Fuel Hedging and Debt Capacity in the U.S. Airline Industry Abstract Does hedging affect the debt ratio? If so, is the direction consistent with the theory regarding hedging and derivatives? This thesis investigates the relationship between jet fuel hedging and the debt ratios of U.S. airlines. Using a sample of 21 U.S. passenger airlines between 2001 and 2007, this paper aims to provide an answer. The research of corporate risk management mainly focuses on what motivates the use of derivatives and if hedging increases firm value. Graham and Rogers (2002) find that leverage has a positive influence on the use of derivatives and that this relationship also runs backwards. The airline industry offers a good perspective, since airlines have a common exposure to volatile fuel prices and fuel costs represent a substantial part of total costs. Analyzing theories of risk management using fuel hedging could provide interesting insights. The coefficients on the fuel hedging variable are negative in the first two models using ordinary least squares and significant at the 10% and 5% level. A third model shows that fuel hedging is positively related to the debt ratio and could be interpreted as hedging increases debt capacity and tax deductions (Graham and Rogers, 2002). The fixed effects model does not find evidence for the hypothesis that fuel hedging is positively related to the debt ratio. Bachelor thesis Emma den Held 10079599 Finance Supervised by dr. J.E. Ligterink Faculty of Economics and Business University of Amsterdam February 2014 Table of contents 1. Introduction p. 3 2. Literature review p. 5 2.1. Corporate risk management p. 5 2.2. U.S. airline industry p. 7 2.3. Fuel hedging p. 8 3. Data p. 11 3.1. Sources p. 11 3.2. Sample description p. 11 4. Methodology p. 13 4.1. Variables p. 13 4.2. Models p. 15 5. Does fuel hedging affect the debt ratio? Empirical evidence p. 16 6. Conclusion and suggestions for further research p. 20 References p. 21 Appendix p. 23 2 1. Introduction The famous Modigliani-Miller theorem states that, without market imperfections, firm value is independent of a firm’s financing decisions and risk management. Violation of the strong assumptions made by Modigliani and Miller (1958) leads to another view. Theoretical research shows that corporate risk management can be value increasing when there are capital market imperfections such as bankruptcy costs, a convex tax schedule (Smith and Stulz, 1985) or underinvestment problems due to costly external finance (Froot et al., 1993). Corporate risk management is important to most firms and they are likely to engage in hedging activities. In the airline industry for instance, Southwest Airlines is known for hedging activities to manage fuel price risk. The company hedged up to a maximum of 95% of next year’s fuel requirements between 2001 and 2007. Even though hedging has been thoroughly investigated for many years, questions remain on what exactly motivates the use of derivatives. Research mainly examines the relation between hedging and firm value. This thesis highlights hedging in relation to debt capacity. In their paper, Guay and Kothari (2003) discussed several studies that examined this subject. Some of them find evidence for a positive relation but others fail to do so. Hence there is no clear-cut answer. This paper contributes to the research of corporate risk management by providing an answer to the question whether fuel hedging, as the independent variable, affects the debt capacity of U.S. airlines. The outcome could help to understand why airlines become involved in hedging activities and give direction for further research like investigating the magnitude of the relation. To reduce their exposure to different sources of risk, airlines make use of hedging strategies. Rising jet fuel prices are an important source of risk facing airlines. Fuel costs often represent a substantial part of total operating expenses. Airlines can hedge their future fuel requirements thereby locking in a part of their future cash flows. There are two main reasons for choosing the airline industry. First, the airline industry is competitive and airlines face similar risk as a result of fluctuating oil prices. Second, Carter et al. (2006) note that in comparison to other underlying assets, for example currencies, jet fuel prices are more volatile. The sample used in their study consists of 28 U.S. passenger airlines. The use of interest rate derivatives among the airlines suggests that risk associated with interest rates is less than risk associated with jet fuel prices. So how does debt capacity fit into all of this? If a firm uses a good hedging strategy the volatility of future cash flows can be reduced. One way to create value is to increase the debt level to benefit from the increased tax shield. Important questions emerge; Does lower 3 volatility mean allowing higher leverage? And when a part of the increased debt capacity remains unused, does this decrease the financial distress costs? This thesis aims to provide answers, taking in account the relation between hedging and debt capacity. Using panel data of 21 U.S. airlines from December 2001 to December 2007, this paper examines the effect of fuel hedging on debt capacity. The mean price of jet fuel is $1.39 per gallon during the period, and the standard deviation nearly 60 cents. Airlines state in their annual reports that their exposure to jet fuel price risk is significant. The results of the regression analysis are hard to interpret. The first two models estimate a negative coefficient on the fuel hedging variable. This result is significant at the 10% level at least and in accordance with Carter et al. (2006) who find that firm leverage is negatively related to the amount of fuel hedged. In their article leverage is defined as long-term debt divided by assets. On the other hand this result is opposed to the results of Graham and Rogers (2002) and Bartram (2009) that there is a positive correlation between hedging and leverage. The paper proceeds as follows. In Section 2 literature regarding hedging and derivatives is reviewed. Background information on the U.S. airline industry is given and fuel hedging explained. Section 3 describes the sample that is used for this thesis and provides the reader with some relevant information regarding the airlines of the sample. Next, Section 4 explains the models as well as the variables used to investigate if fuel hedging affects the debt capacity. The results of the regression analysis are discussed in Section 5. The paper ends with a summary and conclusion in Section 6. An important note to this thesis is that all derivatives that companies hold are solely for hedging purposes and not for trading or speculating purposes. This is stated in their annual reports. 4 2. Literature review 2.1. Corporate risk management Corporate risk management refers to the use of financial instruments, cash instruments and/or derivative instruments, to manage exposure to risk and creating economic value by a firm. Stocks and bonds are examples of cash instruments. Their value is determined directly by the market. Derivative instruments are rather complicated. Their value depends on an underlying entity such as an asset, interest rate or index. Hedging activities are a part of firms’ corporate risk management, who manage risk to increase value. However, it is well known that in a perfect financial market setting decisions regarding risk management do not affect firm value as investors can copy or undo this themselves. Therefore market imperfections drive potential value creation. The remainder of this paragraph discusses what motivates the use of derivatives and earlier evidence with respect to hedging. Incentives for derivatives use A question subject to research is if hedging influences firm value. “The determinants of firms’ hedging policies” by Smith and Stulz, published in 1985, was pioneering in this field of research. The article identifies three reasons a value-maximizing firm could hedge: taxes, financial distress costs and managerial incentives. They only consider non-financial firms. If firms with a convex tax function reduce the volatility of taxable income, this can lower expected taxes. In agreement with Smith and Stulz, Hayne Leland (1998) concludes that the benefits of hedging are larger with greater tax convexity. In this case hedging will reduce the expected taxes more. Also, the greater tax benefits resulting from increased leverage make hedging valuable. Graham and Smith (1999) take a closer look at tax convexity using a sample of over 80,000 firm-year observations. Approximately 50% of the firms from their sample face a convex tax function and one-quarter of the firms with a convex tax function have potential tax savings from hedging that appear material. However, the benefits are not large for most firms. In addition, Graham and Rogers (2002) find no evidence that firms hedge with regards to tax convexity. One of the other reasons a firm might want to hedge is because of reduced financial distress costs. Cash flow volatility can be the reason for a firm to get into a situation where the firm has trouble meeting its payment obligations. If being in financial distress is costly 5 then reducing the probability of encountering such state will reduce the financial distress costs and thereby increase firm value (Smith and Stulz, 1985). The effect is larger for firms with higher costs of financial distress. Costs associated with the failure to invest in profitable projects are included in the financial distress costs. Besides, if having debt in the capital structure is advantageous, hedging could be used to increase debt capacity (Froot et al., 1993). Research by Haushalter (2000) examined the risk management activities of 100 oil and gas producers from 1992 to 1994.