Oil Companies Get Their Hedges Clipped
Why hedge?
The Wall Street Journal reported recently on the large hedging losses booked by oil companies this past year and how some of these companies are now revising their hedging policies to reduce future hedge positions (and losses) in anticipation of another year of high oil prices. The article comments on the inability of oil companies accurately to forecast future oil prices and raises fundamental questions about the purpose of hedging. So let’s ask and attempt to answer the obvious question: Why hedge at all?
In my corporate finance class, one of the most popular cases we study involves Jet Blue a year or so after its IPO in the early 2000s. The company is growing fast and the case asks us to consider different debt and equity financing strategies for the company. One of the business risks identified in the case involves the volatile price of jet fuel, a significant component of cost for any airline. This issue—how best to manage the risks associated with volatile jet fuel costs— always triggers an active discussion in class. Should Jet Blue hedge some or all of its jet fuel price risk? Why or why not? And if so, how?
In addressing these questions, many students initially focus on the current level of jet fuel prices relative to past prices rather than on the impact of volatile jet fuel costs on Jet Blue’s financial performance and position or the impact on Jet Blue’s growth strategy and competitive positioning. Instead of asking “How can Jet Blue best manage this particular risk” and “What are the merits of various alternative hedging strategies”, students instead debate the question “Is now a good time to hedge given the current price of jet fuel”.
This is not just a classroom phenomenon however. The same thing happens all the time in the executive offices and board rooms of major corporations. The specific risk being discussed may be the price of oil, aluminum prices, future interest rates or FX rates, the direction of the stock market or the future price of some particular company’s shares. At some point in the discussion the focus of debate inevitably shifts from “What are our company’s principal risks and how should we best manage them” to “What do we think the price of X will be in the future”.
Unfortunately for shareholders the track record of companies’ price speculation is not particularly good, even in their own shares, and the reason is simple. Not even the experts can reliably predict the future price of volatile and widely traded commodities and financial instruments. Oil companies don’t know the future price of oil; aluminum producers don’t know the future price of aluminum; banks don’t know the future level of interest rates or FX rates; and neither issuers nor investors know the future price of any company’s shares. If they did have this sort of crystal ball they could all make a lot more money in financial speculation than they do in their core businesses, but only if they could find someone naive enough to trade with them.
But what are the implications of this observation for corporate hedging strategy? If even the biggest and best companies can’t predict the future prices of their own products and inputs, how should they go about managing this sort of risk? Well, they could perhaps begin with a healthy dose of humility about their ability to predict the future and with a greater appreciation for the complexity of even seemingly simple risk management decisions. Jet Blue does not know what the future (spot) price of jet fuel will be even just a few months out. Nor does Jet Blue know how much jet fuel it will consume in any given future period. Or how its competitors and customers will respond to volatile fuel costs and changing ticket prices.
Jet Blue is now a large and well established airline, but the airline industry is and always has been notoriously competitive, cyclical and volatile. As a result air traffic volumes and airline profitability can change quickly and sometimes very dramatically, as was the case following the events of 2001 (9/11), 2008 (financial crisis) and again in 2020 (covid). Hedging against a large exposure to rising or volatile fuel costs may backfire spectacularly not only if the price of jet fuel moves in the wrong direction or at the wrong time but also if it turns out that fuel consumption or ticket prices have varied significantly from what was initially forecast, whatever the reason.
The implementation of hedging strategies entails some amount of transaction cost and execution risk, and this too should factor into our analysis. Forward prices reflect the current level of interest rates, price volatility and storage costs, and they are not empirically a good predictor of future spot prices. Option contracts entail leverage and transaction costs, even so-called “costless collars”. The market for hedge products—futures and forwards, options and swaps—is not always liquid in terms of market size or hedge tenor and what liquidity there is today might dry up tomorrow, which often seems to happen exactly at the wrong time (when one wants to unwind a large hedge or put on a new one). And many hedging strategies involve some significant element of “basis risk”, the uncertain and changing price relationship between the specific risk being hedged (eg jet fuel of a certain grade delivered to a specific location on a certain date) and the terms of the derivative product actually employed to hedge the risk (eg standard WTI oil futures contracts traded on the NY Mercantile Exchange).
Even with a sound hedging strategy and the perfect hedging product to use, however, one should still ask whether hedging is a good idea and if so why. The largest oil companies generally do not hedge much of their future production price risk, in large part because they can afford to absorb even very large losses resulting from volatile oil prices. The oil majors generally have large and liquid balance sheets with substantial amounts of equity capital (retained earnings) and relatively little debt (historically), and so it really does not matter too much to them (or to their shareholders) if profits bounce around from period to period due to changing oil prices. But it may also be the case that the oil majors don’t hedge much because their shareholders would prefer to manage oil price risk themselves at the portfolio level rather than have their portfolio companies do it for them.
So why do smaller oil companies, many airlines and other companies engage in so much hedging activity? The answer is generally because they are relatively small players in highly cyclical, competitive or volatile industries, have funded themselves with loads of debt rather than equity, and/or don’t hold much excess cash to protect agains the proverbial rainy day. For these financially vulnerable and unstable companies, hedging can provide some much needed financial cushion to protect against adverse credit events without the dilution associated with raising or retaining more equity capital or sitting on more cash. (There are also some practical benefits associated with the budgeting and business planning process, which are quite real but which I will skip over for purposes of this discussion.)
Hedging activity may be great business for banks and other financial intermediaries, but it isn’t always the right thing to do for companies or their shareholders. Hedging is just one way to manage risk and it isn’t always the most effective or efficient strategy to employ. And even when it is, things sometimes go wrong and hedges break down or “get clipped”. At the end of the day hedging is just one aspect of financial strategy and enterprise risk management, which is what we study in my corporate finance class with the benefit of real world cases like Jet Blue and the reporting on current events provided by the WSJ and others.
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