Unwinding a Hedge

According to a recent Reuters article, Singapore Airlines has announced it plans to retain a hedge that locked in the cost of two-thirds of its jet fuel requirements through the end of March 2015. Other airlines have removed their hedges. Whether you are an airline, a farmer, a manufacturer, or a mining operation, what are the consequences of unwinding a hedge early?

Any business that hedges a commodity price risk has made a decision to mitigate a certain risk. In the case of an airline hedging its jet fuel costs, it is attempting to prevent financial losses, should the cost of jet fuel increase. The airline’s hedger makes a financial commitment to buy the fuel over a certain time period at a fixed cost, usually the market price for those anticipated months of usage. The form of the hedge is typically a “long” position in financial derivatives or in some other contract that would enable the company to acquire the fuel at a locked-in cost. These derivatives could be futures, swaps, or forwards. Or, they could be options that would allow the hedger to acquire any of those derivatives at favorable cost later, should the market price increase.

In this case, Singapore Airlines had entered into a hedge to lock its cost at $116 per barrel. Current pricing is $63 per barrel. If prices stay the same through the remainder of the hedge period, they will lose $53 per barrel on the hedging derivatives from now until the end of the hedge. Yet, the hedge has worked exactly as originally designed: they locked their cost in at $116 per barrel. With perfect hindsight, I’m sure they wish they had not hedged the risk. Yet, there is a bigger picture. They may have recouped some or all of those losses through their ticket pricing strategy. Whether or not they have is beyond our scope and irrelevant to our discussion, but most hedgers are seeking to reduce risk rather than increase it. So, I suspect they had an offsetting benefit to curtail the negative effect of the derivatives.

Unwinding a hedge early usually means cashing up the derivatives and recognizing any embedded gains or losses. The company may simply be able to go out into the futures market and offset its positions by selling like contracts. Or, it may execute a swap agreement that negates the future effect of the existing derivatives until they expire or mature.

Once a hedge has been unwound, the risk that gave rise to the hedge is no longer mitigated. For example, it is possible, although perhaps highly improbable, that jet fuel could be priced at $150 per barrel by next month. Since Singapore Airlines is retaining its hedge, today’s large losses embedded in its derivatives would turn into gains, at least for the portion of time that jet fuel traded above the locked-in cost of $116 per barrel. Had it closed its hedge early, it would have lost $53 per barrel on the derivatives, and another $34 ($150 – $116) per barrel on the jet fuel itself. Even if prices only rebound to $70 per barrel, the company would be better off retaining its hedge because the derivative losses will not be as large as when jet fuel is priced at the current price of $63 per barrel. Without a hedge in place, any subsequent rebound in the cost of jet fuel will cost the airline additional money.

Although it is difficult to “be wrong” about the direction of a commodity price, true hedgers don’t think that way. They are not speculating on the direction of the price. Rather, they are eliminating the risk of an adverse price change.

If you are a hedger, be very thoughtful about unwinding a hedge. When you remove a hedge, you are removing the protection you originally put in place. There may be instances in which the hedged risk has declined significantly, whereupon early hedge removal may be prudent.

If you were running Singapore Airlines and considering removing its hedge on jet fuel, you would want to consider the following: Do I want to speculate that the cost of jet fuel is going to continue to decline through the end of our hedge period? Absent further information about the business, that is the only scenario under which removing that hedge early will benefit it. If the risk of jet fuel prices increasing above $116 per barrel was such a high concern at the inception of the hedge, wouldn’t today’s risk of prices increasing also be significant at the much lower price of $63 per barrel?

Although we don’t know all of the business factors (particularly revenues from customers) that would lead to these decisions, the fundamental questions are the same for any hedger of any commodity in any industry. Don’t compound one loss into another by a knee-jerk reaction that lacks the discipline of a effective hedging program. Weigh all factors carefully and remember the risk.

Note: There are accounting ramifications to unwinding a hedge early that may affect the timing of when related gains and losses are recognized, the disclosure of such gains and losses in the financial statements, and perhaps even the timing of inclusion of such gains and losses on the company’s income tax returns. Accounting for hedges is extremely complex, so consult with your accounting professional.

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