Kenya Airways plans to review its hedging agreements after October when the current ones expire. All of its hedging agreements expire in October, a state which allows the airline to review their position and if they go back to the market, better negotiate to ensure the airline does not suffer as it has done.
Hedging agreements are critical for businesses, because it provides them with flexibility to dictate the prices of various commodities that they depend on to operate. In the agreements, when the prices of the commodities rise above the set amount, the bank or financial institution agreed with will pay the company the difference. In the reverse position, the company will pay the financial institution.
Kenya Airways has two hedging agreements; for its fuel and loans. Kenyans have largely been concerned of the fuel because the fluctuation prices of crude oil has negatively impacted the company, providing fodder to pundits that it is a core reason for the loss making company.
Acting Finance Director Dick Murianki explained that the company hopes to review the hedging agreements so that they can be better informed from their current Operation Pride perspective. Operation Pride is the code name for their five year turnaround strategy that is being led by global consulting company McKinsey Recovery and Transformation Services.
Fuel consumes 38 per cent of Kenya Airways revenue meaning that they need to undertake a thorough audit of the current agreements to better negotiate for new ones.
The company’s Board has allowed the management to hedge fuel up to 80 per cent of its consumption for 12 months but they have the leeway to further hedge 50 per cent of the fuel volume for 24 months. Murianki added that this period cannot be exceeded.
Globally, airline companies hedge between 1 to 3 years but the recent tough financial situation for many airlines in the world is forcing them to reconsider their agreements. When oil prices were rising, hedging often paid off for the airlines. It helped them reduce their exposure to higher fuel costs. But the speed of the 58 per cent plunge in oil prices since mid-2014 caught the industry by surprise and turned some hedges into big money losers.
For Kenya Airways, fuel costs are the largest costs for airlines followed by labor but its complex derivatives to lock in fuel prices has not always paid off. According to the Wall Street Journal, last year, Delta Air Lines Inc., the US No. 2 airline by traffic, racked up hedging losses of $2.3 billion, while United Continental Holdings Inc., the No. 3 carrier, lost $960 million on its bets. But No. 1-ranked American Airlines Group Inc., which abandoned hedging in 2014, enjoyed cheaper fuel costs than many of its rivals as a result.
As noted by Bankelele South African Airline (SAA) and Ethiopian Airline (ET) have equally been hit by their fuel hedges before. ET recognized that jet fuel is a major expenditure of the airline (about $791 million in 2012) and they manage this risk using various hedging strategies for a maximum period of two years on a rolling basis; and the maximum to be hedged is 75 per cent. At SAA, where fuel is also their biggest cost (35 per cent or $754 million in 2012), their policy is to hedge a maximum of 60 per cent of the fuel exposure on a 12-month rolling basis.
KQ has in the past made massive profits from hedges. It did not make any losses related to oil hedges between 2012 and 2014. The hedges returned a cumulative gain on fuel derivatives of Sh4.07 billion, with Sh2.5 billion realized in 2012 alone. But when it announced its financial results for 2014 last year, a whopping sh26 billion loss sent shock-waves in the country. The loss was partly due to hedge derivatives, which accounted Sh7.5 billion.
Mr. Murianki added that a call option can be used by a company that has good cash flows. In the airline industry, cash is king because of the many expenses involved which require immediate payments. But the call option is not possible for the company currently because it lacks solid cash to bargain. A call would entail getting into a hedge agreement where the financial institution pays you when the prices exceed the set limits but you do not pay when they go below the contractual agreement.
The company is equally at a weaker bargaining position with the financial institutions when it will re-negotiate the hedge agreements because of the current financial status.
