Airline fuel hedging under demand uncertainty
Meridian Air forecasts 2.0m tonnes of jet fuel next year and budgets $850 per tonne; fuel is 35% of operating costs. In January it hedged 70% of forecast usage with pay-fixed swaps at $800 per tonne. By June the fuel price has fallen to $650 and passenger demand is 20% below plan because of a recession. The swaps now have a mark-to-market liability of about $210m. The hedge counterparty requires collateral above a $50m threshold, and Meridian has a $100m committed revolving credit facility with $40m already drawn. The CFO wants to know whether the hedge was a mistake and whether to unwind it. The board's policy says hedge 50-80% of forecast fuel, but the policy does not explicitly require demand-linked adjustment. The airline has a June covenant test of net debt/EBITDA ≤3.5x; lower fuel prices will help EBITDA but the swap mark-to-market may affect the covenant depending on the definition.
1. Quantify the economic outcome of the hedge if fuel is $650 and demand is 20% below plan. Compare the hedged and unhedged fuel cost, and calculate the collateral call. Decide whether the hedge was a mistake in hindsight.
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Hedged volume is 70% × 2.0m = 1.4m tonnes. Actual consumption at 80% of plan is 1.6m tonnes. Unhedged fuel cost is 1.6m × $650 = $1.04bn. With the swap, physical purchase is also $1.04bn, but the swap loss is (800 − 650) × 1.4m = $210m, so total cost is $1.25bn. The effective cost is $1.25bn / 1.6m = $781.25 per tonne. The budget fuel cost was 2.0m × $850 = $1.70bn, so actual fuel cost is much lower because both price and demand fell. The hedge nevertheless costs $210m relative to being unhedged. The mark-to-market liability is $210m; after the $50m threshold, collateral required is $160m. Undrawn liquidity is $100m − $40m = $60m, leaving a $100m collateral shortfall before other cash resources. The hedge was not obviously a mistake ex ante: it was within the 50-80% policy and protected against a price rise. The mistake, if any, was failing to link the hedge to demand stress. In hindsight it was costly, but that is the nature of insurance; the more serious issue is liquidity and policy design.
2. Evaluate the liquidity and covenant implications. What actions should the CFO take before the June covenant test?
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The immediate problem is the $160m collateral call against only $60m of undrawn revolver capacity, a $100m shortfall. The CFO should first confirm the collateral terms, threshold and whether other cash or committed facilities are available. Actions include negotiating a higher threshold or a collateral haircut with the counterparty, drawing the remaining revolver, suspending the dividend or share buyback, and reducing the hedge ratio through a partial unwind or restructuring into collars. A partial unwind crystallises part of the loss but reduces future collateral calls; it should be sized to restore liquidity while keeping the hedge ratio within policy. On the covenant, lower fuel prices help EBITDA, but demand is 20% lower, so the net EBITDA effect is uncertain. The swap liability may or may not be included in net debt depending on the definition; the CFO must test both cases. If the covenant is likely to be breached, early lender discussion and a waiver are better than waiting. The board should also disclose the hedge position and collateral sensitivity.
3. Review the hedge policy and governance. Recommend changes to hedge ratio, instrument choice and disclosure, including how to address the board's view that the hedge was a mistake.
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The policy was incomplete because it set a volume range but did not require the hedge to be adjusted for demand scenarios. A better policy would define the hedge ratio against stress-tested consumption, not just budget volume; set layered limits, for example 60-80% of highly probable usage and lower limits when demand is elastic; and require a liquidity buffer for collateral calls. Instrument choice should include collars or options where the cost of swaps and collateral risk is high, and the company should diversify counterparties and set collateral thresholds. Disclosure should show hedge ratio, maturity profile, mark-to-market, collateral posted and sensitivity to a $50 or $100 per tonne move. The board should distinguish a bad outcome from a bad decision: the January hedge was within policy, but the policy did not address volume risk. The review should therefore focus on process, demand-linked sizing and liquidity planning rather than blaming the CFO for a falling market. A full unwind would crystallise the loss and leave the airline exposed if prices rebound; a partial reduction is more defensible.