Fuel hedging

Why do airlines hedge fuel with crude oil?

Jet fuel prices move with crude oil plus a refining margin, the crack spread, which has its own swings. Derivatives on jet fuel exist, but crude oil and gasoil markets are deeper and allow longer hedges, so airlines often hedge with Brent crude or gasoil swaps, options and collars, typically covering a declining share of consumption over the next 12 to 24 months. Fuel is also priced in US dollars, so airlines reporting in other currencies hedge the currency too. Producers hedge the same prices from the selling side; see oil price hedging. Ship operators hedge bunker fuel in a similar way; see bunker fuel.

Can an airline hedge only the crude oil component?

Yes. IFRS 9 allows a risk component of a non-financial item to be the hedged item if it is separately identifiable and reliably measurable. Crude oil is generally accepted as a component of jet fuel, because refiners price jet fuel by reference to crude and market data supports the relationship, even though fuel purchase contracts do not usually state a crude price. Designating the crude component means the hedge covers only the crude price risk, and changes in the crack spread stay outside the hedging relationship. Under IAS 39, the whole jet fuel price had to be the hedged item, so crack spread movements often caused ineffectiveness or failed hedges. See IFRS 9 hedge accounting.

Fuel hedging: a crude oil swap

An airline expects to buy 1 million barrels of jet fuel in the third quarter. It enters a Brent swap for 1 million barrels at US$ 80 a barrel and designates it as a hedge of the crude component of those purchases. When the fuel is bought, the crack spread is US$ 25 a barrel.

Either way, the crude component costs US$ 80 a barrel and the fuel costs 105 million, with the crack spread unhedged. Before the purchase, the swap is measured at fair value and the effective gain or loss goes to the cash flow hedge reserve in equity. When the fuel is bought, IFRS 9 requires the amount in the reserve to be removed from equity and included in the cost of the fuel inventory, a basis adjustment: in the first case, the 10 million gain reduces the cost of fuel from 115 to 105 million. The fuel is usually burned within weeks, so the hedged cost reaches fuel expense almost immediately.

How are options and collars treated?

Airlines often prefer options, which protect against rises while keeping the benefit of falls, or collars, which combine a bought call with a sold put to reduce the premium. Usually only the intrinsic value of an option is designated in the hedge. IFRS 9 then treats changes in time value as a cost of hedging: they are deferred in equity and, for a hedge of fuel purchases, included in the cost of the fuel with the rest of the hedge result, rather than causing volatility in profit or loss. A collar can be a hedging instrument unless it is a net written option, which is the case when more premium is received than paid. See commodity hedging and own use.

What causes ineffectiveness?

Differences between the hedge and the hedged component, such as a swap priced on monthly average Brent against purchases priced on different dates, or a Brent hedge of fuel priced off another crude grade or location. The credit risk of derivative counterparties also affects the swap's fair value but not the hedged item. Hedging more fuel than the airline expects to buy creates ineffectiveness on the excess, so airlines hedge only highly probable volumes and keep a buffer, especially for later periods.

What happens when flying is cut?

If forecast fuel purchases are no longer highly probable, hedge accounting for those volumes stops, and the amount already in the reserve stays there while the purchases are still expected to occur. If they are no longer expected to occur at all, the amount is reclassified to profit or loss immediately. When flights were grounded in 2020, many airlines found that hedged fuel would never be bought and recognised large hedge losses in profit or loss at once, with oil prices then at record lows. Airlines now disclose hedge cover by period and stress how much of it relates to uncertain flying.

How are fuel hedges presented, and how does US GAAP differ?

Hedge results end up in fuel cost, with ineffectiveness and discontinued hedges in a separate line or in other gains and losses. Under IFRS 18, from 2027, gains and losses on derivatives used to manage operating risks are classified in the operating category; see IFRS 18 and derivatives. Under US GAAP, ASC 815 permits hedging a component of a non-financial item only if it is contractually specified in the purchase contract, so airlines buying fuel at prices that do not reference crude oil may not be able to hedge only the crude component. US GAAP also reclassifies hedge results from other comprehensive income when the hedged fuel affects earnings, rather than adjusting the cost of inventory. See airline accounting.

This guide is general information. It is not tax or legal advice for your situation.