Should SIA review its fuel hedging policy?

WHILE anyone holding Singapore Airlines (SIA) shares can appreciate that Covid-19 has dealt an unprecedented blow to the entire air travel industry, it may be time to question if SIA's unique policy of hedging its jet fuel costs five years into the future has exposed shareholders to more hedging losses than necessary.

Fuel is the biggest expense item for SIA, as it is for most airlines. To insure itself against rising oil prices, SIA's strategy is to hedge a large proportion of its projected fuel needs. This is done primarily using swaps. Airlines lose out whenever spot market prices fall below their hedged prices, as the swaps require them to make payments to counterparties, such as banks, on specified dates.

At the end of January, SIA had hedged 79 per cent of its fuel requirements for the next two months at US$76 per barrel.

For FY2021 ending March 31 next year, SIA has hedged 73 per cent of its anticipated fuel needs at average prices of US$74 per barrel for jet fuel, or US$58 per barrel in Brent crude oil hedges.

As for the next four years until end-March 2025, SIA's fuel needs are already hedged up to 59 per cent at similar prices.

But following an oil price war among the major producers, and with the virus keeping many economies in deep freeze, Brent prices are now well below US$30. SIA, meanwhile, has been forced to cancel 96 per cent of its scheduled flights up to the end of June.

SIA said in an April 15 operating update: "The scale of the flight cuts means that the SIA Group is now in an over-hedged position with respect to fuel consumption. Surplus hedges will need to be marked to market as at March 31, 2020, a date on which the Brent oil price was close to its 10-year low, and are expected to generate substantial losses."

UOB Kay Hian estimates that SIA could have incurred about S$2.5 billion in marked to market losses by end-March, which implies a S$2.10 per share reduction in book value. DBS Group Research expects SIA to incur a fuel hedging loss of at least S$1.2 billion for FY2021 if oil prices stay low.

Unusual strategy

The long-dated hedges amount to SIA having taken a view that oil prices would climb higher in the coming years, at a time when oil markets are experiencing unprecedented volatility.

One analyst told The Business Times: "Any institution should have stress-tested to see if its balance sheet can withstand such huge volatility arising from a tail risk. So yes, long-dated forward hedges at such high proportions are highly risky."

For example, SIA consumes around 40 million barrels of jet fuel a year. Hedging half of that expected consumption for five years would give the airline a theoretical exposure of 100 million barrels.

SIA's long hedges stand out in the industry. According to a Morgan Stanley tally of public company statements published last July, SIA leads global airlines in the number of months forward that it hedges its fuel requirements. SIA hedges 60 forward months, followed by Southwest at 45 months, then Japan Airlines and ANA at 36 months. On the other side of the spectrum, many Chinese airlines do not hedge at all.

Most airlines do not hedge beyond two years because crude futures prices tend to flatten out beyond that and are less liquid. It is more common for airlines to hedge their requirements within the next year.

In terms of the proportion of forward 12-month fuel requirements hedged, Qantas led with 97.5 per cent. Ryanair hedges 90 per cent, SIA 68 per cent, Southwest 67.75 per cent and Virgin Australia 67.5 per cent, according to the report. Seventeen of the 33 airlines tallied hedged more than 50 per cent of their 12-month forward jet fuel consumption.

Changing parameters

It should be noted that SIA's hedging policy has evolved over the years. In the past, SIA used to hedge fuel only for a maximum period of 24 months out.

SIA first announced that it would extend some of its Brent hedges to as long as five years in February 2017, covering 33 to 39 per cent of its projected annual consumption. Analysts made no objections, and some were even optimistic about the strategy. SIA was taking a view that oil prices would go up, but in "a safe manner", one analyst had commented at the time: "It's only one-third. If they are wrong, they're only partially wrong. They're not humongously wrong."

But SIA was still in a net cash position then. Its capital expenditure commitments and net gearing have risen steadily since. UOB Kay Hian has projected SIA's net gearing to rise to 1.20 times as at end-March 2021, from 0.28 time as at end-March 2019.

And although SIA has reaped hedging gains in the last two years, its balance sheet is also weaker today.

As SIA goes before shareholders on Thursday for permission to raise more than twice its current market cap in cash, SIA's board needs to assure investors that the parameters of SIA's hedging programme have been carefully considered.

Asked if SIA is reviewing its fuel hedging policy in light of this year's losses, an SIA spokesperson told BT: "Our fuel hedging policy is designed to mitigate the impact of the volatility in fuel prices... SIA is open and transparent about our fuel hedging position, which is disclosed every quarter along with the quarterly results announcement.

"Given the unprecedented impact of Covid-19 on both the air travel industry and oil prices, and the high level of uncertainty in both markets, we plan to monitor developments closely."