Cross-Hedging Jet Fuel with Gasoil Futures
An airline expects to buy 2.4 million US gallons of jet fuel evenly over the next three months. It wants to hedge with ICE Gasoil futures, which are quoted in US dollars per tonne and have a contract size of 100 tonnes. Jet fuel currently costs $2.75 per gallon; gasoil futures for the relevant expiry trade at $780 per tonne. One tonne of jet fuel is approximately 300 US gallons. A regression of monthly jet fuel price changes on gasoil price changes gives a beta of 0.82 and an R-squared of 0.77. The airline's treasurer proposes hedging the full physical volume with gasoil futures. Initial margin is 10% of contract value, variation is daily, and the company has a $1.5 million margin facility. The finance director is concerned about basis risk and the possibility that the hedge will produce large margin calls if gasoil prices fall. The airline has no jet fuel swap lines with banks.
1. Calculate the appropriate number of gasoil futures contracts using the minimum-variance hedge ratio and explain why it differs from a one-for-one volume hedge.
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Physical exposure = 2.4m gallons ÷ 300 gallons/tonne = 8,000 tonnes. Minimum-variance hedge ratio = beta × (spot exposure / futures exposure) = 0.82 × 8,000 = 6,560 tonnes. Contracts = 6,560 ÷ 100 = 65.6, so buy 66 gasoil futures contracts. A one-for-one volume hedge would be 8,000 ÷ 100 = 80 contracts. The difference arises because jet fuel and gasoil are not perfectly correlated: R² = 0.77 means about 23% of jet fuel price variation is unexplained by gasoil, and the beta of 0.82 shows jet fuel moves less than gasoil. Using 80 contracts would over-hedge the price sensitivity and create excessive margin and basis risk.
2. Suppose gasoil falls 20% and jet fuel falls 15% over the period. Estimate the net fuel cost after the futures hedge and compare it with the unhedged cost, using the contract number from (1).
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Gasoil falls from $780 to $624/tonne, a $156 fall. Long futures loss = 66 × 100 × $156 = $1,029,600. Jet fuel falls 15% to $2.3375/gallon, so physical cost = 2.4m × $2.3375 = $5,610,000. Hedged net cost = $5,610,000 + $1,029,600 = $6,639,600. Unhedged cost would be $5,610,000. The initial expected cost at $2.75 was $6,600,000, so the hedge locks the cost close to the original budget (a small over-hedge of about $39,600) rather than allowing the airline to benefit from the price fall. This is the expected result of a long futures hedge: it protects against rising prices and gives up the benefit of falling prices.
3. Evaluate the finance director's concerns and recommend whether the airline should use the futures hedge, an OTC jet fuel swap, or no hedge.
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The finance director is right that basis risk remains: the hedge uses gasoil, not jet fuel, so the jet fuel/gasoil spread can move independently. A 10 cent/gallon adverse move in that spread costs $240,000 on 2.4m gallons. Margin risk is also real: in the 20% gasoil fall above, the futures position loses about $1.03m, which is within the $1.5m facility but uses most of it. A further fall could force additional funding. An OTC jet fuel swap would remove basis risk and avoid daily futures margin, but it creates bank counterparty exposure and the airline has no swap lines. No hedge leaves the fuel budget exposed to a price spike. Recommendation: hedge, but not necessarily the full volume. A 66-contract futures hedge is technically appropriate and affordable, provided the treasury team monitors margin and the $1.5m facility is reserved for it. If swap lines can be established, a partial OTC jet fuel swap may better match the physical exposure.