Managing financial risk in times of crisis: when hedging may not turn out to be a hedge at all…
Andy Pfaff, The Fuel Desk [1]
Events in early 2020 have led to one of the most precipitous drops in global oil prices ever. As of Tuesday, March the 10th, the price of oil had fallen by over 55% in a matter of days.
The drop in demand for oil driven by the effects of the coronavirus has been compounded by the political fallout between Saudi Arabia and Russia. Saudi Arabia’s decision to increase production by 25% to a record level of 12 million barrels per day, together with significant price discounts on their oil – and Russia’s tit-for-tat production increase – has led to global oil prices falling at the most rapid rate in over 25 years.
Oil price volatility, although newsworthy, happens intermittently for different reasons. What is concerning is its financial impact on companies that consume fuel. The financial impact of this event on those companies that have hedged themselves against increases in the oil price is surprising – but not in a good way. The most obvious current example is the airline industry. As fuel constitutes between 37% – 42% of airlines’ operating expenses, many airlines attempt to hedge the price that they pay for this very important input. As highlighted recently in the media,[2] airlines such as Ryanair, Lufthansa, EasyJet and Air France KLM (and in the past, South African Airlines) have hedged their purchases of fuel. They are currently facing significant losses on these hedging positions as a result of the oil price collapse. The current losses for Air France KLM on their hedging strategies are estimated to be in the hundreds of millions of US dollars. While these losses will be offset by lower fuel purchase costs, the presence of the hedge means that these companies do not benefit from this price drop, or perhaps only partially at best. The reason for this shortcoming lies in the way that these hedges are designed and implemented. It is the simplistic approach of these legacy strategies that lead to these significantly counterproductive outcomes.
These financial hedges typically work exactly as they were designed but, as this example shows, they do not always work out as hoped for by the company doing the hedging. When a negative price shock of the current size and speed occurs, traditional hedging strategies do not provide the benefits that most fuel consumers hope for. In fact, these legacy strategies can turn out to be a significant impediment to business’ ability to compete with their unhedged competitors.
The reason for these negative outcomes is that these traditional hedges are based on a naïve and fundamentally incorrect view of risk. It is also equivalent to betting that oil prices are going to remain the same or rise. As this year’s oil price change shows very clearly, prices also fall – sometime very rapidly.
Financial hedges of the type used by these airlines are designed to reduce price risk – the risk of volatility of fuel costs in this case. By holding a portfolio of financial hedging instruments, the value of which varies with the fuel price, the company consuming fuel is protected from increased fuel procurement costs by the rise in the value of the hedging portfolio. Unfortunately, the opposite is true – they lose money on the hedging portfolio if the fuel price goes down. This unwanted consequence is a function of the design of the hedging strategy – the hedging portfolio is specifically chosen to make the prices of their input costs less volatile (or even fixed).
The logic behind this hedging strategy is that, with more stable costs, companies can plan better, increase scale and generally have a better chance at surviving through the business cycle. This logic is internally consistent but is based on an incorrect view of risk from the point of view of the company that is being hedged. By assuming that all price volatility is bad and should be minimised, this strategy effectively assumes that price risks for companies are symmetrical. In other words, lower oil prices are just as bad for oil consumers as higher oil prices. This is clearly wrong – while fuel consumers definitely do not want to have to pay higher oil prices, they do want to benefit from lower prices. Their risk is thus asymmetrical, not symmetrical – so designing a hedging solution on the assumption of symmetry is fundamentally flawed.
It is a bit like saying when driving a vehicle that all speed is risk, and so the car must always be driven with its brakes on. While this strategy undoubtably reduces the risk of crashing, it also limits the ability of the vehicle to save time. After all this is a primary point of using a vehicle. Speed (i.e. taking risk) is required – but it needs to be done in a safe manner. Having access to brakes is vital when driving any speed – but it seems rather silly to have to choose between having the brakes being on all the time as opposed to only when they are required. A more appropriate hedging strategy would provide hedging protection when it is required and remove it when it is not required. More technically, it should provide a conditional correlation with price increases, and low (or no) correlation when prices fall.
Another common misconception about hedging is that using a financial hedge of this sort (i.e. to fix the price or reduce the range of possible outcomes) is a way to make what happens in the future less important to the company. In other words, there is the belief that if you’re hedged in this way you do not need to know what is going to happen in the future. The presence of the hedge makes the impact of both bad and good outcomes less significant.
However, reality is more complicated. As the current fall in the oil price shows, having a hedge of this type is only a good idea after the fact if prices go up. It is clearly a bad idea if prices fall lower than expected – ask the airlines right now! Implementing this type of fuel price hedging strategy is thus only a logical decision if a company holds an ex ante view that oil prices will only rise i.e. that they can predict the future of something which is not their core competence. In reality, commodity prices fall as well as rise and nobody knows when either – or both – will happen. Hedging solutions of this traditional type are not effective in both rising & falling environments.
Is there an alternative? Returning to the car speed/brake metaphor, what companies really need is the ability to brake when necessary, and to do so efficiently and consistently – but only when required. They need brakes with ABS (anti-lock brake systems) not just any old brakes. It is interesting to note that ABS was designed for airplanes. Unfortunately, it took about 50 years for widespread adoption of this technology in the motor car. Fuel consumers are similarly long overdue a comparable advance in hedging technology.
More advanced technology is currently available to fuel consumers to allow them to hedge their costs more selectively, and thus effectively. There is no perfect hedge, but asymmetric payoff profiles of the type needed in this context have been available in the investment industry for years. The use of systematic investment approaches can create the desired payoff profile which is significantly more attractive than current hedging strategies for companies confronted with price risks. In addition, the use of regulated funds (that contain the assets representing the hedging strategy), which a company can hold on its balance sheets to provide this protection, can also fundamentally change the experience for corporate clients. Regulated funds offer simplicity of administration, liquidity and clarity of values and costs. They allow a much cheaper and more flexible solution for fuel consumers of all sizes. This is a far more attractive to fuel consumers wanting to manage their financial risk exposures more intelligently and cost-effectively.
The current oil price shock has clearly highlighted the inadequacies of the current hedging solutions for corporates looking to improve their ability to take normal business risks. In the same way that ABS technology was transferred from airplanes to cars, it is time that investment management technology is transferred to corporate financial risk management through the provision of asymmetric payoff profiles in a regulated fund context. Like ABS, it will allow companies to take on risk in their chosen specialist area – in a safe and controlled manner – which is good for everyone.
[1] Andy Pfaff is the CEO of the Fuel Desk, a division of Coherent Risk Management (Pty) Ltd – a corporate risk management advisory company.
[2] “Forbes: Air France-KLM Faces $1 Billion Fuel Hedging Loss As Oil Price Falls Due To Coronavirus” accessed from: https://www.forbes.com/sites/willhorton1/2020/03/08/air-france-klm-faces-1-billion-fuel-hedging-loss-as-oil-price-falls-due-to-coronavirus/?source=bloomberg on 10th of March, 2020.
“Oil Slump Offers Scant Relief to Heavily Hedged Airlines”, accessed from https://www.bnnbloomberg.ca/oil-slump-offers-scant-relief-to-heavily-hedged-airlines-1.1402515 on 10th March, 2020.