Delta Airlines reduces hedged fuel exposure
During my review of Delta’s investors day presentation, I noticed something that stuck out to me (and probably to many investors) – a $1.2B loss from their hedge book expected for 2015. When you ask the average retail investor if low oil prices are good for airlines, you will almost certainly get a response of “yes, of course!”. However when you dig down further you’ll find the answer isn’t as cut and dry as it first sounds and depends greatly on a number of factors, including which airline is being discussed. In the case of Delta, as apparent in their most recent investor presentation, lower oil prices have lead to a rather large loss and a restructuring of their hedge book. So how did Delta end up in this situation?
Oil has become an increasingly volatile commodity which has forced airlines to adopt hedging strategies in order to protect themselves from future price fluctuations. In the case of Delta, their hedging strategy has been very active as opposed to passive, some might even argue innovative. Their highly publicized and controversial purchase of the Trainer refinery is probably their most apparent sign of their strategy, although behind the scenes Delta has run a very active desk in house to manage their fuel hedge book.
From the investor presentation this week, however, it is clear this active strategy is starting to show signs of strain. Along with their projected loss of $1.2B for 2015, they disclosed 65% downside participation for 2015 along with a 100% (“full”) downside participation for 2016. This suggests a few things, firstly that Delta is expecting the price of oil to stay suppressed into 2016 and large unpredictable drops in the price of oil for the foreseeable future. Additionally, as they are moving towards full downside participation they are undoubtedly reducing their hedge book overall scope and drastically reducing both swap and collars from their book. Their increased reliance on call options is a sign they are moving towards a traditional “passive” hedge scenario, where they are simply guarding themselves on a steep increase in oil prices. The cost of these options however are not insignificant, and as they become more dependent on them they will have to reduce the overall scope of their hedge book compared to their overall fuel strategy. Delta has had issues with its oil hedging in the past, it seems they’ve assessed the losses associated with their swaps and collars were too great and exposed them to too much risk going into 2015 and onward.
But what does this mean for Delta’s venture into refining? For Delta, their fuel hedging is broken out into two general areas, the crack spread and the cost of raw materials (oil) for refinement into Jet A. There exists very few financial instruments to hedge against Jet A which is why airlines tend to hedge using more liquid commodities such as oil and kerosene. The other side to the hedging strategy involves the crack spread – the cost per barrel it cost to convert crude oil to refined Jet A. Delta’s refinery fits right into this part of its hedging strategy as they expect to see the crack spread continue to increase. By owning and producing its own Jet A, Delta can limit its exposure to sharp increase in the crack spread. Although the refinery has a large initial capital investment on the part of Delta ($150M, plus cost of refurbishment), in the long run this will most likely continue to be part of its long term hedging strategy. Delta said the refinery will produce $75M in profit for this quarter alone, which is a marked improvement from the $41M loss in the first quarter of this year. They are specifically looking for the refinery profits to now offset the losses being incurred by its hedge book. It is unclear however as to how the refinery will continue to perform going forward. The increased downward pressure of oil should in theory help the refinery profits, however in time the crack spread will begin to shift to take into account the depressed cost of raw materials. Although Delta would like to tout its relatively new refinery as an easy money maker, the refinery business is a crowded and competitive market, and a costly one to run especially for an airline whose core competency doesn’t reside in oil refining. Its not as easy for Delta to dump an entire refinery as it is for them to rearrange their hedge book. Plus, from a PR perspective, offloading their refinery would cause unwanted negative press and probably spook their investors. I see Delta holding onto their refinery for the foreseeable future as they continue to explore how they can leverage it to mitigate their crack spread exposure. Other airlines will be closely watching how Delta fares with their relatively new venture, and might outline strategies other airlines could try to replicate in the future.
Delta is a unique example compared to other airlines. Southwest for example, which famously hedged all of their fuel buys and recorded $221M market to market loss when fuel prices rose in 2012, is proof in point that a hedging strategy from one extreme to another isn’t a good idea. It will be interesting to see how Delta continues to adapt their fuel cost management, however it is clear they are expecting continued depressed oil prices for the foreseeable future, and have reduced their hedge book accordingly.