Cathay Pacific Airlines Case Study

Contents

Introduction        2

Why does the oil price volatile        2

Fuel price risk of airlines        4

The impact of shale oil and shale gas to energy prices        5

Forward and future Contracts        6

Example of Forward Agreements        6

Options        6

Introduction – hedge with exchange traded futures contract        7

Difficult of hedge with exchange traded futures        9

Common model used with future contact oil hedging        9

Cross hedging        10

Collar strategy        11

Payoff of collar and effect on fuel cost        11

Advantage of collar        12

Disadvantage of Collar        12

Conclusion        13

Introduction

Cathay Pacific, being Asia’s largest international airline, experienced a net loss of HK$575m in 2016, compared with a HK$6b profit in previous year. One of the reasons behind is that it lost HK$8.46b on fuel hedges in 2016, largely incurred on hedges put in place when the fuel price was much higher than today. Despite the low fuel price in current year, Cathay Pacific will continue suffering a difficult time for the next two to three years due to its fuel hedging. As a result, Cathay Pacific launched a strategic review, saying it would undergo a re-organisation, to revamp its workforce and to shorten its fuel hedging programme. It appears that unpredictable price avalanche have led some to question the long-term benefits of hedging. This initiate our further study on the fuel price risk, and to find out how the airlines cope with it.

Fuel price risk of airlines

Fuel cost is definitely a significant cost to airline companies. As shown in figure 1, fuel cost account for about one-third of total operating expenses of the airline. As such, airlines treat hedging as a strategy for increasing the certainty of fuel prices. Airlines that locked in prices prior to big increases in oil price will achieve competitive advantage.

Figure 1 Fuel costs to total operating expenses of different airlines

Why does the oil price volatile

Crude oil is one of the most economically mature commodity markets in the world, global supply and demand determine its price. As shown in figure 2 below, the world crude oil price is volatile, varying from $15/barrel to $150/barrel in past 20 years. And the current WTI crude oil price is $52.24/barrel.

[pic 1]

Figure 2 World crude oil price between 1999 and 2017

First of all, considering the oil consumption, oil price goes up when there is an increasing demand. Structural conditions in each country's economy influence the relationships among oil prices, economic growth, and oil consumption. In 2015, more than 53% of world oil consumption consume by the Organization of Economic Cooperation and Development (OECD), including US, much of Europe and other advanced countries. Large economies consume more oil than the non-OECD countries, but have much lower growth in oil consumption. The US Energy Information Administration (EIA) projects that virtually all the net increase in oil consumption in the next 25 years will come from non-OECD countries. Particularly, China's strong economic growth has recently resulted in that country becoming the second largest oil consumer in the world. China's rising oil consumption has been a major contributor to incremental growth in worldwide oil consumption.

On the other hand, considering the supply of crude oil, 40% of the world’s crude oil is produced by the Organization of the Petroleum Exporting Countries (OPEC), including United Arab Emirates, Iran, Iraq, Saudi Arabia etc. This organization seeks to actively manage oil production in its member countries and maintains targeted price level by setting production targets as well as spare capacities. Crude oil price increase when OPEC production target is reduced. Besides, the spare capacity indicates the world oil market's ability to respond to potential crises that reduce oil supplies. Oil price tends to increase when OPEC spare capacity reaches low levels. For example, during the period between 2003 and 2008, OPEC's total spare capacity remained near or below 2 million barrels per day (or less than 3% of global supply). This provided very little cushion for fluctuations in supply in a context of rapidly rising demand, and thus, lead to the upward trend of oil price.

In addition, remaining 60% of world oil production comes from non-OPEC, including North America, regions of the former Soviet Union, and the North Sea. Disruptions of non-OPEC production reduces global oil supply will lead to higher oil prices. Also, Non-OPEC production occurs largely in areas that have relatively high finding and production costs. The uncertainty about when the production will return to markets further adds to price volatility.

Nonetheless, geopolitical and economic events would affect the supply and demand of crude oil. Figure 3 below showing the crude oil prices during 1970 – 2015, pinpointed with some key events during the period. Events that disrupt supply or increase uncertainty about future oil supplies tend to drive up prices. Much of the world's crude oil is located in regions that have been prone historically to political upheaval. Given the OPEC's market significance, events that entail an actual or future potential loss of oil supplies can produce strong reactions in oil prices. Several major oil price shocks have occurred at the same time as supply disruptions triggered by political events, like the Arab Oil Embargo in 1973-74, the Iranian revolution and Iran-Iraq war in the late 1970s and early 1980s etc. And most recently, the oil price surged about 15% once after the US launched an airstrike on Syria. Furthermore, weather can also play a significant role in oil supply. For example, oil and natural gas production shut down during hurricanes in 2005. This made oil and petroleum product prices increased sharply as the supply dropped.