Abstract
This chapter develops empirical measurements of the shape of airline firms’ cost functions as they relate to price variation of oil-based inputs and outputs during the 1998–2009 periods. Using the estimates, we assess the value-added potential for hedging and risk taking with respect to oil prices. We find reasons to believe that the potential value-added of hedging fuel costs with oil derivatives is somewhat limited on average, but that it varies across the business cycle. Our evidence helps explain why, although many airlines hedge, also many do not hedge, why hedging is incomplete, and why hedging intensity varies over time within many airlines.
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Notes
- 1.
Even so, if the firm does enact hedges, the value added would be reduced to the extent that the risk being hedged corresponds to a priced factor in the security markets. Effectively, the firm would need to pay an insurance premium for the risk it lays off; this effect would be offset if the firm's reduced-risk profile results in a lower discount rate being applied to its cash flows by the market.
- 2.
Airlines typically state in annual reports that their derivatives use is for hedging purposes.
- 3.
News reports sometimes emphasize this point of view. For example, Freed (2012) reports that hedging losses turned a strong second quarter of 2012 operating profit into a loss overall for Delta Airlines.
- 4.
We measure costs relative to the asset size of the firm. Not only does this facilitate comparisons across airlines, which vary dramatically in size, but it also makes our estimates more economically meaningful. To the extent that a firm can adjust its asset base over time to match the rise and fall of its dollar costs, then it essentially already hedged against changes in the investment opportunities that those assets represent.
- 5.
That is, if oil price is high at the time of high demand by Western macroeconomies, and therefore high demand for air travel also.
- 6.
There is the logical possibility that it is an over-hedged fuel cost, i.e., that the total effect of the realizations and the marking-to-market takes cost exposure in the opposite direction from its natural one.
- 7.
Seat-miles, or the number of miles flown times the number of passengers carried on a flight, summed across all flights, is a commonly-used normalizing factor in the industry. However, a seat-mile normalization would leave a systematic firm-size effect, for smaller airlines inherently have fewer seat-miles across which to spread costs that do not vary directly with business activity (such as headquarters costs and even lumpy aviation equipment costs).
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Acknowledgments
We acknowledge and greatly appreciate the contributions of Jiao Tu, who worked with us at the early stages of this project. We are extremely grateful for the advice and comments of the editors.
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Laux, P.A., Yan, H., Zhang, C. (2014). Cost, Risk-Taking, and Value in the Airline Industry. In: Ramos, S., Veiga, H. (eds) The Interrelationship Between Financial and Energy Markets. Lecture Notes in Energy, vol 54. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-55382-0_2
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