Dec 3, 2014

Airline Fuel Hedging Retreat: New Entrants and the Future of the Derivatives trading desk

Bank commodity trading desks have suffered significant losses over the past several years. In addition to new regulations and losing talent to hedge funds, another challenge has risen to the top of the list – fuel hedging.

As reported in a recent article in Risk Magazine, once a prosperous business for bank commodity desks, the airline fuel hedging business has seen a sizable drop-off. In this blog, Numerix FX expert Udi Sela examines this shift and discusses new entrants to the market, as well as the impact of new hedge account rules and the move away from derivatives to hedge fuel costs.

Weigh in and continue the conversation on Twitter @nxanalyticsLinkedIn, or in the comments section.


Video Transcript:

Jim Jockle (Host): Hi welcome to Numerix Video Blog. I’m your host Jim Jockle. Joining me today, Vice President of the Client Solutions Group here at Numerix, Udi Sela, Udi welcome.

Udi Sela (Guest): Thank you, Good Morning Jim. 

Jockle: As bank commodity desks have suffered many blows over the past year, whether it’s losing talent to hedge funds or seeing the closures of actual particular hedge funds, Risk.net came out with a very interesting article focusing on airlines moving away from hedging, specifically around jet fuel. So, I want to jump into a lot of topics today, but why don’t we start there Udi and perhaps you can give me a little bit of a summary of what’s going on as it relates to the departure of airlines, in terms of their hedging strategies.   

Sela: Well Jim, just with the starters, so indeed banks have suffered their drop in business and losses, and the same applies for hedge funds. And we recently heard of a few hedge funds closing down, specifically in a commodity space, due to the, let’s say, unprecedented move in the market. And the third type of player is of course, hedgers. In our example, airlines and where we see also, in at least the American larger Airlines, have reduced their hedging programs, if not stopped them completely. So yes, these three factors are to be played in. And of course, we’ve seen this massive (price) move in the market.                    

Jockle: One of the elements has been the lack of volatility around oil prices. I mean obviously there was when oil prices were high, going to 2008, but relatively stable. How much is that playing into the US airlines decisions as it relates to hedging strategies?

Sela: That’s a great question. Because actually, until recently, let’s say up to a few months ago, over the last 18-24 months, yes commodity prices, especially energy prices, were high, but were stuck in range. So basically when you feel comfortable and when security prices trade in range, most typically the implied volatility comes down and ultimately the urge to hedge.

Now if you’re a consumer of energy and of course airlines are a huge consumer of energy, the typical large American airline would consume; the budget for jet fuel would be 5-10 billion dollars, depending on the size of the company, you feel comfortable. Now, specifically American Airlines, if you take the CEO of American Airlines, his approach was there is natural hedge. If prices come off, then that’s good and there’s no need for hedging and if prices go up there is more demand. And if there is more demand, he has a natural hedge by actually applying his pricing power in raising airline tickets.

And indeed in Europe, this does not exist because in Europe they did not go through the same consolidation as the American airline industry, where you have practically 4 to 5 large groups. In Europe, the market is much more fragmented, the pricing power doesn’t really exist. It also has to do with different economic cycles in Europe, as opposed to America.      

Jockle: So it’s almost the same Wal-Mart effect, if you will, as it relates to price elasticity and oil in demand. 

Sela: Absolutely. 

Jockle: So one of the things that I found really interesting, that I didn’t realize, was with any shift in the marketplace, you have new entrants. Two new entrants that have registered as swap dealers under Dodd Frank were BP and Shell. We’re starting to see others emerge in terms of offering services. Tell us a little bit about that shift and balance.   

Sela: So I think we kind of touched this in other ways in video blogs we conducted together, again this is a regulatory arbitrage. So, the cost of doing business in the derivative space, well we’re discussing really in commodities, the cost for banks is much higher than for corporates. Now if you look at a company like Shell or like BP or RWE in Germany or GDF Suez in France, because this is their underlying assets, which is really petrol, or crude energy if you like, it’s really a vertical integration for them, it’s almost a natural hedge to deal in this market.

The other thing is, since banks have lost the appetite, plus the increasing regulatory cost, the fine traders are actually moving from the sell-side to the buy-side. And they bring the know-how and the knowledge of managing derivative books. So in a sense, it’s much more natural for those large energy companies to manage a derivatives book, and that’s what we see. 

Jockle: Well also, just thinking about the physical storage of that, we see, I think it was Goldman and Morgan Stanley removed elements of their commodities businesses, as not having to manage the physical storage of the commodities itself. So, as we go forward, I mean looking ahead into Europe, what do we see in terms of these new entrants and the robustness of hedging and how much of dealing with accounting rules are the airlines trying to manage as it relates to just move away from derivatives.  

Sela: Yes so, the consumption of the capital, that needs to be set aside when you trade forwards, (simple forwards where you can buy future) contracts, as opposed to buying an Asian option, is lower. Therefore, the appetite for these consumers to actually hedge is using less “Vanilla” products lower.

Now why the market (price) is dropping so dramatically and the reason is you plug geopolitical shift in the sense that America, the US, is becoming an exporter of oil and energetically independent. So that means that there is much more usage of fracking, and as a result there is much more supply of oil in the world, and therefore, you know, the urge, the story that we heard up to two years ago about shortage of energy is actually turned upside down. So therefore the appetite to hedging (against price hikes) is much more limited. And when people hedge, they tend to do that with more vanilla product.

And the third thing is, that in some cases corporates look at the counterparty risk. So I remember from my days as a trader that we used to look at corporates, but now corporates look at banks (for creditworthiness). And in some cases, some strong solid energy companies are perceived to be ranked higher in terms of credit worthiness as opposed to banks, that’s another thing. So I’d rather trade with a company that has the know-how, that has the underlying asset, and perceived to be stronger from a credit perspective. So again, this is something that drives business away from banks.   

Jockle: Well I think one of the things that are hopefully lessons learned, over the past few years is better transparency. Especially if you’re having more and more companies regardless of credit quality, providing that type of derivative type product. When we look at Enron with the regulatory rules and as a particular counterparty, the lack of transparency, which arguably, as an energy trading company, not as a power company, got into some particular problems. So hopefully, with the new regulation there may be much more transparency as it relates to these activities and offerings that different companies are now coming to market with. 

Sela: Yes, just as you mentioned, when we have those corporates, which we mentioned earlier, register as SEFs, it’s really a paradigm shift. Where the market-making will not just come from the sell-side. Where it’s pretty much like regular banks. 

Jockle: Well Udi, I want to thank you so much for joining us today. And obviously this is going to be something that we are going to watch, especially as we get to the end of the year totals of derivative trading. We want to get your insight as to the overall shift of issuance and notional outstanding as we’re continuing to see some declines as it relates to overall notionals in the OTC markets. Thank you very much. And I look forward to the opportunity to speaking with you again. 

Sela: Thank you very much for your time and organizing this, Jim. 

Jockle: And of course we want to talk about the topics that you want to talk about so, please feel free to follow us on Twitter @nxanalytics, or stay up to date with all our ongoing information into the marketplace on LinkedIn, or on numerix.com. We’ll see you next time, Udi.

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