Risk Management & Jet Fuel Hedging

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1 ACL Air Charter & Leasing Ltd Geleitsstrasse Offenbach am Main Germany T: +49(0) M: +49(0) E: Risk Management & Jet Fuel Hedging Information Sheet ACL have excellent business relationships with several global financial counterparties, including investment banks and brokerages, and can offer a full risk management and hedging service for your airline. Please find general information regarding jet fuel hedging strategies listed below, but please contact us to discuss your specific requirements in more detail. Why is jet fuel hedging so important for airlines? In today s volatile energy & financial markets and with jet fuel accounting for between 30-40% of overall airline operating costs, it makes a financial sense to hedge at least some of your jet fuel price exposure for the next 1-2 years in order to generate a more constant & stable cash flow. Typically airlines choose to hedge between 30-70% of their future fuel requirements, depending upon their views on future price movements and their attitude towards risk, however there are initial costs involved when setting up and actively managing a hedging programme and if the airline gets things wrong about the direction of jet fuel prices, this can result in substantial losses for the airline. ACL would always recommend that the hedging programme is as flexible as possible, offering protection but at the same time giving the airline the possibility to reduce, or even cancel, the hedge at short notice if fuel prices move significantly in favour of the airline. Most airlines find it difficult to pass on fuel price rises directly to their passengers in the ticket price and if your competitors are not hedged, having a hedging policy in place can give you a significant competitive advantage. Financial analysts usually revise airline earnings lower as fuel prices rise (and vice versa of course), so by having a fuel hedging policy in place, this can increase your company s value by around 15% compared to an un-hedged rival airline.

2 Frequently Used Airline Hedging Instruments Below you can find information regarding the most commonly used hedging contracts used by airlines: Swap Contract An agreement whereby a floating price is exchanged for a fixed price over a fixed period of time, typically 1- year for a specific volume of fuel (e.g. 5,000 mt/month). It is an off-balance-sheet financial arrangement, which involves no transfer of the physical item. Swap contracts are OTC (over-the-counter) contracts, meaning that they are not traded on a regulated exchange, but rather negotiated directly between the airline and the counterparty and are based on the specific requirements of the airline. Both parties settle their contractual obligations financially by means of a cash transfer, usually monthly. The airline is usually the fixed-price payer, with the counterparty (bank or broker) taking the floating-price. Swap Contract - using a simple jet fuel swap contract arranged in the OTC market During the life of the swap contract, the airline buys physical jet fuel in the cash market from their usual airport suppliers at each destination, but the separate swap contract (typically with a bank/broker as counterparty) makes up the difference when fuel prices rise and removes the difference when fuel prices decline. The result for the airline is a fixed price for the period covered. Airline pays fixed rate of $550/mt per the swap contract Airline (USD$550/mt) Fixed Rate Payer Counterparty (bank/broker) Floating Rate Payer Airline receives floating rate based on the monthly average jet fuel price The fixed rate price is usually based on the price and market conditions when the swap contract is initiated, whereas the floating price of jet fuel is based on a global benchmark, such as Platt s Jet Fuel Rotterdam, which changes daily and is calculated on a monthly average of the closing price each working day during the month. For example if the floating rate for a month averages USD$ 600/mt and the fixed rate is USD$550/mt, then the floating rate payer (bank/broker) makes a USD$50/mt payment that month to the airline. However if during the following month the floating rate averages USD$500/mt, then the fixed rate payer (airline) must pay the floating rate payer (bank/broker) USD$50/mt.

3 Swap Contract with a fixed price of USD$550/mt Advantages - No margin payments - No set-up fees - Stable fixed price for duration of the swap contract (usually 1-year) Disadvantages - Swap contract is usually for a duration of 1-year and there are usually very high exit fees. If jet fuel prices fall dramatically from the fixed price agreed in the swap contract, the airline cannot take advantage of the lower prices as they have effectively agreed a fixed price for 1-year Call Options A call option is the right to buy a particular asset at a pre-determined fixed price (known as the strike price ). OTC options in the oil industry are usually cash settled, while exchange traded oil options through regulated exchanges such as CME or ICE are exercised into futures contracts. OTC option settlement is normally based on the average price for a period, usually a calendar month. Airlines like settlement against average prices because an airline usually refuels its aircraft several times a day. Since the airline is effectively paying an average price over the month, they typically prefer to settle hedges against an average price (called average price options ). In the energy industry, options are often used to hedge cross-market risk, especially when market liquidity is a concern. For example, an airline might buy an option on heating oil or gas oil as a proxy hedge against a rise in the price of jet fuel.

4 Proxy hedges must only be used if prices are highly correlated, for example gas oil or heating oil are more closely correlated to jet fuel than crude oil such as Brent or WTI, making Brent or WTI options a poor hedge against jet fuel. Airlines value the flexibility that energy options provide, but energy options can be seen as expensive relative to other option classes. The reason for this is the high volatility of energy commodities, causing the option to have a higher premium. For this reason, zero-cost collars are often used. Call Option with a strike price of USD$550/mt Advantages - No margin payments - Stable fixed price for duration of the call contract - Possibility to remove hedge (sell call options) if fuel prices fall below strike price Disadvantages - High premiums for highly volatile energy options Collars (including Zero-Cost & Premium Collars) A collar is a combination of a put option and a call option. For an airline planning to purchase jet fuel, a collar is created by selling a put option with a strike price below the current jet fuel price and purchasing a call option with a strike price above the current jet fuel price. The purchase of a call option provides protection during the life of the option against upward jet fuel price movements above the call strike price.

5 The premium received from selling the put option helps offset the cost of the call option. By establishing a collar strategy, a minimum and maximum fuel price is created around the airlines position until the expiry date of the options. If more protection against upward price movements is desired (i.e. having a lower call option strike price) or more benefit from declining prices (i.e. selling a put with a lower strike) a premium collar is used. With this strategy, the cost of the call is only partially offset by the premium received from selling a put. Premium Collar airline will never pay more than USD$550/mt and never less than USD$450/mt Zero-Cost Collar A collar can be structured so that premium received from the sale of the put option completely offsets the purchase price of the call option, this is known as a zero-cost collar. Using a zero-cost collar or premium collar may appear to be a reasonable hedging strategy for an airline since it involves no upfront costs (or very low upfront costs), however if jet fuel prices fall significantly (e.g. from June 2014 to June 2015, when jet fuel prices fell in the region of 50%), airlines may end up paying more for their fuel than a competitor who did not employ a collar strategy.

6 Advantages - No margin payments - Low or even zero upfront costs involved to set up a collar strategy - Stable fixed price for duration of the call contract Disadvantages - Airline cannot take advantage of dramatic falls in the price of jet fuel Three-Way Collar Traditionally airlines tend to hedge their fuel price risk using zero-cost collars as described above, however the airline is subject to significant downside risk if fuel prices decline dramatically below the strike price at which the put option was sold (USD$550/mt in the example below). To reduce this downside exposure, the airline can purchase a further put option (USD$400/mt in the example below), which then reduces their downside risk to the difference in strike prices of the two put options (i.e. the difference between USD$550/mt and USD$400/mt in the example below). Futures Contracts A futures contract is an agreement to buy or sell a specified quantity and quality of an energy product for a certain price at a designated time in the future. Typically monthly futures contracts can be purchase up to 6 years into the future, giving airlines the possibility of long term hedging if required, however liquidity is always best in the first few contract months and year end contracts such as the December contracts The buyer has a long position, which means he/she agrees to take delivery of the energy product (i.e. purchase the product).

7 The seller has a short position, which means he/she agrees to deliver the energy product (i.e. sell the product). An initial premium is payable for each exchange traded futures contract and if the position begins to move against you, then additional maintenance margin is payable, usually on a daily basis. Futures contracts are traded on regulated exchanges, which removes the possibility of counterparty risk, as all trades are cleared by the actual exchange (e.g. CME or ICE) For the futures contract, there is effectively a daily cash settlement (known as maintenance margin ) during each business day throughout the duration of the contract, with a need to ensure that funds are available, otherwise the contract will be terminated. Only a small percentage of futures contracts traded result in actual physical delivery of the energy product. Instead buyers and sellers of futures contracts generally offset their position prior to contract expiry. Advantages - No counterparty risk as all futures contracts are settled through regulated exchanges - Highly liquid markets, so you can increase or reduce your hedge position quickly if required Disadvantages - High upfront costs (initial margin) - Need to ensure funds are available to fulfill maintenance margin if prices move against your position throughout the duration of the futures contract Forward Contracts A forward contract is the same as a futures contract except for two important differences: 1. Futures contracts are standardized and traded on organized exchanges, whereas forward contracts are typically customized and agreed between airline and counterparty and are not traded on an exchange. 2. Futures contracts are marked-to-market daily, whereas forward contracts are settled at maturity only. Advantages - No initial or maintenance margin - No daily mark-to-market pricing - Low start-up costs

8 Disadvantages - Counterparty risk if prices move dramatically during duration of forward contract - Contract is financially settled upon maturity date, can restrict airline cash flow if funds are set aside to cover adverse price movements We hope that the above information has been useful, however do not hesitate to contact ACL to discuss your hedging requirements in more detail. Contact ACL today to discuss your hedging requirements in more detail ACL Ltd Geleitsstrasse Offenbach am Main Germany T: +49(0) E: info@acl-frankfurt.com