OFS CASE STUDY

Fuel Hedging at
JetBlue Airways
Presented by Group 2:
UM22047 - Saksham Baveja
UM22060 - Sourabh Andani
UM22061 - Taashi Parasrmpuria
UM22075 - Ankit Gajwa
UM22081 - Himanshu Sharma
UM22091- Mukul Lundia
UM22095 - Mehul Agarwal
UM22096 - Pankaj Kumar Sharma
UM22097 - Naman Shah
UM22104 - Radhika Agrawal
 Case Summary
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
underlying 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.
 Continued...

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.
 QUESTION 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?

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A time series analysis of data and plotting of historical jet fuel prices shows that the prices of jet fuel
are falling lately and a time series analysis shows a trend of mean reversion. Thus Jet Blue should not
hedge because Jet fuel prices should not be hedged for 2012, but if they were to hedge, they should
hedge it using Heating oil futures. They could also consider entering into a collar strategy whereby to
take advantage of falling oil prices, they could sell OTM call contracts and buy OTM puts.
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
Read More

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.
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 QUESTION 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?

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 QUESTION 2
(Continued..)

The multiple regression output shows that jet fuel price is correctly calculated by WTI, Brent and Heating
oil being the independent variables and jet fuel as the dependent variable. From our analysis and the
regression output, we have identified that heating oil is the most ideal hedge for jet fuel, if jet fuel otc
contracts themselves are not available. The R^2 of the regression
Read More output is 0.99.

Jet fuel has the highest correlation with Heating Oil in the period 2007 to 2011.
 QUESTION 3
(Continued..)
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
Read More a solid foundation for effective risk
management and cost containment.
 QUESTION 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
Read that
More 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.
 QUESTION 3
(Continued..)

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
Read More

dynamics of the global oil market.

 QUESTION 4
How would a WTI or Brent futures hedge work? And what do you learn from backtesting a WTI
hedge versus a Brent hedge.

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 QUESTION 4
(Continued..)

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 basisRead
andMore
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.
 QUESTION 5
Should JetBlue switch to Brent hedging?
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

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 QUESTION 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 futuresRead
contracts,
More 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 mayRead More
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.
THANK YOU

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