Kenya Airways fuel hedging impacts

October 6, 2016

Kenya Airways is an airline facing challenges that many argue would have been avoided.With oil prices on the decline, and analysts predicting record profits for airlines were awfully wrong to include Kenya Airways and South Africa Airways on the same bracket as Africa’s success story of Ethiopia Airline.Kenya Airways and South Africa Airways are under increasing pressure to abolish fuel surcharges and lower their fares.In Kenya, consumer protection authority is said to be investigating whether Kenya Airways has been misleading with its surcharges, amid a growing perception the airline has been pocketing all the fuel savings without passing any of the benefits on to their loyal customers.Someone familiar with the matter told your blogger that Kenya Airways will absorb all fuel surcharges into the base fares as soon as hedge contracts allow it and or competition forces it to do so. As consumers are traditionally less price sensitive to the fuel surcharge compared to the base fare, unbundling both has been beneficial to Kenya Airways. The question is not if but when fuel surcharges, which only apply on international flights, will be reintegrated into the ticket price. All fares are also expected to come down further.Over the past decade fares and cargo rates have fallen in Kenya by more than 50% after adjusting for inflation, according to the data available. Kenya Airways’ international airfares, including the fuel surcharge, have never been lower. Consumers have not therefore enjoyed lower fares while jet fuel prices went down, which is not something other transport Airlines can do.

In theory, Kenya Airways should be among the top beneficiaries of the oil price slump as fuel costs have become the largest cost category for airlines in the last decade, often representing 30-40% of total operating expenses.Low cost carriers like JamboJet, FastJet are particularly exposed to fuel price changes, as they have reduced all other costs such as staff costs to a minimum. For example, Kenya Airways’ owned JamboJet aircraft fuel expenses are over 45%. This means nearly all low cost carriers hedge.While it is a no brainer that airlines will benefit from the recent sharp decline in oil prices in the long run, in the short to medium term hedging contracts and foreign exchange rate risks can make things a lot more complex like it has happened with Kenya Airways.One would have expected Kenya Airways to post a net profit with lower oil prices being one of the main drivers behind the improved profitability. Given that the average net post-tax profit margin of Kenya Airways is around 0.1%, the soon to be materialised profits are important for much needed capital and debt management as well as fleet modernisation and product improvements.That said, despite all the excitement about the massive profits the hedged Kenya Airways was expected to make, Kenya’s Aviation regulator expects the return on invested capital to grow to 4.6% only. While this is a significant improvement on the 2.1% 2015, it is still below the 7.3% global’s expected weighted average cost of capital, so Kenya Airways will still destroy shareholder value. For Kenya Airways, the recent depreciation of the Kenya shilling means that some of the fuel price gains will be diminished as most of the jet fuel and many other expenses is traded in US dollars.What is more, most Kenya Airways customers may have to be patient as lower fuel prices will be realised with a time lag, due to forward fuel-buying practices that are aimed at protecting both Kenya Airways and its consumers.

Photo above shows a plane belonging to Kenya Airways at Kilimanjaro International Airport that I took few years back on my way to Serengeti National Park
Photo above shows a plane belonging to Kenya Airways at Kilimanjaro International Airport that I took few years back on my way to Serengeti National Park

Fuel hedging is just one example of the risk mitigation strategies taken by Kenya Airways. The exposure to risk relating to the volatility of fuel prices, currency fluctuations and interest rates are widely hedged by Kenya Airways using different types of financial instruments.How different Kenya Airways and other airlines approach hedging varies. Some will hedge almost all of their fuel requirements, currency and interest rate exposures, some do not hedge at all.Others will report paper losses but will at the same time benefit from the fuel price drop as not all of their requirements are hedged and those that are hedged are often designed to cap losses both ways.To determine whether Kenya Airways speculate with the fuel price requires in depth analysis on the types of fuel hedge instruments they use.A lack of disclosure requirements makes it almost impossible to establish how exactly or when Kenya Airways hedged. Despite being a publicly listed company, Kenya Airways does not publicly discuss details of its strategies, as successful fuel hedging is a competitive advantage.However, from my sources, it is highly likely Kenya Airways use costless collar hedging which is using a call option while at the same time going short with a put option at a lower strike price. By doing so, Kenya Airways can cap losses and pay for it by also limiting the upside benefits, which therefore limits volatility and clearly shows hedging is not a bed of speculation but is purely protection from volatile fuel prices.It is therefore inevitable that there will be a time lag in terms of customers being able to enjoy lower fares as a result of lower jet fuel prices as Kenya Airways case has proved.Once Kenya Airways start paying fuel prices close to the current low spot market prices, competition will force them to pass on much of those savings to their customers especially the Entebbe-Nairobi route that many Ugandans have complained over the years as a result of its near monopoly with its charges for one way ticket for a flight less than an hour costing half the ticket prices from Entebbe to Amsterdam. What will not be passed on will ensure that private investors will see at least some return on their investments in this extremely competitive market.

Contador Harrison