The Empirical Analysis of Ryanair s Hedging Policy and its Effectiveness

Transcription

1 The Empirical Analysis of Ryanair s Hedging Policy and its Effectiveness All Ryanair data used in this paper is gathered from Ryanair s 20-F, quarterly and annually reported results available via their website, link provided in the reference section. Introduction Ryanair is an Irish budget airline, headquartered in Swords, Dublin, Ireland with two primary operational bases at Dublin and London Stansted Airport. Ryanair s 2014 annual report states total revenue was billion for fiscal year (FY) 2014, and EBITDA of million. The company has grown revenue at 10-20% for the past 3 years, mostly due to increased average fare price, capacity and successful launch of new bases. Ryanair has made a profit for each of the last ten years, and continues to grow its passenger numbers year-over-year, carrying 81.7 million in FY 2014 its highest amount to date and a 3.03% increase on FY 2013, mainly as a result of increased routes and operating bases. It is a stable and growing airline and continually looking to expand, with a near future business plan of entering the lucrative transatlantic route, Wild (2015). Ryanair is one of Ireland s most world-renowned firms, and has been a market leader in implementing budget air transportation within the European market. Ryanair has become the world s biggest airline of international passengers (IATA data), and along with their unique CEO, who is a Trinity graduate; I have personally felt it to be an interesting company to follow the past few years. The current fuel hedging debate The recent plummet in oil prices, which has seen crude oil fall from $110 per barrel in 2014 to under $50 a barrel in 2015, has subsequently caused oil price hedging carried out by airlines to become a debatable strategy, and therefore interesting hot topic to cover. As prices are now at there lowest, hedging now should make sense as prices would be expected to rise, yet the strategy is still debated as a too costly form of insurance. Lufthansa like Ryanair consistently hedge fuel requirements in advance, and in Gordon & Wild (2014) Mr Luft, the head of its fuel management, explains the scepticism in the strategy and the need to pay a premium for hedging instead of relying on spot prices even when the market is flat. But with the volatility involved, paying the premium for certainty in costs and insurance against unpredictable jumps in prices tend to silence the critics, once they are witnessed. Although fuel hedging reduces risk, it also can diminish the benefit of falling spot prices, Rowling (2014). As hedging involves locking into prices in advance, instead of relying on fluctuating spot prices, there exists a chance that airlines can lock themselves into expensive contracts and end up accumulating large losses should the spot price decline in the future. Several airlines experienced this during the 2008 oil crisis, such as Air France-KLM which consequently lost $600 million, Rowling (2014). It is not only European airlines that were affected: Chinese airlines were particularly hit hard in 2008, resulting in substantial losses occurring and the Chinese government subsequently banning airlines from hedging, O Donnell (2014). US Airways were also badly impacted and have since not hedged. Now in 2015, airlines are experiencing extremely low oil prices are debating whether to risk operating unhedged and rely on cheaper spot prices, reducing operating costs and boosting profits. This is a risky strategy given the volatility of prices, and even though a gain exists from using spot prices rather than the slightly more expensive forward prices, it can result in a potentially sudden increase in costs that could easily wipe out the 1

2 previous gains. Hedging on the other hand should reduce swings in profits, enabling a constant close to average profit to be made, Morrell & Swan (2006). This study is going to analyse the effect of hedging on Ryanair for the previous ten fiscal years, determining whether it has been a worthy strategy. The study will also compare the effect of hedging on airlines within the European market and if hedging increases their market value. This study finds that hedging has been a major success for Ryanair in terms of profit levels, and hedging in the aviation industry appears to be related to increasing an airlines valuation, which is similarly concluded in other studies such as that by Carter, Rogers & Simkins (2004). Jet Fuel: Airlines biggest variable cost Jet fuel prices are persistently airlines biggest variable cost and attributed to 31% of total cost in the airline industry in 2013, O Donnell (2014). Along with being the largest driver in cost, they are also extremely volatile since they are so closely related to crude oil prices, Rowling (2014). Figure 1 shows their close relationship, which stems from the fact that jet fuel is refined from crude oil, from April Quarter one (Q1) FY to December Quarter three (Q3) FY There exists a calculated correlation of , and annualised jet fuel price volatility of 25% for the period, compared to just 19% for crude oil. This finding that jet fuel is more volatile than prices of underlying assets is similarly found in Carter, Rogers & Simkins (2004). Table 1 shows the coefficient on crude oil resulting from a regression of kerosene (jet fuel) on crude oil for the same period. The regression shows us that for a $1 increase in a barrel of crude oil, a barrel of kerosene increases by $0.7683, and this result is significant at the 1% level. During the 10-year period, the quarterly mean price for crude oil was $82.38 per barrel with a standard deviation of Being such a volatile but crucial commodity to the airline industry, many airlines have used hedging as a perceived reliable method of risk management, mitigating their exposure to oil price volatility, by locking in a set quantity of fuel for a set price at a certain future delivery date. This has enabled firms to plan ahead, with a more stable investment environment and given them the ability to fund investments even during periods of high fuel prices as Carter, Rogers & Simkins (2004) found. Figure 1: Spot price Kerosene Jet Fuel against WTI Crude Oil denoted in US dollars per barrel. 2

3 Kerosene OLS Number of observations 39 Crude oil *** ( ) Adjusted R F 1, {Prob>F} {0.000} Table 1: Results from a regression of Kerosene (Jet Fuel) oil spot prices on crude spot prices between April 2005 (Q1 2006) and December 2014 (Q3 2015). Standard error is shown in parenthesis. The Case of Ryanair Despite the current debate, Ryanair remains fully committed to hedging. Even with the current low spot prices Ryanair has hedged 90% of total fuel and oil requirements for the upcoming fiscal year of 2016 and 35% for 2017, at $92 and $68 per barrel respectively. Ryanair has been a firm believer in hedging for the past ten years, consistently hedging 90% of total fuel and oil requirements for the proceeding financial year, by the final quarter of the prior financial year. This makes Ryanair a prime candidate airline to empirically analyse the effectiveness of hedging oil and determine if it has so far been a successful strategy. As stated earlier, oil and fuel are the major cost for an airline. In the case of Ryanair, it was calculated that fuel and oil accounted for between 32% and 50% of Ryanair s total costs, with an average of 40.33% for the 10-year period analysed between April 2005 and December Ryanair s beta value for its stock is 1.17, but is mainly totally attributable to non-market risk such as oil prices, and hence another reason why hedging is an important strategy, Morrell & Swan (2006). Table 2 shows the results of a regression ran on Ryanair s profits from 1995 to 2014, and indicate that a 1 increase in fuel and oil can reduce after tax profits by With a p-value of this result is significant at the 10% level and again highlights the importance of reducing this volatility and negative impact upon profits, by the means of hedging. After Tax Profits OLS Number of observations 16 Fuel & Oil * ( ) Average Fare Price (1.55e+07) Passengers ( ) 3

4 Salary ( ) Dividends ( ) Route Charges * ( ) Adjusted R F 6, {Prob>F} {0.0670} Table 2: Results from a regression of after tax profits on selected explanatory variables, from 1995 to Standard errors for each coefficient are shown in parenthesis. With the availability of data, the period analysed is the previous 10 fiscal years: from April 2005 (Q1 FY 2006) to December 2014 (Q3 FY 2015) and incorporates the 2008 oil crisis. Data for this period showed hedging occurring at every quarter, with 90% of fuel and oil requirements being consistently hedged, apart from Q1 and Q2 in FY 2006 and Q1 and Q4 in FY 2009 where no hedging took place at all, and therefore no analysis of a hedging strategy could be applied to these quarters. With the data, I wanted to compare operating profits achieved when hedging of fuel and oil prices took place, against a simulated operating profit that would have occurred if spot prices were used and constituted 100% of Ryanair s total fuel and oil costs for the same period. Carter, Rogers & Simkins (2006) suggests airlines that hedge benefit from more stable profits and have higher valuations. Fuel and oil costs were assumed to be the only variable, and other operating expenses were unchanged. The Process and Results The first stage involved compiling the operating profit each quarter when oil hedging was used, by subtracting revenue from total operating expenses stated within Ryanair s financials. For simplicity I assumed 100% of total fuel and oil cost were hedged at the stated price, whereas in reality they only hedged 90% of total fuel costs on average. Total fuel costs were reported in euros, so converting them into dollars, using the average dollars per euro exchange rate for each year stated within the annual report, it allowed to calculate the amount of barrels Ryanair purchased by dividing the total fuel and oil cost, now in dollars, by the forward price per barrel Ryanair paid each quarter. Then using the number of barrels purchased and average spot price of kerosene (jet fuel) each quarter, I was able to simulate total fuel and oil costs that would result from no hedging at all, and relied on spot prices alone. Converting this simulated fuel and oil cost back into euros and subtracting from the actual totally hedged fuel and oil cost, the difference between the two schemes could be computed. Adding this difference to the actual total operating expenses stated for each respective quarter, therefore computed the simulated operating profit that would have been achieved from no hedging at all. I was then able to compare this simulated profit to actual operating profit achieved by Ryanair through hedging, and analyse the effectiveness of hedging throughout this period. The result is visually represented below in figure 2. 4

5 Figure 2: Operating profit achieved through hedging, compared to a simulated operating profit achieved by hypothetically operating unhedged for each quarter from FY 2006 to FY The results show us that hedging has been an overall major success for Ryanair for the last 10 fiscal years. The mean operating profit achieved throughout the 10 years was million whilst operating hedged, compared to a simulated profit of million achieved as a result of no hedging in the same period. It can be seen, actual operating profit, which was achieved when complete hedging took place, has been higher in 33 of the 35 quarters analysed, with only simulated operating profit, which is when no hedging was used, achieving a higher profit in just Q3 of FY 2015 and Q3 of FY This is most clearly represented by figure 3 and shows operating unhedged would have resulted in a higher total fuel cost in 33 of the 35 quarters. The relatively higher unhedged operating profit that would have been attained in Q3 of FY 2009 can be attributable to the 2008 oil price crisis. A barrel of jet fuel increased to around $150 in Q1 and Q2 in FY 2009, and then dropped significantly to $78 by Q3 and only $56 by Q4. Ryanair had entered fiscal year 2009 unhedged but was then faced with skyrocketing prices in Q1 it quickly decided to hedge for Q2 and Q3, but in doing so locked into high forward prices of $129 and $124 respectively. Then when spot prices slid in Q3 to $78, they were locked into paying $124 a barrel and subsequently made a substantial operating loss of $93.40 million. Ryanair panicked when prices rose and ended up tying into expensive forward prices as spot then dramatically fell. Q3 in FY 2015 saw operating unhedged being a more profitable strategy as well. Ryanair locked in to forward prices of $96 a barrel by Q4 in 2014, and since then spot prices have fallen, although a positive operating profit was still achieved in Q3 in FY 2015 it could have been slightly higher as spot prices fell to $92 a barrel. Although Ryanair positively benefited from the relatively low forward prices in Q1 and Q2 in FY 2015, 5

6 spot prices have now fallen below $96 and the effect on the subsequent quarter and fiscal year remains to be seen Q Q Q Q Q Q Q Q Q Q Q1 Q3 Q Q Q Q Q Q Q Q Q Q Q Q1 Q Q1 Q Q Q Q Q1 Q Q Q Q3 Figure 3: Scatter plot of spread in actual profit and simulated profit each quarter between FY 2006 & FY The resulting graphs show that for 94% of the time, hedging has resulted in an absolute higher profit compared to the simulated profit achieved when relying on spot fuel prices. It can be seen when profits were positive they were higher than the simulated operating profit achieved by no hedging, and when profits were negative, that is a loss occurred in that quarter, it was a smaller loss than what was achieved as a result of no hedging. There also exists a positive trend in the actual operating profit, while there is only a very small positive trend in the simulated operating profit. This shows profits have been steadily increasing year-over-year, and suggests Ryanair has been increasing its operating profit by reducing its main cost, that being fuel and oil, by the correct implementation of fuel and oil hedging contracts. It is apparent from their financial reports that Ryanair begins hedging up to a year in advance, but only purchase contracts for a small percentage of total requirements, and then over time as oil prices are realised, they will only become fully hedged for the following fiscal year by the prior fiscal year end. This limits Ryanair s chance of becoming locked into expensive contracts, simultaneously mitigating their oil price risk and has enabled them to continually profit and become a market leader. Hedging has been an important and successful strategy for Ryanair, and the analysis of a specific firm has given evidence to its effectiveness in the aviation industry. Should other airlines correctly hedge their fuel costs they could similarly benefit, and this gives rise in the current debate for hedging. 6

7 It should be noted that Figure 2 also shows us a very slight positive trend in the simulated operating profit. It is expected that there would exist no trend and operating profit, achieved with no hedging, would fluctuate quite substantially due to the highly volatile nature of oil price and hence jet fuel. Although the mean profit is higher as a result of hedging, as stated previously, one interesting observation is the standard deviation is higher (200.25) than the standard deviation from no hedging (192.53), but with both being so high it demonstrates the high amount volatility in the industry. It would be expected that standard deviation in profits would in fact be lower as a result of hedging as it is reducing volatility, but this is not what is observed in the data. Morrell & Swan (2006) also highlight this finding and state profit volatility may not be dampened out as oil prices and air travel demand cycles are linked when oil supply reductions drive GDP declines. But oil and travel are negatively correlated when GDP demand surges drive oil price increases. Therefore oil prices can either increase or decrease airline profit cycles. Whilst evidence has shown a specific firm to benefit from hedging, the next stage analyses the effect within the industry. Evaluating the effectiveness of fuel hedging and the value of the airline within the European aviation market can be seen in figure 4. The hedging levels by European airlines were reported by Gordan & Wild (2014) in a Financial Times article, and the valuation of airlines was determined by the price-tosales ratio, as of market close on March 13 th Price/Sales Trailing 12 Months Ryanair Easyjet Aer Lingus IAG Norwegian Air France Finnair Lufthansa Percentage of fuel hedged Figure 4: Plot of European airline s total fuel and oil hedging amounts for 2014 against their current price-to-sales ratio. Figure 4 is based on Cobbs & Wolf (2004) analysis of the effect of hedging on airline s valuation in the North American market, which was preformed in 2003, with their results seen in figure 5. Although my results are not as clear as Cobbs & Wolf (2004), a positive correlation does still appear. This reinforces Carter, Rogers & Simkins (2004) and O Donnell (2014) findings that, fuel hedging increases airline s valuation by 12 to 16%, mainly due to airlines returns being negatively exposed to the price of jet fuel, which is found in Carter. et al (2004). The effect of hedging can be seen on Ryanair; being the airline that hedges the most in our sample and has the highest valuation, a direct consequence of its sustained high 7

8 profit levels as a result of hedging. Comparing this finding to Norwegian Air Shuttle, another budget airline, who did not hedge at all in 2014, we see they have a much lower valuation and while it could be due to a number of factors such as firm size, dividends, leverage, profitability etc. the lack of hedging, which Carter, Rogers & Simkins (2004) show does effect value, can certainly be attributable as one reason to the lower valuation. Easyjet has similarly benefited like Ryanair but the other airlines seem to have mixed results. Some European airline s valuations do not appear to have benefited from hedging, but this can result due to the different number of factors that affect an airlines valuation. It is important to remember although figure 5 shows a clearer positive relationship, it is based upon a different market, the North American market, where the average percentage of fuel hedged is only 9.2%, compared to Europe s 40%, O Donnell (2014). US airlines are more prone to operate unhedged such as US Airways and American Airlines who do not hedge at all currently, Kohlman, Elward & Cheong (2014). Having focused upon Ryanair, an airline solely operating within the European market, it seemed appropriate to compare Ryanair to the European market only. Comparing European airlines was harder, with limited information only a small sample was established and fewer airlines were operating completely unhedged like the American market. Also with European airlines being based in different stock exchanges throughout Europe and the world, in different currencies, discrepancies appear in calculating the price-to-sales ratio. Nonetheless, the findings show a positive correlation coefficient with the levels of fuel hedging on valuation, and applying a trend, the effect can be seen to become more dominant as the level of hedging increases. Figure 5: Scatter plot for American airline s total fuel and oil hedging amounts for 2004 against their price-to-sales ratio on December 31 st Figure 5 is found in Cobbs & Wolf (2004). Possible improvements The analysis carried out could be enhanced in a number of ways. An assumed simplification that 100% of total fuel and oil was hedged each year, could be removed in order to achieve more accurate and realistic results. In reality only 90% was hedged 8

9 and the remaining 10% could be estimated through average spot prices for the associated period. When simulating the effect of operating unhedged, it was assumed no other costs were affected, but this ignores associated hedging costs such as broker fees that would now not occur and therefore again result in imperfect results. When converting exchange rates, an average for the year was used, and if variable rates, or the average exchange rate for each quarter were to be used, more realistic results would be obtained. In comparing the European market, a larger number of airlines valuations and hedging rates could be analysed, although this information was hard to find for recent years, it may be available for another year in the not so distant past. Conclusion Although the practice of fuel hedging is currently being disputed by some airlines, having empirically analysed the Ryanair approach, evidence has proven hedging to be a valuable strategy historically. Resulting profits from hedging were higher 94% of the time, compared to profits that would have been attained whilst operating unhedged. Locking in fuel prices in advance has enabled Ryanair to plan for the future with its most volatile cost now guaranteed. Ryanair operated unhedged in Q1 FY 2009, just before the 2008 oil crisis. Being fully exposed to the price shock resulted in a loss occurring and Ryanair panicked into hedging, resulting in paying high forward prices which could have been avoided had they continually hedged each year. The 2008 oil crisis negatively impacted many airlines including Ryanair but instigated structural change in hedging, Rowling (2014). Airlines are now hedging fuel prices with a much shorter time horizon limiting the chance of being locked into expensive contracts. This selective process, which has been implemented by Ryanair, is testament of their hedging success. In hedging consistently 90% of total fuel costs by fiscal year end, and reducing volatility in costs, hedging has ultimately helped Ryanair establish continued profits, growing their position within the European market as one of the highest valued firms. Although the value of a firm is not solely dependent on the amount they hedge, it is a relevant factor, and although not all airlines decide to hedge fuel, this could be because the costs exceed the benefits from the strategy and not because they do not find hedging to be valuable strategy. References F, quarterly and annual Ryanair reports, available at: 2. Dave Carter, Dan Rogers, & Betty Simkins (2004), Fuel Hedging in the Airline Industry: The Case of Southwest Airlines, Oklahoma State University. Available at: 3. Carter, Rogers & Simkins (2006) Does Hedging Affect Firm Value? Evidence from the US Airline Industry. Financial Management, , Spring 2006, Vol. 35, Issue 1 4. Cobbs & Wolf (2004), Jet Fuel Hedging Strategies: Options Available for Airlines and a Survey of Industry Practices. Available at: 5. Sarah Gordon & Jane Wild (2014), The Financial Times, June 22 nd 2014, Oil price volatility hits European airlines, available at: feabdc0.html#axzz3UHvMYg2a 6. Matthew Kohlman, David Elward & Su Yeen Cheong (2014). Platts Blog. US airlines are taking the hedge off on jet fuel. Available at: 9

10 7. Peter Morrell & William Swan (2006). Airline Jet Fuel Hedging: Theory and practice. Transport Reviews, Volume 26, Issue 6 November 2006, pages Available at: %20hedging%20-%20theory%20and%20practice.pdf 8. Duncan O Donnell (2014). The Queen s Business Review. Is Fuel Hedging Effective in the Airline Industry? Available at: 9. Rupert Rowling (2014), Bloomberg Business August 14 th 2014, European Airlines Cut Jet Fuel Hedging as Prices Fall. Available at: Jane Wild (2015), The Financial Times, March 16 th 2015, Ryanair board approves plan for transatlantic airline, available at: feab7de.html#axzz3UYlz5HEO 10