Case study of 2012 Fuel Hedging at JetBlue Airways

Student number: 28856031

Background
JetBlue was founded in 2000, which was a low-cost airline that focused on low-cost
airline market. During 2002, JetBlue experienced a remarkable growth and finally
went public. As an airline company, the movement of fuel oil price was crucial since
the increasing fuel oil price led to the increasing cost for JetBlue. JetBlue’s fuel
consumption experienced an uptown trend from 31.4% in 2009 to 39.8% in 2011,
which became its largest operating expense. Even though JetBlue can offset this
cost by applied fuel surcharges, the strategy only viable when it matches with
competitors. Under this circumstance, using hedging instrument was chosen by
JetBlue in order to protect its profit.

Hedging strategy of JetBlue

Fuel hedging refers to the airlines lock in a particular price to offset the losses
caused by the rise in oil price through various derivatives. However, airlines could
suffer from the decrease of oil price. According to the given information, JetBlue had
adopted the fuel hedging strategy by using over-the-counter swaps and options as
well as collar contracts with underlyings of jet fuel, crude, and heating oil. In details,
JetBlue’s average hedged fuel percentage kept range between 50% to 60% from
2007 to 2008 since the jet fuel reached highest price, followed by 9% in 2009
because the jet fuel price went relatively low at that moment. The major hedging
commodity between 2007 to 2009 was heating oil. In 2010, as the fuel price
increased again, JetBlue started pay attention on West Texas Intermediate (WTI)
crude oil hedges and jet fuel hedges directly. Finally, in 2011, the crude oil on WTI
became the major hedging commodity.
However, WTI hedging became ineffective since the correlation between WTI and
global crude oil market went down in 2011. Although JetBlue decreased its WTI
hedging percentage, JetBlue still suffered a loss from the WTI hedging. It is note that
JetBlue maintained good performance against the market price with hedging
compared with those that not hedged. As the rising fuel consumption, JetBlue should
continue to hedge in 2012 to limit its fuel cost since the risen fuel price at the end of
2011. Considering the basic risk on WTI, the hedged percentage need decrease.
Appropriate hedging Commodity for JetBlue
There were three hedging commodities that need be analyzed: WTI crude oil, Brent
crude oil and heating oil. WTI oil and Brent oil were two major benchmarks for world
oil prices. In the past, Brent was more likely to trade at a slight discount of $1 to $2 to
WTI due to WTI’s relatively higher quality, however, the oil glut in Cushing caused by
the rising crude production from the Bakken shale formation and Canadian oil sands
turned the typical discount of Brent over WTI into a premium with the Brent-WTI
spread of $29.70 per barrel. In this case, JetBlue’s hedge strategy will be the cross
hedge. A cross hedge is used to manage risk by investing in two positively correlated
securities that have similar price movements (Chen, 2019). Thus, to examine the
appropriate hedging commodity, the hedging commodity that had highest correlated
with jet fuel will be chosen. By calculating standard deviation of the basis risk versus
WTI, Brent and heating oil, the tracking error of the basis versus heating oil was the
lowest (table 1.1), which means the price movement in heating oil price was the
closest to Jet Fuel price movement from 2007 to 2011.
Table 1 Tracking error
Basis vs. WTI Oil Basis vs. Brent Oil Basis vs. Heating Oil
0.227 0.160 0.051
Besides, the standard deviation and correlation of WTI, Brent and heating oil were
calculated, therefore, the optimal hedge ratio can be accessed. The hedge ratio H is
given by the relationship, H = p * σ (spot) / σ (futures), where p is the correlation
between the spot jet fuel price and selrected futures contract, σ is the standard
deviation of each respective contract. The table below shows the results.
Table 2 Optimal hedge ratio
Standard deviation correaltion with jet fuel optimal hedge ratio
spot (Jet Fuel) 27.2806
WTI 20.6324 0.9585 1.2674
Brent 23.9278 0.9742 1.1107
Heating oil 26.4796 0.9973 1.0275

To hedge the price change of Jet Fuel, the require number of future contracts need
to be entered is 1.2674 WTI, 1.1107 Brent and 1.0275 heating Oil. In conclusion,
heating oil was the most appropriate hedging commodity in 2012 as its highest
correlation with spot jet fuel price and smallest optimal hedge ratio.
Backtest
Regard to evaluate whether the hedge had helped reduce fuel cost volatility, there
are some assumptions that needed implemented. Firstly, assuming JetBlue’s fuel
consumption for 2012 was expected to match that of 2011 (525 million per year) and
JetBlue decided to hedge 20 million gallons of jet fuel per month (240 million per
year). Besides, stimulating JBLU used a simple futures contract to hedge, where 1
contract was for 1,000 barrels (42,000 gallons). Moreover, based on the
convergence of Futures to Spot, the futures price was equal to or very close to the
spot price.
There are three scenarios: without hedge, hedge with WTI and hedge with Brent.
Therefore, the average and volatility of fuel cost in each scenario would be
calculated.
As the table shown in Appendix, the volatility per gallon is 41.5% without hedge,
23.7% with WTI oil and 31.9% with Brent oil. The average monthly cost is 104.69M
without hedge, 140.14M with WTI and 141.20M with Brent. Therefore, hedging with
WTI and Brent both reduced the volatility of fuel cost. Considering WTI’ lowest cost
and volatility, hedging with WTI is still preferable despite some unusual fluctuations
in WTI.

Risk of being hedged and unhedged

As mentioned above, JetBlue purchased call option against price increase, however,
if the price decreased, JetBlue would loss option premium. To address this problem,
JetBlue used collar option, which combined the sale of put option and the purchases
call options, so that the cost of buying call option was offset by the sale of put option.
However, JetBlue still could encounter basic risk as the hedging commodity price
and the underlying jet fuel price was not synchronized. Under this circumstance,
JetBlue may suffer huge loss. In addition, regarding the disadvantage of hedging, as
JetBlue tended to enter into over-the-counter derivatives, the default risk would be
another concern. Moreover, political situation has a negative impact on fuel price,
JetBlue need pay attention to country risk.
When it comes to unhedged position, it is obvious that unhedged position makes the
companied expose to the price movement. Under the normal market condition,
companies may not suffer a lot but it would be worsen if the market condition
become fluctuating.
In conclusion, it is suggested that JetBlue took a position as a hedger rather than a
speculator by using derivatives to hedge its fuel price movement
Appendix
 HEATING
JET FUEL (per WTI (per BRENT
OIL
Year gallon) Barrel) ( per
( per
Barrel)
jet fuel per barrel WIT per gallon BRENT per gallon Gallon) heating oil per barrel
Jan-2007 73.88 1.759 58.17 1.385 56.52 1.346 1.681 70.60
Feb-2007 77.83 1.853 61.78 1.471 59.39 1.414 1.781 74.80
Mar-2007 84.71 2.017 65.94 1.570 68.47 1.630 1.871 78.58
Apr-2007 86.06 2.049 65.78 1.566 67.23 1.601 1.897 79.67
May-2007 85.85 2.044 64.02 1.524 68.18 1.623 1.892 79.46
Jun-2007 87.78 2.09 70.47 1.678 72.22 1.720 2.023 84.97
Jul-2007 92.32 2.198 78.2 1.862 77.01 1.834 2.095 87.99
Aug-2007 89.67 2.135 73.98 1.761 72.29 1.721 2.037 85.55
Sep-2007 96.10 2.288 81.64 1.944 80.97 1.928 2.199 92.36
Oct-2007 108.86 2.592 94.16 2.242 89.87 2.140 2.506 105.25
Nov-2007 107.86 2.568 88.6 2.110 88.71 2.112 2.499 104.96
Dec-2007 112.27 2.673 95.95 2.285 93.68 2.230 2.648 111.22
Jan-2008 108.02 2.572 91.67 2.183 91.58 2.180 2.523 105.97
Feb-2008 122.43 2.915 101.78 2.423 100.9 2.402 2.806 117.85
Mar-2008 128.56 3.061 101.54 2.418 102.33 2.436 3.078 129.28
Apr-2008 139.82 3.329 113.7 2.707 111.12 2.646 3.195 134.19
May-2008 156.91 3.736 127.35 3.032 127.85 3.044 3.647 153.17
Jun-2008 168.84 4.02 139.96 3.332 138.4 3.295 3.89 163.38
Jul-2008 149.27 3.554 124.17 2.956 124.1 2.955 3.435 144.27
Aug-2008 138.43 3.296 115.55 2.751 113.49 2.702 3.15 132.30
Sep-2008 126.92 3.022 100.7 2.398 93.52 2.227 2.851 119.74
Oct-2008 87.95 2.094 68.1 1.621 60 1.429 2.085 87.57
Nov-2008 73.92 1.76 55.21 1.315 47.72 1.136 1.696 71.23
Dec-2008 55.44 1.32 44.6 1.062 35.82 0.853 1.314 55.19
Jan-2009 59.47 1.416 41.73 0.994 44.17 1.052 1.437 60.35
Feb-2009 53.13 1.265 44.15 1.051 44.41 1.057 1.271 53.38
Mar-2009 56.32 1.341 49.64 1.182 46.13 1.098 1.336 56.11
Apr-2009 54.35 1.294 50.35 1.199 50.3 1.198 1.299 54.56
May-2009 70.22 1.672 66.31 1.579 64.98 1.547 1.636 68.71
Jun-2009 75.10 1.788 69.82 1.662 68.11 1.622 1.715 72.03
Jul-2009 76.90 1.831 69.26 1.649 70.08 1.669 1.793 75.31
Aug-2009 74.80 1.781 69.97 1.666 69.02 1.643 1.773 74.47
Sep-2009 75.35 1.794 70.46 1.678 65.82 1.567 1.805 75.81
Oct-2009 82.99 1.976 77.04 1.834 74.91 1.784 1.965 82.53
Nov-2009 84.17 2.004 77.19 1.838 77.77 1.852 1.984 83.33
Dec-2009 87.70 2.088 79.39 1.890 77.91 1.855 2.109 88.58
Jan-2010 80.22 1.91 72.85 1.735 71.2 1.695 1.894 79.55
Feb-2010 86.31 2.055 79.72 1.898 76.36 1.818 2.02 84.84
Mar-2010 91.90 2.188 83.45 1.987 80.37 1.914 2.162 90.80
Apr-2010 97.61 2.324 86.07 2.049 86.19 2.052 2.265 95.13
May-2010 85.64 2.039 74 1.762 73 1.738 2.006 84.25
Jun-2010 83.71 1.993 75.59 1.800 74.94 1.784 1.975 82.95
Jul-2010 87.91 2.093 78.85 1.877 77.5 1.845 2.038 85.60
Aug-2010 84.42 2.01 71.93 1.713 75.51 1.798 1.966 82.57
Sep-2010 94.04 2.239 79.95 1.904 80.77 1.923 2.239 94.04
Oct-2010 94.63 2.253 81.45 1.939 82.47 1.964 2.211 92.86
Nov-2010 96.22 2.291 84.12 2.003 86.02 2.048 2.288 96.10
Dec-2010 106.18 2.528 91.38 2.176 93.23 2.220 2.546 106.93
Jan-2011 115.16 2.742 90.99 2.166 98.97 2.356 2.723 114.37
Feb-2011 125.92 2.998 97.1 2.312 112.27 2.673 2.928 122.98
Mar-2011 132.76 3.161 106.19 2.528 116.94 2.784 3.098 130.12
Apr-2011 141.46 3.368 113.39 2.700 126.59 3.014 3.263 137.05
May-2011 131.63 3.134 102.7 2.445 117.18 2.790 3.049 128.06
Jun-2011 125.83 2.996 95.3 2.269 111.71 2.660 2.936 123.31
Jul-2011 132.76 3.161 95.68 2.278 115.93 2.760 3.086 129.61
Aug-2011 130.75 3.113 88.81 2.115 116.48 2.773 3.068 128.86
Sep-2011 119.45 2.844 78.93 1.879 105.42 2.510 2.781 116.80
Oct-2011 127.18 3.028 93.19 2.219 108.43 2.582 3.04 127.68
Nov-2011 126.04 3.001 100.36 2.390 111.22 2.648 3.012 126.50
Dec-2011 122.51 2.917 98.83 2.353 108.09 2.574 2.917 122.51
average 2.393 1.972 2.025 2.341
variance 27.28 41.5% 20.63236 23.7% 23.928 31.9% 26.48

Average and volatility of fuel cost

 volatility average cost per gallon average monthly cost
without hedge 41.5% 2.393 104.69
with WTI 23.7% 1.972 140.14
with Brent 31.9% 2.025 141.20
Average monthly cost:
Without hedge: 2.393*525M=104.69M
With WTI: 2.393*(525-20) + 1.972*20=140.14M
With Brent: 2.025* (525-20) + 2.025*20=141.20M

Reference
Chen, J. (2019). Cross Hedge. Retrieved from

https://www.investopedia.com/terms/c/crosshedge.asp