Unpredictable and Unstable Prices of Fuel

The global airline industry’s fuel bill was approximately $181 billion in 2015 and expected to decrease to $ 127 bn in 2016 (accounting for 27% and 20% of operating expenses respectively). However, these numbers are more than 4 times of 2003’s fuel bill of $ 44m and accounting for just 14% of operating expenses .

Fuel prices are highly volatile. Hedging allows the airline companies to fix or cap their fuel prices, protecting them from sudden rising fuel prices and thus having a more stable profit stream over the years. In 2008, high fuel prices resulted in losses of $ 26.1bn in the airline industry , which could have been avoided or reduced by hedging. Low volatility in profits and smooth cash flows also enable the companies to increase sustainable level of debt financing, therefore increasing the value of the firm from tax shield as well as the increase the stock prices. Minimising cash volatility and generating internal cash flows also protects a company’s ability to fund opportunistic investments in times of recessions. Moreover, hedging reduces the impact of agency problems either between bond and equity holders or management and shareholders. Reduced risks decrease the probability of a financial distress and also reduce volatility of riskier projects, which might be unattractive to managers despite high NPV due to shorter horizon but attractive to shareholders. Lastly, hedging allows companies to reduce their tax bill through smooth profits as corporate tax rates increase.

However, hedging comes with its share of disadvantages. While hedging protects airline companies from rising fuel prices, it also prevents savings from decreasing prices. For e.g Delta Air Lines suffered losses of over $ 1.2 bn in 2015 from the drop in fuel prices . Such situations also prevent the airline to lower its prices, while other competitors might be doing so, thus causing the risk of loss of market share. Furthermore, airline companies incur additional costs to maintain an active risk management policy while the owners of the companies, being the investors, are assumed to have a diversified portfolio and thus already elimination a high proportion of their risk through diversification strategy. Hedging also comes with additional costs in terms of bid-ask spreads and other trading charges. The companies need to engage cash to fund the margin calls and also maintain a higher cash balance on their balance sheets.

Fuel cost is the single largest costs of Ryanair and accounts for 43% of its cost base. However, the price of fuel is very unpredictable, rising from $28.8/barrel in 2003 to its peak of over $140/barrel in 2007 and falling down again to $ 55/barrel in 2015. Therefore, it is very important for Ryanair to manage the risk associated to its biggest cost element to avoid any earnings surprise and thus hedge its fuel price risk.

For the FY17, 95% of its fuel is hedged at approximately $62bbl and 44% hedged for FY18 at approximately $ 50bbl .

Hedging protects Ryanair from rising fuel prices. Given that Ryanair’s revenue is mostly in Euro, it also hedges its US Dollar exposure. The relationship between US Dollars and fuel prices has been historically consistent in the sense that when the dollar strengthened, the fuel prices would fall and vice versa. Therefore, if Ryanair makes any losses on its fuel price hedging in times of falling prices, this will offset against the gains from the US Dollar hedging and thus reduce the impact on its Income Statement.

Ryanair has total debt amounting to EUR 4bn and total equity of EUR 3.59bn on its balance sheet for its FY16 . In order to be able to meet its debts interest obligations, Ryanair needs to ensure consistent and smooth cash inflows in the company. This can be achieved by hedging its fuel risk to avoid any sudden drop in profits and cash flows from high fuel prices.

Ryanair is consistently expanding and increasing its fleet size in order to cater for its increase in number of passengers and new routes. It has increased its fleet from 272 in 2011 to 308 in 2015 and plans to have over 520 planes in operation by 2024 . Such expansion requires high capital expenditure. A consistent cash flow will allow Ryanair to have more internally generated cash flows for financing its fleet, thus saving on costs associated to external fundraising.

Ryanair’s strategy focuses on offering its customers the lowest prices. In order to maintain the lowest price, Ryanair cannot afford to take unforeseen risks of rise in fuel prices, which could lead to fluctuations in its ticket prices.

Therefore, it is advised that Ryanair continues to hedge its fuel risk.