Fuel Hedging Background
Fuel hedging is a practice that companies use to protect themselves from volatility of fuel costs. Between the years 1987–2005, oil price has fluctuated more than other commodity prices. Since then hedging has become a common practice in dealing with volatility. Empirical evidence does not provide clear findings whether hedging is profitable for the company (Allayannis and Weston, 2001). In our study we have focused on the hedging of oil prices since our case study is comprised of shipping company, Gotlandsbolaget. Moreover our study will also focus on relation between ticket prices and oil prices which we will discuss in the later part of the background.
There has been a continuous increase of trend of hedging oil prices, especially in shipping and airline business and it has been profitable for many companies. A best example which stands in airline sector is that of Southwest airlines which has had big profits, by using good hedging policies Carter et al., (2004). Shipping companies like Frontline ltd., Teekay Corporation and Stena line have seen profits and losses from the hedging of the oil prices. In fact in an academic survey of International Swaps and Derivatives Association (ISDA) in 2004, 99 % of the participants agreed that the impact of derivatives on the global financial system is beneficial. An explanation for this fact can be that the oil price has been continuously fluctuating since the discovery to use it as a source of energy. Year 2008 has brought so many changes around the world due to the economic crisis; oil prices have been soaring up and climbed up to almost $150 per barrel. Therefore due to high oil prices and continuous fluctuations many companies were facing high oil costs and eventually companies have decided to hedge oil prices as a risk management strategy. But again the point is that if the prices decrease then companies will face the loss. So hedging always put company and management in the risk position (Morrell and Swan, 2006).
Furthermore, using hedging policies in the oil price sector consists of facing the risks associated with it. In hedging, liquidity is one of the main issues to be taken under consideration. In many industries it has a great importance and it helps companies to reduce the risk and cope up with the changes. In this way a company has to choose between liquidity and higher oil prices. According to the International Swaps and Derivatives Association (ISDA), most of the academicians argue for hedging. In order to accomplish that, there are many methods and achieving a full hedge for a company is far from reality. Subject of dispute has been also that whether hedging generates or adds shareholder value.
Companies use different approaches to hedging derivatives. Hedging derivatives and their integration, i.e. futures, forwards, swaps and options, in the cash market make the major part of the oil company’s operations in the global oil market (Mattus, 2005). Companies choose the hedging tool according to their own needs and required strategies. Above mentioned derivatives are consist of different time periods, some consists of shorter hedging period and some consists of longer time period as shown in the Figure 1.
One of the very important changes that have been noticed in the current scenario of oil market is the extension and increment in the length of trading horizons from forward to future contracts. In the beginning it was hard for the oil companies to set the prices for the future deliveries until the introduction of the forward and future contracts in the market (Mattus, 2005). In that scenario the entire burden was put on the spot market, where the decision related to the trade may have affected the time horizon as the spot time period might range from day 1 to any time in the future that could only add to the price volatility (Long, 2000).
