As we can see from figure 1. 2, the overall fuel cost for Easyjet has risen by 9. 7% from 2006 to 2007 and 66. 6% from 2007 to 2008. This big increase is a result of crude oil prices rocketing to $147/barrel. By studying the accounts from 2007 to 2008 Easyjet hedged 40% of the fuel at $735 per metric tonne compared to 66% being hedged at $1147 per metric tonne over the 2008-2009 period. In previous years Easyjet used forward contracts effectively to minimize fuel cost, however, in 2008 it is obvious Easyjet did not fully appreciate the economic climate.
With a worldwide downturn being predicted and a reduction in demand for oil from emerging economies such as China and India we believe Easyjet did not expect oil prices to drop drastically from exceptional highs of $147/barrel to lows of $32/barrel5. As fluctuations in fuel price will affect Easyjet’s performance, an increase in fuel cost (which is a very big proportion of total cost) will cause a decrease in profits6; therefore, higher cost per seat, as a result hedging must be seen as a viable option to control such fluctuations.
The aviation industry as a whole was affected adversely during 2008 due to the oil prices, however not all airlines were as badly affected as Easyjet who hedged 66% of its fuel requirements. We have looked into other airlines, to provide an indicator to the general hedging consensus. Lufthansa hedged 24 months out, building up their hedges by 5% per month, so by the time their hedging reached 85-90% it was already 18 months out. So by August 2008 Lufthansa had hedged 54% of its fuel requirements. Air France-KLM also have a similar approach to hedging but hedged 48 months out, 80% in year one, 60% year two, 40% year three and 20% year four7.
This policy limits the affect of volatile prices but they are taking the risk of paying more than the current market price. It should be noted that both Lufthansa and Air France-KLM have a different business model to Easyjet therefore will be able to invest more into their hedging strategies. In such volatile markets it was incorrect for Easyjet to lock in fuel prices over a period of 12 months, where in fact they should have initiated contracts over a smaller time period 3-6 months, as a 12 months period is not efficient, as the company cannot adapt to favourable conditions8.
Nonetheless the use of forward contracts is correct as it provides flexibility for Easyjet. Another option at Easyjet’s disposal is the use of futures contracts. Future contracts are very similar to forward contracts, except they are exchange-traded and defined on standardized assets9. The future option is not viable due to the above reasons as Easyjet have specific requirements such as different volumes required during a particular year that may well not be available on an exchange, therefore, their needs must be tailor made.
A third financial instrument that could be used to mitigate fuel cost risks is an option. The option can be divided into two subsections of a collar and a cap10. The collar works by allowing the airline to purchase put and call options based on a set range of oil prices. The airline trades off some of the upside cap by agreeing to a floor rate, below which the airline will not benefit. This is a good option as there are no upfront premiums that an airline needs to pay. Secondly, with the cap method the airline will pay a premium to buy an option to cap the maximum amount it will pay for its fuel in the future.
If the market price for a barrel of oil goes up, the carrier pays no more than the capped level. The cap is effective for airlines with a favourable credit risk. Both of the mentioned methods can be expensive due to volatility of underlying asset and counterparty risk involved but provide an excellent level of flexibility for Easyjet. Foreign exchange risk Foreign exchange risk is another major risk affecting Easyjet due to major input costs being in different currencies, for example fuel costs are priced in USD, and as mentioned previously, have a major impact on profitability of Easyjet.
Furthermore a selection of the planes used by Easyjet are leased from US suppliers the leases are also priced in USD. On the other hand, the widely held routes for Easyjet are European so the main proportions of their fares are in EUR and GBP. The foreign exchange market is very volatile with prices fluctuating every second, therefore Easyjet need to have a sufficient risk mitigation strategy in place to hedge against currency movements. As small as 1 cent change in currency either direction can cause significant changes in the profitability of the company due to the large volume of transactions.