Dart Group – Follow up on fuel hedging and comprehensive income
As proposed in the last Dart Group post, I wanted to take a better look at the impacts on fuel hedging.
Quick summary (or spoiler): During writing the post, I got less and less sure of what to do with the fuel hedges, so the post got very long without a satisfying end. If you are not interested in the process and accounting details, the result is: I am not sure.
Let us start with a “accounting refresher” first.
Accounting for Cash flow hedges
Dart Group uses “cash flow hedges” for their fuel hedges. What does that mean ? Normally, any derivative financial instrument would be considered a “trading instrument” and would have to be marked-to-market directly through P&L.
If a company however wants to hedge a future cashflow (doesn’t matter if in- or outflow) one can apply a technique called “cash flow hedging” which requires basically two things
1) one is able to predict future cashflows with a reasonable accuracy
2) one uses a heging instrument which is “efficient” i.e. tracks the value of the hedged
If one achieves “cash flow hedging” treatment, then the hedge will treated in the balance sheet (under iFRS) the following way:
A) the value changes in the derivatives can be recorded under “OCI” (other comprehensive income)
b) in the future, when the cashflow actually happens, the corresponding hedging gain or loss will then be added or subtracted from the then realised spot price
This is what Dart Group is doing with its fuel hedging and as Wexboy commented fully aligned with accounting standards.
However my argument was that you shouldn’t ignore those movements in OCI but try to understand them and make adjustments if necessary. In order to understand this better, we have unfortunately step beck a little bit and ask the following question:
What is a hedge anyway and when is a hedge a speculation ?
In the case of Dart and airlines in general, this question is quite difficult to answer. In an ideal world as a company, you would like to pass on all your changes in costs directly to your customers and just earn a fixed fee on your products. As we all know, prices on tickets are relatively volatile, however many clients prefer to fix a price well before they start a trip in order to be able to control their budget.
An airline could also, if they were really really good speculators, create a big competitive advantage if they for example could hedge their fuel at low prices while the competitors have to buy much more expensive fuel on the spot markets if prices are rising. However, this is clearly speculation, not hedging as it could go the other way as well.
accounting wise however, one does not distinguish between “economic” hedging and what I call speculation.
So let’s look at Dart Group.
First step: READ THE ANNUAL REPORT
Before one starts to speculate how and what Dart is hedging, it makes sense to look at the annual report to find out what they are actually saying.
On Page 21 of the 2011 report they give us the following information:
| 2011 | 2010 | |
|---|---|---|
| Average hedged Price per ton $ | 870 | 786 |
| Percentage of estimated annual fuel requirement hedged for the next financial year | 91% | 90% |
So we know now, that they have hedged ~90% of ALL fuel requirements according to this and we know the price.-
On page 67 we can look at fuel costs (in GBP):
| 2011 | 2010 | |
|---|---|---|
| Fuel Cost | 122.8 | 95.3 |
On page 57 we can see the fair values of the fuel hedges, both an the asset and liability side:
| 2011 | 2010 | |
|---|---|---|
| Fair value Assets Forward jet fuel contracts | 55.9 | 16.4 |
| Fair value Liabilities Forward jet fuel contracts | -17.8 | -8.7 |
| calc net Fair Value | 38.1 | 7.7 |
| Delta yoy | 30.4 |
On page 58 we can see that in 2011, none of the fair value movements have been recorded in equity, we can also look at the total fair value movement of the ALL hedges (including currency) which were
| 2011 | 2010 | |
|---|---|---|
| Fair value Assets all hedges | 59.4 | 21.7 |
| Fair value Liabilities Forwardalll hedges | -24.7 | -9.7 |
| calc net Fair Vlaue | 34.7 | 12 |
| Delta yoy | 22.7 |
So basically, fuel hedges increased by ~ 30 mn GBP in vALue, FX hedges lost ~ 8 mn GBP
On page 61 they give us another interesting piece of information:
| 2011 | 2010 | |
|---|---|---|
| Impact on Profit and Loss 10% change in jet fuel prices | 3.8 | 0.8 |
| 2011 | 2010 | |
|---|---|---|
| Profit for the year | 17.3 | 15.6 |
| Exchange differences on translating foreign operations | 0 | 0 |
| Effective portion of fair value movements in cash flow hedges | 23 | 10.6 |
| Net change in fair value of effective cash flow hedges transferred to profit | -1.8 | 0.1 |
| Taxation on components of other comprehensive income | -5.2 | -3 |
| Other comprehensive income and expense for the period, net of taxation | 16 | 7.7 |
| Total comprehensive income for the period all attributable to owners of the parent | 33.3 | 23.3 |
One important final piece of information:
Prepayments or “deferred income” stood a 177 mn GBP against trailing sales of 540 mn GBP.
So how to interpret those numbers ?
A) as the hedges seem to qualify almost completely as “cashflow hedge”, we can assume that they use “traditional hedges” like forwards or (tight) collars to hedge
B) IMPORTANT: Dart Group “hedges” 90% of next years fuel prices, but only 177/540 = 32% of (trailing) sales are prepaid. So one could argue that in order to “truly” hedge, Dart should only hedge a third of next year’s fuel consumption as for the rest, the final sale price of the tickets is still variable.
If the competitors don’t hedge, than Dart would have locked in potentially different fuel prices than the competition for 60% of next years fuel consumption and therefore run the risk of being uncompetitive if fuel prices fall.
So coming back to the initial question: What are we going to do with the change in value in OCI for dart Group ?
I have to say I am not sure anymore. I am oK with “ignoring” the part that is covered by deferred income but I honestly don’t know what to do with the part which is “speculation”.
I have quickly checked Ryanair’s latest statements and Easyjets last annual report.
While Ryanair similar to Dart seems to hedge 90% of next years fuel cost, Easyjet only hedges 65-85% of next years fuel charges and 45-65% of the costs in 2 years time.
Ryanair interestingly said that increasing fuel prices were responsible for a 29% profit decline. That sounds strange as they were supposed to be 90% hedged. Interestingly, fuel prices for Jet fuel decreased strongly in Q2, so the problem for Ryanair seem to have been locking in high fuel costs whereas some competitors were able to buy cheaper fuel in the spot market and compete better on ticket prices.
Bloomberg even compiles hedging ratios across companies:
Jet Fuel Hedging Positions for Europe-Based Airlines (Table)
2012-07-30 07:46:25.103 GMT(Updates with Ryanair.)
By Rupert Rowling
July 30 (Bloomberg) — The following table shows the amount
of jet fuel consumption hedged by European airlines to guard
against price fluctuations.
Data is compiled mainly from company statements and is
updated as it becomes available. Hedges are for prices per
metric ton of jet fuel, unless otherwise stated.*T
Company/ Percent Hedging Period Price
Disclosure Date Hedged
————— —— ————– —–Ryanair Holdings Plc
7/30/12 90% July to Sept. 2012 $840
7/30/12 90% Oct. to Dec. 2012 $990
7/30/12 90% Jan. to March 2013 $998
7/30/12 90% April to June 2013 $985
7/30/12 90% July to Sept. 2013 $1,025
7/30/12 90% Oct. to Dec. 2013 $1,005
7/30/12 90% 2013 $1,000
7/30/12 50% Jan. to June 2014 $940EasyJet Plc
7/25/12 85% Three Months to Sept. 2012 $983
7/25/12 79% Year to Sept. 2012 $964
7/25/12 77% Year to Sept. 2013 $985Air Berlin Plc
5/15/12 82% April to June 2012 Not Given
5/15/12 92% July to Sept. 2012 Not Given
5/15/12 61% Oct. to Dec. 2012 Not GivenInternational Consolidated Airlines Group SA*
5/11/12 80% April to June 2012 Not Given
5/11/12 69% July to Sept. 2012 Not Given
5/11/12 55% Oct. to Dec. 2012 Not Given
5/11/12 55% 12-month forward Not GivenVueling Airlines SA
5/10/12 76% 2012 $1,023
5/10/12 71% April to June 2012 $1,008
5/10/12 83% July to Sept. 2012 $1,035
5/10/12 74% Oct. to Dec. 2012 $1,042
5/10/12 28% 2013 $1,027Air France-KLM Group
5/4/12 60% April to June 2012 $1,081
5/4/12 53% July to Sept. 2012 $1,081
5/4/12 50% Oct. to Dec. 2012 $1,078SAS Group
5/3/12 50% April to June 2012 Not Given
5/3/12 49% July to Sept. 2012 Not Given
5/3/12 48% Oct. to Dec. 2012 Not Given
5/3/12 50% Jan. to March 2013 Not GivenAer Lingus Group Plc**
3/29/12 62% 2012 $972
3/29/12 7% 2013 $991Deutsche Lufthansa AG
3/15/12 74% 2012 $107/barrel
(Brent crude)NOTES:
*Hedging breakeven for 2012 at $1,003 a ton, according to May 11
presentation.
**Aer Lingus figures as of Dec. 31
Summary:
To be honest, I am not sure what to do with the fair value movements in OCI. To simply ignore them and assume mean reversion would be very naive. The extent of the movements is just too large. However the impact of the fuel hedging is difficult to estimate as it depends on the behaviour of the competitors.
In general, a positive movement in fair value should be positive for the company and vice versa. nevertheless, the whole fuel hedging issue exposes Dart to quite substantial business risk, especially for the part which is not covered by deferred income.
However, this exercise made it clear to me that running airlines is a quite difficult business, especially in times of volatile fuel prices.
For the time being, I will stick with my half position and try to learn more about it.
One technical remark with regard to hedging:
In the “good old times”, fuel hedging could be done without cash collateral. A bank would happily “step in between” the airline and the futures market and only require cash at settlement of the contract.
As one of the consequences of the finanical crisis, every bank now requires cash collateral on a short term basis from the airlines for the fuel hedging contracts. For the airlines this means a significant increase in reuqired working capital. Lufthansa et al are lobbying strongly against this, but especially for smaller carriers this is a problem.
As a proxy I would use 25% of the notional as working capital requirement for fuel hedges. For Dart this would mean that 25% of around 150 mn GP or 40 mn GBP of Dart’s liquidity should be considered as “locked” for fuel hedging cash collateral.
value and opportunity 