By Ashok Mittal
Of late airline companies in India have been crying hoarse against rise in fuel prices and have responded by increasing the fuel surcharge. So are the hunky-dory days of Low Cost airlines over? That seems to be the case with rising fuel costs forcing airlines to increase airfares, slash discounts. Even premium airlines are also feeling the heat. Indian airline companies are cutting flights and postponing plans for fleet acquisition due to lower revenues caused by rising fuel prices.

In fact over the previous eight months crude prices have increased over 70 percent, from nearly $80 per barrel in October, 2007 to $135 per barrel in May, 2008. A similar increase was seen in the case of Arabian Gulf Jet prices. Even with this price increase, IATA has forecast the loss in aviation sector to be nearly USD 2.3 billion (more than 9500 crores) in 2008.

Aviation Turbine Fuel more popularly known as ATF, continues to be the single largest cost factor for airlines constituting nearly 40 per cent of the total operating costs. Hence as ATF prices start to increase, airlines typically respond by raising fuel surcharges. Only Rs 225 of the surcharge is payable to AAI (Airports Authority of India); the balance goes to the airlines.

In the past six months alone, fuel surcharge has increased from nearly Rs 950 to Rs 2,350. That’s nearly an increase of more than hundred percent. Considering a basic fare of Rs 1,000 and other charges, cost of flying has nearly doubled. That is deterring the low and middle income group travelers who were beginning to switch to air travel mode from travelling by railways.

So is there a way out or will the era of low cost carriers come to an end overburdened with rising fuel costs? With relentless oil price fluctuations, the only answer for Indian Airline companies is to take a leaf out of the book of their global counterparts and incorporate a sustained hedging programme to maintain fuel cost as a percentage of total expenditure.

The best example is that of Southwest Airlines whose hedging against rising fuel costs has helped the discount carrier soar high above its competitors. Southwest treasurer Scott Topping mentioned in an interview that with their hedging advantage, they have enjoyed more flexibility in managing revenues. Southwest locked in oil at $51 a barrel prior to crude's yearlong run-up. For the first nine months of '07, the Dallas-based carrier realized gains of $427 million. Those hedging profits, a result of a shrewd call by Southwest CEO Gary Kelly, have kept costs down.

So why were Indian companies reluctant to follow the same especially when the RBI had allowed Indian airline companies to hedge their ATF price risk as early as May 2007 when crude prices were trading at nearly $70 per barrel? The question arises here is why these Indian airline companies did not take a decision to hedge their price risk through derivatives – was it lack of understanding of the hedging mechanism or something else? In my view that lack of understanding would not have been the case as the managerial personnel of these Indian companies come from excellent academic background and have vast experience.

So was it a fear of accounting for “Hedging loss” in the books of accounts? The important point to remember here is that hedging is a tool that neither gives profits nor makes losses but fixes the cost and protects the margins. If they had fixed the cost of ATF to some extent they not only could have continued their operations with cost almost fixed for their operations but also kept their customers happy offering them very competitive prices. Almost 74% of 40% that is about 30% of the total operational cost (which is the cost of fuel) would have been fixed and there was no need to worry for increase/ decrease or volatility in aviation fuel prices. Most of the other costs any way are fixed in terms of ground handling cost, manpower cost, lease and rentals etc.

So how can airlines hedge their ATF risks especially when ATF is not traded on any commodity exchange across the world? The answer lies in surrogate hedging which basically means choosing an alternate commodity which has a high degree of price correlation with the original commodity. In this case since ATF is unavailable, we will have to look forwards to hedging in either crude oil or heating oil.

The viability of surrogate hedging can be established from the fact that there is strong correlation between Arabian Gulf Jet Fuel Prices (this is the basis taken by India oil marketing companies for declaring their ATF prices) and NYMEX WTI Crude prices. The price correlation between these two has ranged from 0.96 to 0.98 over the previous five years. In the case of Indian airline companies, they should go for surrogate hedging on MCX Crude Oil contracts, because hedging on the NYMEX would also involve hedging foreign currency risk thereby involving additional costing.

MCX is India’s largest commodity exchange, and in terms of liquidity is the fourth largest commodity exchange in the world as far as volumes in crude oil is concerned. Indian airline companies willing to hedge on MCX Crude will be exposed to the same volatility as NYMEX WTI Crude as the price correlation between these two has ranged from 0.97 to 0.99 over the past three years since the launch of crude contracts on the MCX platform.

However before an airline undertakes a programme of hedging or surrogate hedging as the case may be, it has to understand that surrogate hedging in crude will not fully cover the ATF price risk, as nearly 74 per cent of ATF price contribution is directly linked to an international benchmark, while 19 per cent is indirectly linked to it, as the other components are computed as a notional percentage while pricing.

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