Brussels Airlines future and financial perspective

[Inquirer]

I think some people are in need of a simple explanation on how commodities (like oil) are generally hedged.
I may not know a lot about airlines, but I happen to be fairly into 'collar contracts' which are used to lock a price range of a commodity and protect both seller as well as buyer at the same time, so I will write an easy to understand explanation of this rather complicated method in order for all those who think hedges come with no bottom as that is obviously wrong.

I'll come Bach to this topic later.

[FlightMate]

Inquirer, believe me: SN wants to see the price of oil going down, even if seeing prices go up means they will benefit from their hedging. (paper profit)

[Inquirer]

Of course,but the point I make is that when you are hedged by means of a collar construction (which I know them to be for a fact), any drop in oil price is tapered off for the duration of the hedge, just as much as any increase in oil price intuitively is, something many here seem to be unaware of.

I'll write an easy to understand explanation on how commodities are hedged and why flankers assessment that Brussels airlines has reaped the full fruits of the rapidly dropping oil prices this year already, is most certainly not correct. In fact, I'd say they have a big chunk to come still next year (provided they aren't hedged several years ahead).

In case you want to know: I've been into commodity trading for a while, so somebody accidentally stepped into my turf, so to say.

[sean1982]

You guys should start an airline together .... If the deeds are as good as the words it will be an instant hit.

[fcw]

Of course,but the point I make is that when you are hedged by means of a collar construction (which I know them to be for a fact), any drop in oil price is tapered off for the duration of the hedge, just as much as any increase in oil price intuitively is, something many here seem to be unaware of.
I'll write an easy to understand explanation on how commodities are hedged and why flankers assessment that Brussels airlines has reaped the full fruits of the rapidly dropping oil prices this year already, is most certainly not correct. In fact, I'd say they have a big chunk to come still next year (provided they aren't hedged several years ahead).

In case you want to know: I've been into commodity trading for a while, so somebody accidentally stepped into my turf, so to say.

Hedging in aviation industry is quite different. There are no over the counter contracts.
Most fuel hedges are purchases of an oil or gas future and not even aviation fuel. Most of the time this is done with combined puts and calls, which would indeed top off the benefit in case of a drop in fuel price.
BUT: Contracting future prices requires a guarantee that the company can pay the losses if the contract goes against the airline. No one wants a bet with someone who cannot pay off if they loose. An airline near bankruptcy cannot come up with the margin requirements to back futures commitments. They cannot post a credible bond.
There is a way for such airlines to hedge that does not require a margin. Airlines can buy a ‘call’ option that pays off above some upper bound on oil prices. This requires cash and that is probably the reason behind last years LH credit line..
This call option covers you when the oil price rises and in case the oil price drops the benefit is all yours. The worst case is a stable oil price at the strike price as then you loose the premium paid for the 'call' option and you pay your fuel at the highest possible price.

[Inquirer]

Well, my social obligations for the day are done, so I got some time to come back to this topic with an attempt to make a few things clear concering hedging, as all too many people seem not to have a clear view on what it is, how it is technically done these days and what is possible because of it, so this is an attempt to shed some light on it, as all too many people here have clearly no real world experience with it, and quote simply from a somewhat outdated schoolbooks.
(yes, the world changed since 2008, in case you haven't noticed it yet)


First of all, as good as all airlines use structured financial products to protect against the volatility of fuel prices.

The first structured financial product which immediately comes to mind is a swap: in an oil swap a buyer agrees with a supplier to buy a certain quantity of oil at a certain price. The average price over a given period is subsequently compared with the contractual price: if it exceeds it, the oil supplier will refund the difference. However, if the average price turns out to be lower, then the buyer will have to pay up the difference. Swaps generally have no capping at either end and so can become very high risk if market volatility is high for either party, hence they are considered speculative structural products and not very popular.

Airlines have traditionally tried to control volatility of fuel prices is through purchasing options.
In buying a call option on fuel the airline buys the right to a pre-agreed quantity at a certain price (called the strike price). Contrary to a swap, there’s no guarantee to the seller that the airline will actually call the option, so taking an option always comes at a cost (called the premium) but it does allow protection from any significant upswing of fuel prices. If prices stay go however, the airline can take full benefit from the lower market price (contrary to a swap), but it will lose the premium paid.
A popular way to avoid losing too much on premiums is by combining a call option with a put option.
In this so-called collar deal, the airline first protects itself from rising fuel prices by buying a call option and then annuls the cost of the premium paid for this protection by selling a put option in case prices drops below a certain lower level, for which it receives a premium from that buyer, thus lowering the protection cost, but because of this put option however, the extent to which the airline can profit from any reduction in fuel prices is therefor limited, as the fuel price is effectively locked within a certain bandwidth.

However, these days, banks are not very eager to secure deals which are 'simple' collar deals and so many airlines (incl. Brussels airlines) have been using a more complicated variant of the above, known as a double collar (or 'four-way' in the USA) because of tighter rules on risk mitigation.
In such a double collar deal, the airline purchases one call option and sells a second call option with a higher strike price than the first call option. Then, the airline sells one put option combined with the purchase of another put option with a lower strike price than the first put.
(read it over a few times in case I've lost you).
That way most of the advantages of the old fashioned collar are still guaranteed to the airline, while the potential losses to financial counterparties holding the put options are more contained and thus more easily accepted by them. The main consequence of this is however that there’s now a further cap on the immediate profit from any drop in fuel prices, which is of course the whole point and was in fact the starting point of this discussion.

[sn26567]

Thanks for these clear and extended explanations, Inquirer.

[Flanker2]

Mr. Inquirer, I'm sorry but you don't know what you're talking about.

As fcw and Flightmate clearly point out, the purpose of hedging is not to lock the prices, but to protect oneself from major fluctuations, no matter how many constructions and tools you use to cap your losses. If you want to get the technical reason for this: as a hedger, you will always choose options with strike prices spread far enough from current spot prices. If you take options too close to current spot prices, the risk increases beyond the purpose of the hedging, it becomes Las Vegas, because it no longer protects against large fluctuations, which is exactly what airlines are most worried about.

With the small fuel price fluctuations seen in the past 2 years, I doubt that any options purchased under hedging contracts would go into the money, and if they did in the disadvantage of the airlines, the spread of the strike price versus spot price at purchase would have been significant enough as to reduce the intrinsic value resulting of any decrease of the futures, and make the airlines benefit from the decreased direct-purchase fuel prices much more than they lost from the exercised put option that they sold.

[b-west]

Mr. Inquirer, I'm sorry but you don't know what you're talking about.

That's funny, that's what I think when you make claims like "N'djili is only a few blocks away from the Memling hotel"

[Pocahontas]

Nobody knows except for one person...

[Airbus330lover]

Mr. Inquirer, I'm sorry but you don't know what you're talking about.

That's funny, that's what I think when you make claims like "N'djili is only a few blocks away from the Memling hotel"

Quite normal..... NLO is perfect for the SN Q400 (Allo Mr de St Exupery.....)

[Flanker2]

I find it quite insulting and condescending that Inquirer thought that he was going to teach a "lesson about finance", to us, to his eyes blatant ignorants.
So I think that my comment was appropriate to teach him a lesson about humility, unless you agree with his attitude mr. B-West and Airbus330Lover?

[AvroRider]

Well I must say that Inquirer post was interesting and his explanation was clear and correct. He was not teaching us a lesson, but took some time of his private life to explain us fuel hedging. That´s how a forum work IMHO.

Talking about humility Flanker2, you are far from being in the position to have such comment. As you think that your posts and comments are the only "true" truth and others arent´t. Maybe humility is not a word you understand.

In French we say : "C'est l'hôpital qui se moque de la charité."

[b-west]

come to think of it, this post can be deleted. I won't let myself get dragged into a cat fight

[fcw]

Inquirer gives a very clear explanation about futures. It is the first time I see it explained so clearly in so few words. I must admit the double collar is something unfamiliar to me.
Whilst the double collar makes it less difficult for troubled airlines to find buyers for their futures it also limits the advantage you can take from a decreasing oil price. But there still is an advantage for the airline to be made till the oilprice reaches the highest of the put strikes.
To make it clear with an example:
oil price on 1/1/2013: 100$
Bruair buys a call at 110 and sells another one at 120
sells a put at 90 and buys another one at 80.
BruAir takes full advantage of the fuel price if it goes down from 100 to 90.
Likewise it is only when the price goes above 110 that the hedging will be beneficial.
As the fuel price went down this year BruAir did benefit from it, unless they collared very tight, but I doubt a company in difficulties would find a buyer for a put close to the actual price. If you want to limit your risk to zero you will not buy your Insurance from a company in difficulties, who might not be able to pay out should there be a need.

[FlightMate]

Quite an informative post, inquirer. Thanks.

What I take out of all that, is that maybe it's not worth trying to be smarter than the fuel companies

[Flanker2]

As the fuel price went down this year BruAir did benefit from it, unless they collared very tight, but I doubt a company in difficulties would find a buyer for a put close to the actual price. If you want to limit your risk to zero you will not buy your Insurance from a company in difficulties, who might not be able to pay out should there be a need.

They can't collar tight indeed, because then you aren't hedging anymore.
The closer the strike prices are to your current spot prices, the higher the chance that you would come out at a loss. If prices decrease strongly, you see all your benefits of decreased fuel prices dissipate. Also, buying close at strike price nulls all the advantage of setting up such a contract, you could just as well save the contract costs and stock exchange taxes and not hedge at all.

The double collar would only become relevant if the fluctuations were huge... so it's totally irrelevant in this discussion because the year-on year fuel/oil price fluctuations were within 10% year on year for the past 2 years. Hedging at strike prices within 10% is not done in the airline world, it's the called the "cost of doing business".
So the explanation of "double collar" forced upon the airlines by the bank to cap the bank's risks is totally irrelevant, as is the assumption that SN didn't benefit from the decreased fuel prices.

You thought that you were going to blow me away with that?
I trade plenty on options, futures, and combine collar constructions with turbos and sprinters to cap my losses. I got accounts at Lynx and Binck Bank. I was very curious on what miracle explanation you would pull out, but I'm very disappointed that you're totally off.

Inquirer trying to show off with his "knowledge" but totally off-topic...owch.

Anyways let's not get dragged away from the real discussion, SN's reduced loss is mainly owed to higher euro and lower fuel... their hedges aren't going to change that.

[sean1982]

As the fuel price went down this year BruAir did benefit from it, unless they collared very tight, but I doubt a company in difficulties would find a buyer for a put close to the actual price. If you want to limit your risk to zero you will not buy your Insurance from a company in difficulties, who might not be able to pay out should there be a need.

They can't collar tight indeed, because then you aren't hedging anymore.
The closer the strike prices are to your current spot prices, the higher the chance that you would come out at a loss. If prices decrease strongly, you see all your benefits of decreased fuel prices dissipate. Also, buying close at strike price nulls all the advantage of setting up such a contract, you could just as well save the contract costs and stock exchange taxes and not hedge at all.

The double collar would only become relevant if the fluctuations were huge... so it's totally irrelevant in this discussion because the year-on year fuel/oil price fluctuations were within 10% year on year for the past 2 years. Hedging at strike prices within 10% is not done in the airline world, it's the called the "cost of doing business".
So the explanation of "double collar" forced upon the airlines by the bank to cap the bank's risks is totally irrelevant, as is the assumption that SN didn't benefit from the decreased fuel prices.

You thought that you were going to blow me away with that?
I trade plenty on options, futures, and combine collar constructions with turbos and sprinters to cap my losses. I got accounts at Lynx and Binck Bank. I was very curious on what miracle explanation you would pull out, but I'm very disappointed that you're totally off.

Inquirer trying to show off with his "knowledge" but totally off-topic...owch.

Anyways let's not get dragged away from the real discussion, SN's reduced loss is mainly owed to higher euro and lower fuel... their hedges aren't going to change that.

You need to put your reading glasses on, it wasnt even inquirer who posted what you quote
Guess we can drop the smack talk as well then?

[teddybAIR]

guys, I've been a loyal luchtzak member for the last 10 years, but I must admit that I am increasingly reading other fora since this one is becoming dominated by a limited number of forum members who turn every single subject in a pissing contest! Honestly guys, is it that hard to keep a positive tone of voice in a simple conversation about the financial perspective of a particular airline?!

This is the first and last general comment that I will make on the general atmosphere on luchtzak.be. I've known this website to have huge traffic numbers and virutally unlimited interesting subjects opened weekly with constructive discussions going on. There is a reason why this is not the case any more: people don't want to come to a forum to simply argue and Always have to defend their point of view.

Can we in 2014 try a little more to accept the fact that points of view can be different and that that very fact is why we can have interesting discussions? If we'd all agree in the first place, a discussion forum would probably be the most dull place in the world now wouldn't it.

Best regards,
bAIR

[sn26567]

Can we in 2014 try a little more to accept the fact that points of view can be different and that that very fact is why we can have interesting discussions?

Wise words that I strongly support, with the hope that all our readers will comply.