About 40% of the capital of airlines is utilized on fuel consumption and oil procurement, hence affecting the business in numeral ways. The oil market is highly volatile. The controls of the prices are centralized to OPEC (Organization of Petroleum Exporting Companies).It is easy to comprehend that airline price stock returns are related to fuel price variations. Still, the relationship is not as simple to establish, given the volatility of oil prices and the strong influence of fuel prices on airline costs.The volatility of oil prices leads to uncertainties in airline operations like the cost of tickets, etc. To get some power over this situation, airline companies try to use various financial approaches—one of the most popular ones being hedging.
A fuel hedge contract is where an airline is allowed to purchase fuel at a predetermined cost. When the market is experiencing constant hikes, this strategy comes in handy to increase the certainty of fuel prices, which helps planning ticket prices and fleet planning instead of speculating. It also increases the competitiveness among different airlines.There are four significant ways in which airlines hedge against oil prices:
Purchasing current oil contracts –If the airline believes that there will be a hike in oil prices in the future, they can buy large amounts of fuel at the current price and store it for future usage.
Purchasing Call-Options-Under this approach, a price is fixed for a certain fixed amount of time. An airline can purchase the oil at that price within that period. The benefit being it is not obliged to buy, and they can change transactions if prices fall below fixed costs.
Implementing a Collar hedge-In this approach, a company buys both a call option and a pull option. A call option allows an investor to buy oil in the future at a price agreed upon today; a pull option allows the company to sell oil in the future at a price agreed upon today.
Purchasing Swap contacts-A swap locks a purchase of oil at a future price at a specified date. If oil prices decline, then the company can potentially lose much more than the call-option strategy.
The downside of hedging is that airlines miss-out on million-dollar savings when the price drops below contract values. To handle these various other strategies like purchasing new efficient aircraft, well-maintaining airplanes, optimized fleet scheduling to reduce flight cycles, and proper capacity planning helps big time. It is sometimes taken that when oil prices increase in the global economy, it’s natural that stock prices of airlines drop and vice-versa. But the relation is not that direct and several other factors affect airline stock prices. Moreover, short-term oil price swings don’t matter the change in stock values. Over more extended periods, stock prices aren’t tightly correlated with fuel prices. The absolute level of the fuel price is less critical to airline stocks than the rate of change in fuel prices and rival airlines’ relative hedging positions.
To consider this volatility (or rate of change in fuel prices) while relating oil prices and airline stock prices, researchers use GARCH models ( Generalized Auto-Regressive Conditional Heteroskedasticity ).This model is used to estimate the return volatility of stocks, bonds and other investment vehicles. It provides a more real-world context than other models when predicting the prices and rates of financial instruments. It aims to minimize errors in prior forecasting and to enhance the accuracy of on-going predictions. Other widely used methods are namely – Classic historical volatility method and exponentially weighted moving average volatility method.Airline companies use a lot of this data to make informed business decisions.