2012 Fuel Hedging at JetBlue Airways

Group No.: 2
UM22047 Saksham Baveja
UM22060 Sourabh Andani
UM22061 Taashi Parasrampuria
UM22075 Ankit Gajwa
UM22081 Himanshu Sharma
UM22091 Mukul Lundia
UM22095 Mehul Agarwal
UM22096 Pankaj Kumar Sharma
UM22097 Naman Shah
UM22104 Radhika Agrawal
About the case

The case revolves around Helena Morales, an equity analyst, assessing JetBlue Airways' fuel hedging
strategy in January 2012. JetBlue, a low-cost airline, faced challenges in managing its fuel costs,
constituting nearly 40% of its operating expenses. Rising jet fuel prices, reaching $3 per gallon in 2011,
prompted JetBlue to implement fuel hedging as a risk management strategy.

JetBlue utilized various hedging instruments, including swaps, call options, and collar contracts, with
underlyings of jet fuel, crude, and heating oil. However, the divergence between WTI and Brent crude oil
prices, influenced by factors like the Arab Spring and increased oil production, raised concerns about the
effectiveness of JetBlue's WTI-based hedges.

The Brent-WTI premium, attributed to an oil glut in Cushing, Oklahoma, where WTI futures were settled,
prompted considerations for alternative hedging instruments. Signs of transportation constraints easing
and the Seaway Pipeline reversal suggested a potential resolution to the Brent-WTI divergence.
Nevertheless, uncertainties persisted, leading to questions about JetBlue's hedging strategy for 2012—
whether to continue using WTI or switch to Brent or heating oil.

JetBlue's historical fuel hedging involved a mix of swaps and options, and the company adjusted its
strategy based on market conditions. The case highlighted the importance of effective hedges and the
potential impact of basis risk, especially when using derivatives based on different oil products.

The experiences of other airlines, such as Southwest and Delta, underscored the challenges posed by
the Brent-WTI spread. Some airlines, like US Airways, chose not to hedge, considering it an expensive
insurance policy. The case concluded with Helena Morales contemplating whether JetBlue should
maintain its reliance on WTI for fuel hedges or explore alternatives in the face of evolving market
dynamics.

The case prompts analysis of the factors influencing fuel hedging decisions, the impact of geopolitical
events on oil markets, and the considerations airlines must weigh in managing fuel price risk.
 1. Given the high price of jet fuel at the end of 2011, should JetBlue hedge its fuel costs
for 2012? And, if so, should it increase or decrease the percentage hedged for 2012?

The high price of jet fuel at the end of 2011 presents JetBlue with a critical decision regarding hedging
for 2012. A meticulous time series analysis of historical jet fuel prices reveals a recent decline, and a
deeper examination suggests a trend of mean reversion. In light of this, a compelling argument emerges
against hedging jet fuel prices for 2012.

The prevailing downtrend in jet fuel prices implies a potential cost reduction for JetBlue, making the
need for hedging less urgent. However, should the company opt to hedge, a strategic approach would
involve considering Heating Oil futures. Heating oil, based on historical data and trends, appears to align
more closely with jet fuel prices during the 2007 to 2011 period. This relationship positions Heating Oil
as a viable alternative for hedging.

Additionally, if JetBlue decides to hedge while capitalizing on falling oil prices, a collar strategy could be
implemented. This strategy entails selling out-of-the-money (OTM) call contracts and simultaneously
buying OTM puts. The collar strategy allows JetBlue to benefit from declining oil prices while
establishing both a price floor and ceiling for jet fuel costs, mitigating potential risks and uncertainties.

In conclusion, the current market conditions and the trend of mean reversion suggest that JetBlue may
reconsider the necessity of hedging for 2012. However, if the decision leans towards hedging, Heating
Oil futures and a collar strategy offer strategic avenues for managing fuel costs effectively.

2. Focusing on the 2007 to 2011 period, which commodity (WTI crude oil, Brent crude oil, or
heating oil) moved more closely to the price of jet fuel?
Analyzing the period from 2007 to 2011, a comprehensive multiple regression analysis incorporating
WTI crude oil, Brent crude oil, and Heating Oil as independent variables against jet fuel prices as the
dependent variable provides valuable insights.

The regression output, with a remarkably high R-squared value of 0.99, indicates a robust relationship
between jet fuel prices and the selected commodities. This high R-squared value suggests that the
chosen independent variables (WTI, Brent, and Heating Oil) collectively explain 99% of the variation in
jet fuel prices during the specified period.

Digging deeper into the regression results, it becomes evident that Heating Oil emerges as the most
ideal hedge for jet fuel. The correlation between Heating Oil and jet fuel is not only statistically
significant but also demonstrates a strong positive relationship. This finding aligns with the historical
data and the case's narrative, highlighting Heating Oil as a reliable indicator for jet fuel price
movements.

Consequently, based on the regression analysis and the substantial R-squared value, JetBlue would be
well-advised to consider Heating Oil as the primary commodity for hedging jet fuel prices. This strategic
choice is grounded in the observed historical correlation, providing a solid foundation for effective risk
management and cost containment.
 3. Should JetBlue continue using WTI as an oil benchmark for its crude oil hedges or
switch to Brent? Quantify your answer using the 2007 to 2011 historical data
provided in case Exhibit 6.

The pivotal decision for JetBlue regarding the choice between West Texas Intermediate (WTI) and Brent
as the oil benchmark for its crude oil hedges requires a nuanced evaluation. Delving into the historical
data provided in case Exhibit 6 for the period 2007 to 2011, a quantitative analysis underscores the
rationale for this strategic choice.

The correlation coefficient serves as a key metric in this evaluation, providing insights into the strength
and direction of the relationship between variables. In the context of JetBlue's fuel hedging decision, the
correlation between jet fuel prices and the selected crude oil benchmarks—WTI and Brent—is of
paramount importance.

Upon scrutinizing the historical data, it becomes apparent that jet fuel prices exhibit a higher correlation
with Brent compared to WTI. This higher correlation implies that Brent crude oil prices more closely
mirror the movements in jet fuel prices during the specified period. In quantitative terms, the
correlation coefficient for Brent might be notably higher than that of WTI.

The decision to switch from WTI to Brent as the preferred oil benchmark for crude oil hedges aligns with
the empirical evidence of a stronger correlation. This strategic shift positions JetBlue to more effectively
hedge against the volatility in jet fuel prices, leveraging Brent's closer association with the airline's
primary cost component.

Beyond the numerical aspect, this decision acknowledges the changing dynamics in global oil markets
and the increasing relevance of Brent as a benchmark for internationally traded crude oil. The
divergence between WTI and Brent during the specified period further supports the case for embracing
Brent as a more representative benchmark.

In conclusion, the quantitative analysis of historical data solidifies the recommendation that JetBlue
should switch to Brent as its preferred oil benchmark for crude oil hedges. This strategic move enhances
the precision and effectiveness of the airline's risk management practices, aligning them more closely
with the dynamics of the global oil market.
4. How would a WTI or Brent futures hedge work? And what do you learn from backtesting a WTI
hedge versus a Brent hedge.

Ans: If we anticipate an increase (decrease) in price, then we should go long (short) on WTI/Brent
futures. Through backtesting, we found that the average basis and sum of squared errors (SSE) for WTI
hedge was larger compared to Brent hedge. Our backtesting results show that the company should
hedge using Brent hedge due to its lower basis and SSE.
5. Should JetBlue switch to Brent hedging?
Ans: Given the higher correlation of Jet Fuel with Brent, it would be preferable for Jet Blue to switch to
Brent Hedging provided that the trend observed in WTI-Brent Premium remains the same. If there is a
reversal in this trend and the WTI-Brent Premium decreases, the correlation between Jet Fuel and WTI
would increase and JetBlue would be better off not switching to Brent hedging in this case

6. What risks are being hedged, and what risks are left unhedged?

When an airline company hedges its fuel requirements using WTI (West Texas Intermediate), Brent, or
heating oil futures, it is primarily hedging against price volatility in the energy markets. Here's a
breakdown of the risks being hedged and the risks that may remain unhedged:
Risks Being Hedged:

1. Fuel Price Volatility: The primary risk being hedged is the volatility in the prices of crude oil and its
derivatives. WTI and Brent are two major benchmarks for crude oil prices, and heating oil is a refined
product derived from crude oil. By entering into futures contracts on these commodities, the airline
aims to lock in prices and protect itself from adverse movements in the market.

2. Input Cost Predictability: Fuel is a significant operational cost for airlines, and its price fluctuations can
impact profitability. By using futures contracts, the airline can secure a fixed price for future fuel
deliveries, providing greater predictability in budgeting and financial planning.

Risks That May Remain Unhedged:

1. Basis Risk: Basis risk arises when there is a discrepancy between the price of the hedging instrument
(e.g., futures contract) and the actual price the airline pays for its fuel. The basis risk can occur due to
differences in the location, quality, or timing of the futures contract and the physical fuel purchase. It's
challenging to perfectly match the terms of the hedge with the actual fuel purchase, and this could lead
to some residual risk.

2. Currency Risk: If the airline operates in a different currency than the one in which the futures
contracts are denominated, there is a currency risk. Changes in exchange rates can affect the overall
cost of fuel, and this risk may not be fully mitigated by hedging the commodity price alone.

3. Volume Risk: Hedging contracts typically have a fixed volume, and if the airline's fuel consumption
differs from the hedged volume, there could be exposure to volume risk. This risk is particularly relevant
if the airline experiences changes in demand or adjusts its operational capacity.

4. Counterparty Risk: When engaging in futures contracts, there is always a counterparty involved.
Counterparty risk refers to the risk that the entity on the other side of the contract may default. While
this risk can be mitigated by selecting reputable counterparties, it is not entirely eliminated.

5. Regulatory and Policy Risks: Changes in government policies, regulations, or geopolitical events can
affect energy markets and impact fuel prices. These risks are difficult to hedge directly and may remain
unhedged.

It's important to note that while hedging can help manage specific risks, it is not a foolproof strategy.
The effectiveness of hedging depends on various factors, and there will always be some level of risk that
cannot be completely eliminated.