1986-1990 Inflation Leads to 115.8% Increase in Fuel Price - Essay Sample

Introduction

Between 1986 to 1990, the inflation rate leads to an increase in fuel price by 115.8 per US cents per gallon. The development of the Gulf war was the leading cause of an increase in fuel prices in 1990. The invasion of Kuwait by Iraq and the advancement in the attack in 1991 prompted a further increase in fuel price by 114.5 cents per gallon. The terrorist attack on the US on September 11, 2001, lead to the fall in demand for fuel, the cost of the air jet fuel per US gallon decline from 82.2 cents to 67.8 cents. However, it has been steadily increasing after recording a low value of 55.3 US cents in December 2001, and there has been an upsurge in price by approximately six times to 329.2 cents in 2008 (Ec.europa.eu/, no date, p. 3).

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In 2011, the jet fuel prices catapulted to surpass the $ 3-per-gallon mark; this was the highest increase since 2008. The increase was due to drastic changes in oil prices because of the Libyan civil war, Arab spring, and the demand growth of fuel from China. Between July 2004 and July 2008, the cost of aviation fuel increased by 244%, becoming the largest operating cost item for airline industries. The period From 2002 and 2012, saw the cost of two types of fuel utilized by general aviation rise substantially, with jet fuel prices increasing more than quadrupling from $0.72 to $3.10 per gallon and aviation gasoline prices going up in excess, and tripling from $1.29 per gallon to $3.97, based on EIA recorded data. Also, according to FAA, in the same period, the annual number of entire aviation operations (landings or takeoffs) at airports with an active air traffic control tower decline from approximately 38 million to almost 26 million (www.gao.gov/, 2014, p. 15).

Increase in Oil Prices Since 2000

Since the beginning of 2000, the price of crude oil has been skyrocketing. The price of crude oil was sold at USD24.09 per barrel, but it has been rising steadily up to USD145.65 as of July 2008. The worldwide recession leads to a drop to USD43.84 within the end of five months. The price bounces back rapidly to approximately USD120 per barrel and has been selling over USD100 on the market for some time. Jet fuel manufactured from crude oil shows a high correlation with the changes in the price of crude oil. The crack spread, which constitutes the refining margin over the price of crude oil fluctuates over the period. Refining margin broadens during the time of high volatility oil prices and military squabble, which increases the demand for air-jet fuel ( Hanninen , 2016, p. 24).

Approaches Used By Airline to Deal With Volatility of Fuel Cost

Volatility in fuel prices reached a climax during a recent sudden increase in crude oil prices, and this forced most airlines to acquire short-term and medium-term tactics to compensate for the rise in fuel prices. The first approach was to raise revenue by adopting fuel surcharges. The second approach was to embrace the complicated hedging mechanism.

Fuel Surcharges

Fuel surcharges are an extra fee that carriers such as FedEx, UPS, and DHL, charge on top of normal shipping rates. These charges were developed to allow the carrier to compensate for the cost linked to the fuel. Particularly, with the consistent change in the fuel prices. They have been put in place by several airlines located in Europe. With an increase in fuel prices, the costs have also raised their charges. They are adjusted through the class of travel and by the sector length. In May 2004, The British form of surcharges had transformed from a blanket GBP2.50 for every passenger in May 2004 to the existing rate system where they charge a business class passenger can fly at an extra GBP133 for a long-distance flight. Analysis indicates that current surcharges can compensate up to 50% of the nominal price of fuel.

Example of Airlines That Practice Fuel Surcharges

During 2008, when the air jet fuel prices skyrocketed to $147/barrel, Pacific Rim or Asia-based airlines sought its compensatory measures by implementing hefty fuel surcharges. Particularly for those people traveling for long distant international trips. The industry added $200-$500 for every round-trip ticket price (Searles, 2017, p. 2).

Fuel Hedging

The objective of fuel hedging is to manage the fuel price risk. The intricacy of hedging operations has gone up with the advancement in financial instruments that are available in the market. Airline industries have no assurance that fuel will be dispatched at a specific price in the future but may corroborate financial derivatives to hinder themselves from being hit by fuel prices, which may prove unfavorable to them.

An Example of the airline industry that practices fuel hedging is JetBlue Airways. During the year 2005, the profits of JetBlue went down due to the rising cost of jet fuel. Hence, monitoring the jet airline fuel prices was fundamental for the airline. Even though the airlines had maximized the use of fuel surcharges to the price of air tickets previously, these surcharges were worthy only when equated to major competitors. With the limited pass-through customers, fuel hedging hindered the airline cost structure from spikes in the cost of jet fuel and enabled them to adhere to their business schedule. JetBlue used various hedging instruments like collar contracts, call options, and swaps together with underlying heating crude oil and jet fuel. Significant number of these derivatives could amount to millions of dollars. There was also a considerable risk that the airline would realize negative impacts from a sharp reduction in fuel prices (Matos, 2017, p. 2).

Aerodynamic Design

The airline industries can increase the efficiency of the fuel by upgrading operational profiles. for example, an aircraft can lessen the burning of fuel by adding new technology to the riblets and winglets. But, the outcome here is restricted relatively, small one-off improvements. Winglets are devices placed at the tip of the wings. Their main function is to boost the efficiency of the aerodynamic of the wing, specifically by flowing around the wing to enhance additional thrust.

Renewable Fuel

The airline industry is focusing on manufacturing renewable fuel since they are free from carbon than fossil fuel. The production of this form of fuel will reduce air-jet fuel volatility. Commercial aviation is estimated to have used biofuels of 0.5 percent, and it is projected to increase to 15.5 percent by the end of 2024. The aviation industry recommends the use of Hydro- processed Esters and Fatty Acids (HEFA), also referred to as Hydrotreated Renewable Jet fuel and via a Fischer-Tropsch (F-T) process. This technological process leads to the production of a combination of coal and biomass and transforms the gas into synthetic liquid fuel via an F-T method. An equal mixture of conventional fuels and F-T synthetic fuel is utilized O.R. Tambo International Airport in Johannesburg in commercial aviation. When HEFA is applied, renewable oil such as algae oil, waste grease, animal fat, and vegetable oil is processed through hydrogen treatment (hydroprocessing) to produce fuel in the distillation range of naphtha, diesel, and jet fuel (Wollersheim et al., 2013, p. 3).

Managing Fuel Price Risk Using Derivatives Instruments

Airline industries used derivatives instruments to mitigate the price of oil. Some of these instruments are options, futures, forwards, and swap contracts.

Option Contracts

An option grant gives an individual authority to sell or buy the underlying in the future for a price set in advance. However, the owner of the option is not obliged to exercise the option. In contrast, a writer owning a choice has to prevent the purchaser of an option from exercising an option. A put option mandates a person the right to dispose of a property at a predetermined price during a call option. The airline industries can get an option in jet fuels from the over the counter market in addition to significantly heavy traded products. A bank can serve as a counterparty in these option contracts. Options offer airlines with extreme flexibility about the future prices since they protect against price increase over the option strike price, and at the same time enable them to derive benefits from declining fuel prices ( Hanninen, 2016, p. 41).

Futures

A futures contract is a dedication sell or purchase a contract at a prior set price. In future contracts, the following are clearly stated underlying asset, contract size, delivery cycle, expiry date, grade or quality specification of the underlying and the delivery location, and settlement. Airlines assume a long position when hedging against fuel risk using futures contracts. A long position is the best for a company intending to purchase a commodity in the future and the price of which it wants to lock in before getting. Airlines are open to basis risk when they are trying to manage fuel price risk with futures. There is a possibility that the spot price and the futures price are not moving alongside one another. Airlines hedge jet fuel price, risk applying futures with other underlying commodities than jet kerosene. As a consequence, they involve cross hedging ( Hanninen, 2016, p. 36).

Forwards

Forwards contracts are applied in ascertaining the cost of a commodity for a future date and also in obtaining supplies of a product. Airlines can make use of forward contracts in hedging in opposition to the fuel price risk. They can sign forward with fuel suppliers. In this form of contract, the contractual parties must carry the entire counterparty risk. In consequence, there is a possibility that the other party in the contractual agreement is facing financial distress before the maturity of the forward contract.

Applying a forward contract to hedge against price risk is straight forward. For instance, an airline signs an agreement with the fuel supplier. The airline agrees to purchase 100 000 gallons of jet fuel three months before the future at USD1.50. By the end of three months, when the contract came to a halt, the spot price of fuel has attained USD1.80 per gallon. Hence, the airline gains USD 0.30 per gallon on the hedge, which translates to (USD 1.80-1.90)/ gallon= USD0.30/gallon. So the delivery of 100,000 gallons will cost the company USD150 000 per shipment. Mathematically, 100,000 gallons*USD 1.50/gallon, It would have cost the firm USD180000 for the delivery had it not entered into the contract. In contrast, had the spot price been lower than the agreed forward price, the airline would have made a significant loss on the hedge ( Hanninen, 2016, p. 39).

Swaps

A swap is a type of contract which makes parties trade-off to specified income at a predetermined period. The Seller and the buyer trade-off a fixed price that is currently in possession of the unpredicted floating price in the future, they are purely made for the airlines to enter a contract with the jet fuel supplier. If an airline enters into a swap contract with the supplier, the supplier will deliver a specified quantity at a fixed price for a specific period. If they realized the price is higher, then the supplier pays the adjusted price. Swap contracts enable companies to assume the advantage of price movements in the underlying asset that the swap price is connected to ( Hanninen, 2016, p. 31).

References

Ec.europa.eu/ (no date) Fuel and air transport A report for the European Commission . Available at: https://ec.europa.eu/transport/sites/transport/files/modes/air/doc/fuel_report_final.pdf.

Hanninen, J. (2016) Jet Fuel Price Risk Management and Exposure In Small Airlines. Available at: https://www.utupub.fi/bitstream/handle/10024/144266/H%...