dollars (USD) in 2011 (IATA, 2012b). Delta Air Lines, for example, reports fuel expenses of 36 percent of total operating costs in 2012 (Delta Air Lines, 2013). Even the golf-carrier Emirates with its supposed easy access to oil declared fuel costs of 34 percent (Emirates, 2012). In addition to the cost level, fuel price volatility and a large crack spread with the underlying commodity crude oil add to the airlines’ fuel problems (IATA, 2012b). However, the exposure to market pressure prevents airlines from raising ticket fares in response to the high kerosene prices (Carter et al., 2004). Button et al. (2011), analyzing the Portuguese airline market show that full cost recovery is impossible in the current competitive situation. As airlines are unable to increase ticket prices they put their efforts on hedging activities.2 Airlines started to employ fuel hedging as a risk management strategy in the late 1980s. Before, mostly currency derivatives to counteract exchange rate fluctuations were used (Morrell and Swan, 2006). Under the assumption of the famous Modigliani and Miller Proposition 1 (1958) debt policy and consequently risk management are extraneous for investors under perfect market conditions as investors can diversify on their own. Nevertheless, due to existing market imperfections (Deshmukh and Vogt, 2005) research results suggest hedging does make sense under different conditions and in fact, might add to firm value. Companies can hedge by either using financial derivatives or by altering real option decisions (operational hedging) (Smith and Stulz, 1985). Firms generally use financial and operational hedging complementary (e.g. Kim, Mathur and Nam, 2006; Treanor, 2008). Real options may include fleet diversity, fleet fuel-efficiency and optimized fleet assignment (Morrell and Swan, 2006; Naumann, Suhl and Friedemann, 2012; Treanor, 2008; Treanor, 2012; Treanor, Rogers, Carter and Simkins, 2012a). The purpose of this paper is to uncover the determinants of airline commodity exposure. Exposure, in general, can be defined as the sensitivity of firm value to changes of the underlying financial risk (Jorion, 1990). Although various research papers have been published regarding the use of derivatives within the aviation industry, the author suggests that a further study could add to the existing body of knowledge. There are certain gaps in previous research which can serve as a valuable starting point for further research. Prior 1 IATA stands for International Air Transport Association, the largest trade association representing 240 airlines worldwide. 2 Obviously, not only passenger airlines are exposed to fuel prices and use financial derivatives but also cargo carriers and the military aviation industry encounter commodity exposure. Nevertheless, the limited information available on military operations inhibits a more detailed analysis of this sector. Cargo airlines are mostly part of a larger airline group, e.g. Deutsche Lufthansa, and are thus included in the analysis. Atlas Air is the only pure cargo carrier analyzed in this paper. 1 empirical research on jet fuel hedging has concentrated on the U.S. market. While the author acknowledges the difficulty of obtaining data outside the U.S., she suggests that it is important to examine data from other countries. In 1999, Rao points out that European airlines hedge more actively than American airlines. While analyzing the cost competitiveness of 22 major worldwide airlines, Oum and Yu (1995, 1998) uncover that Asian carriers are more cost competitive than American and European airlines. American airlines in turn have a better cost position than European carriers. Cobs and Wolf (2004) also point to differing hedging strategies among LCC and value carriers. Therefore, the author will focus on differences in commodity exposure between Asian, European and North American carriers3 as well as differences between LCC and premium airlines in the period of 2002-2012. So far, to our knowedge, no empirical research has dealt with regional or business model differences. A fixed effects regression model using panel data should estimate the effectiveness of operational and financial hedging. Lastly, based on statistically established results, this paper will provide managerial implications on how to reduce airline risk exposure.4 2. PREVIOUS RESEARCH 2.1. Airline fuel and fuel contracts Bessembinder (1991, p. 519) defines hedges as “contracts that reduce an agent's risk”. Therefore, hedging is part of the overall corporate risk management strategy (Batt, 2009; Nance, Smith and Smithson, 1993). Hentschel and Kothari (2001) further distinguish between hedging, which reduces return volatility, and