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Airlines and energy prices

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  1. Introduction.
    1. Course of analysis.
  2. Oil price: A significant risk for an airline.
    1. Crude oil and jet fuel.
    2. Reasons why oil price is of critical value to Airlines.
    3. Southwest Airlines: A special case.
  3. Ways of hedging and reducing exposure to jet fuel price.
    1. Risk Management: Best business practices and navigational technologies.
    2. Using financial tools hedging strategies.
    3. OTC instruments and exchange-traded futures.
  4. Final evaluation and concluding remarks.
  5. Appendix.
  6. References.

Business environment is fraught with risks; each company in order to succeed in this unpredictable environment must mitigate risks. Risks can arise from varied sources; the airline industry is like any other industry, also confronted by pressures from several business areas. In the late 90's and beginning of this decade the biggest risk confronting the airline industry was high fixed labor costs and competitive pressure from low cost airlines with substantially less fixed labor costs. Just as the industry reorganized itself to become more competitive and lean from the perspective of labor costs, a new form risk has arisen in the last 3-4 years. Now energy posses the greatest risk to airline industry. The importance of energy in the airline industry is reflected by the fact that airlines like Air India, which had never engaged in energy risk management through hedging using financial derivatives, are now doing so . The objective of this paper is to understand how airlines are mitigating the risks posed by primarily high oil prices.

[...] South West Essentially sets the fares and most airlines have to react and match the fares to stay in the business. Some of the larger airlines, especially Delta, Northwest and Continental have no hedges because the limited hedging that these companies held were sold under court orders during the restructuring process, post 9/11[7]. Without current hedges, and poor credit ratting these companies are essentially at the mercy of the oil markets An outlook into the future What implications does Southewest's ability to hedge fuel as far as 2009 have for the entire industry? [...]

[...] Uncertainties concerning further oil prices make hedging strategies difficult to implement as a drop of the price could lead the airlines to book losses than gains. But airlines will have to use those ones if they still want to use their planes. Appendix Appendix Payoffs from forward contracts Source: Appendix Main differences between forwards and futures contract Forwards Futures Contract Customisable Standardised terms Negotiation By phone Trading floor or electronic ways system Counterparty Yes No (clearing house) risk Liquidity High Low Price Opacity Transparency Delivery Final cash settlement Contract usually close out prior maturity Settlement A the end of the contract Settled daily Source : Hull (2003) p36 Appendix 3 : Correlation coefficient between jet fuel spot price and crude oil futures Source: Cf Cobbs, Wolf (2004) Appendix 4 : Heating oil futures description Heating Oil Futures Trading Unit: 42,000 U.S. [...]

[...] Spot Price) (Cash price minus futures price) gain basis loss Result: Cash purchase price of jet fuel 103.6 cents/gallon Minus heating oil futures gain - 32.31 cents/gallon Net purchase price of jet fuel 71.29 cents/gallon Source: References BMO Nesbitt Burns Corporate and Institutional (2006): Hedging commodity price risk in Derivations, Volume Release date: 2006, Call date: Cobbs Richard, Wolf Alex (2004): Jet fuel hedging strategies: Options Available for Airlines and a Survey of Industry Practices in Finance, Volume Release date: Spring 2004, Call date: Contingency Analysis (2006): Forward Contract, Release date: 2005, Call date: Harbin Beth quoted in Marsh Joe: Hedging on the fly, Release date: 06.2004 Call date: pp 49-50. [...]

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