“I have the mandate of all airlines to demand that airlines begin importation of fuel. If we can buy planes of millions of dollars, we can also import fuel ourselves. Let NNPC give airlines licenses, we want to import ourselves,” said Allen Onyema, the Chief Executive Officer of one of the largest airlines in Nigeria.
Background
Airlines usually approach turbulence mid-air but it appears that Nigerian airlines are currently experiencing turbulent times on ground with expensive jet fuel threatening to ground their operations. The fuel scarcity has revealed all stakeholders, their modus operandi, price mechanisms, and the supply and distribution chain of petroleum products in Nigeria.
So it has come to the public notice, that airlines get their fuel from oil marketers who import fuel from overseas. Aviation fuel or Jet fuel is then priced by the marketers and sold to the airlines who then use it as a benchmark to affix flight costs.
Prices for Jet A1 fuel have exceeded N600 ($1.44) per litre this month. This is a massive jump from N180 ($0.43) per litre in February 2021, while just one month ago, the price was around N400 ($0.96) per litre. If the Federal Government does not intervene, Airlines have said this would have ground operations.
To avert the crisis, Airlines called on Nigeria National Petroleum Corporation (NNPC) Ltd to grant them a license to import fuel as they blamed aviation fuel marketers for not being transparent on the reason behind the price hikes. The Nigerian National Petroleum Corporation has said it would issue import licenses to airlines to bring in jet fuel into the country making them a player in the international fuel market.
How can airlines make profit?
Theoretically, jet fuel prices are correlated with oil prices as fuel is derived from oil. Oil is procured in dollars which Nigeria does not have a surplus of at the moment.
Now airlines will find themselves delving into the currency business and jet fuel markets.
The currency business involves sourcing for FX to import fuel. Many marketers decried that the exchange rate has increased their costs and with the rising cost of petroleum products, there is no way ticket prices would not skyrocket.
Aviation fuel, also known as Jet A1, accounts for between 30 to 40 percent of operating costs in aviation. Deregulated and exclusively controlled by suppliers, the price has consistently been fluctuating along with naira to the dollar exchange rate.
Given this significant influence on costs, fuel prices can determine the profitability of airlines. IATA’s Director-General, Willow Walsh, said a sudden spike in fuel prices is putting pressure on airline costs. “When we made our most recent industry financial forecast last autumn, we expected the airline industry to lose $11.6 billion in 2022 with jet fuel at $78/barrel and fuel accounting for 20 percent of costs. As of March 4, jet fuel is trading over $140/barrel.
Nigerian airlines for the past 10 years have been paying N180, N170, N140 per litre but as at this period, they are reportedly paying N680 per litre.
The move to allow airlines to bring in their own fuel will eliminate middlemen who have been profiteering from the recent crisis by hoarding the product that has been in their inventory for months now.
But this licence to import fuel would mean Nigerian airlines would have to start adopting a practice and popular mechanism used by international airlines – Hedging.
The Jet fuel market involving Airlines’ profitability is more than a little bit dependent on jet fuel prices, and yet there are limited resources available to mitigate the risks of a volatile oil market. The most widely used tool for this purpose is fuel hedging, which is when airlines agree to purchase oil in the future at a predetermined earlier price.
There are different financial instruments used in hedging fuel prices (aviation fuel, diesel fuel, natural gas etc). Traders use either futures contracts, call options, basis swaps, collars and spreads on options to hedge against volatile prices.
Swaps
A jet fuel swap is an agreement whereby a floating (or market) price is exchanged for a fixed price, over a specified period(s) of time. In addition to jet fuel, swaps are also used to hedge numerous other commodity risks including bunker fuel, crude oil, diesel fuel, electricity, natural gas, etc.
Airlines utilize swaps in order to hedge their fuel price risk by fixing or locking in their fuel costs. Similarly, many fuel marketers, refiners and traders utilize swaps to hedge their inventory and margins as both are impacted by price volatility.
As an example of how an airline can utilize a jet fuel swap, let’s assume that Air Peace who consumes a large amount of jet fuel in Nigeria and have decided to lock in 50% of your fuel costs for a specific month as they have sold 50% of their available seats during said month. For sake of simplicity, let’s assume that Air Peace is looking to hedge 5,000 BBLs of fuel which will be consumed during the month of April. In order to do accomplish this Air Peace could purchase an April 2022 jet fuel swap, on 5,000 BBLs, from a counter-party (often a major oil company or bank). If Air peace had purchased this swap at the prevailing market price (as at March 4), the price would have been $140/BBL.
Now let’s look at how the swap would perform if the average price of jet fuel during the month of April averages both $10 per barrel lower and higher than the price of Air Peace’s swap, $140/BBL.
In the first scenario, let’s assume that jet fuel prices in Europe increase and that the average price for jet fuel, for each business day in April, is $150/BBL. In this scenario, the hedge would result in a “gain” of $10/BBL or $50,000. As a result, the counter-party would owe Air Peace $50,000, which would offset the increase in your actual April fuel costs by $10/BBL.
In the second scenario, let’s assume that jet fuel prices in Europe decrease and that the average price for jet fuel is $130/BBL. Given the $10/BBL decrease, Air Peace’s hedge at $140/BBL would result in a “loss” of $10/BBL or $50,000. As a result, they would owe their counter-party $50,000, which would offset the decrease in your actual April fuel cost by $10/BBL on 5,000 BBLs.
Scenario one appears more likely, as projections for oil and jet fuel are on the upside.
Now in theory any hedging losses from the swaps or costless collars should be offset by lower physical fuel costs. So it is not particularly zero-sum as profit margins can still be established.
Other financial instruments still exist and now that Nigerian airlines are in the fuel market during these volatile times as Russia and Ukraine war on, perhaps we see the use of more hedging strategies.
