Fuel Hedging and Risk Management. Gajjala Vishnu N.

and done, it is the consumer who pays for the consumed good, thereby providing the fundamental incentive for producers to produce. Furthermore, consumers can consolidate market power with the help of regulations or legislation, like consumer protection laws that aim to defend the bargaining power of end consumers in recognition of their political power as potential voters. The same applies to the demand for a book, as there are more consumers than producers interested in a book about fuel risk management. Quite often, we hear friends, taxi drivers, or even restaurant owners complaining about high oil prices or justifying the high cost of their services. However, we seldom hear any feedback from these same people when oil prices collapse, save when they have fuel hedges in place and become very vocal about any associated financial losses.

       R. Arous

      Isn't that how hedging mechanisms work?

       S.M. Dafir

      Yes, but when a risk manager takes credit for the positive payout of a hedge that he/she has put in place, he/she should also accept blame for future negative payouts. So many risk managers praise themselves for the market timing of their hedges and seek appropriate recognition from senior management. It is a very common human behavior to take credit for good luck and associate it with skill, while negative outcomes are usually explained by bad luck. In financial markets, losses are very often blamed on “volatility,” but high profits from price spikes are usually presented as good market timing.

      For example, take the spectacular decline of oil prices witnessed in 2008. Many Asian airlines reported significant losses on fuel hedging derivatives, eliciting strong reactions from top management, tremendous concern from banks about the risk of default on hedging derivatives, and a tsunami of bad publicity regarding structured hedging derivatives. It was very easy back then for any layperson to raise his or her voice and designate structured and exotic derivatives as too complex, warranting their avoidance or even prohibition, as if complexity could be accepted as reasonable grounds for culpability. That was an easy way out for many stakeholders. However, the recent dramatic decline of oil (2014–15) amounted to a replay of past events that proved how the allegations made in 2008–9 overlooked the underlying culprit behind the unfortunate mishaps. In other words, the last five years of change in airlines' hedging policies, which were designed to avoid complex exotic and structured products, could not prevent large losses in 2015. Unfortunately, the media and many so-called experts have been recycling the same narrative of the past as if the market suffers from amnesia.

       R. Arous

      When money is lost, people need an “acceptable” explanation and a scapegoat. Isn't it the same here?

       S.M. Dafir

      Yes. This is no different from how the concept of witchcraft was used to identify scapegoats for natural disasters or newborn malformation. For some religious leaders to reconcile the concepts of omnipotence and an all-loving deity, they might have invented “witches” in order to explain the existence of evil.

      The recent decline of oil prices was good news for the airline industry, although many airlines reported big realized/expected losses from fuel hedges in 2015, including Southwest Airlines (over $1 billion), Cathay Pacific (over HK$3 billion), Singapore Airlines, and Delta Airlines. The problem is that without hedging, you can always blame the market, but if you make losses because of your hedging, then it is your fault. As I explained earlier, this is only fair if a risk manager chooses to take credit for the hedging gains without considering the performance of the business as a whole. In fact, those airlines that had fuel hedges in place saw this benefit muted by hedging losses. In my opinion, what is commonly perceived as evil is nothing but the absence of good, in the same way that blindness is the absence of sight and deafness is the absence of hearing. Those who describe these risk management instruments as “casino-like hedges” show a profound misunderstanding of how financial markets and price discovery mechanisms work. They fail to accept that, in the absence of value creation, one person's gain is another person's loss. When fuel prices keep rising, those who make money, including producers, investors, speculators, and even certain hedgers, make huge gains that must come from someone else. When these gains are not reinserted into the economy in the form of consumption, a transfer of wealth takes place. One party in the economic equation will experience financial bleeding that can't be sustained forever. When such status quo gets challenged, extreme and rough events occur!

       R. Arous

      Are you referring to mean reversion?

       S.M. Dafir

      In a sense, yes. Mean reversion might reflect the rebalancing of the distribution of value that is finite. Let me tell you a story. My father visited me once and kept himself happily engaged taking care of the potted plants on the roof terrace. Among the things he planted was a pumpkin seed, which grew quickly into a pumpkin tree and even bore small fruit. My dad was so excited and enthusiastic that he started telling me how we would no longer need to buy pumpkins from the supermarket. That was until I reminded him that the tree that he expected to produce a dozen pumpkins was planted in a small pot not even the size of one ripe pumpkin!

       R. Arous

      But you could still add more soil and water to sustain its growth.

       S.M. Dafir

      Exactly! That is precisely what happens with rising oil prices. Increasing debt makes energy products affordable and allows the economy to continue to grow. Without debt, oil prices would plummet. Similar to the potted pumpkin tree, recycling the petrodollar helps reinject some of the liquidity through a well-functioning financial system. However, if the outstanding credit drops, growth gets impacted and oil prices plummet. Quantitative easing was nothing but a response to this phenomenon.

       R. Arous

      What about volatility?

       S.M. Dafir

      In my opinion, volatility spikes are akin to revolutions; they are prompted by a demand for decorrelation, regime change, or a more equitable division of created wealth. For example, a sharp decline in the price of oil has the effect of boosting consumers' spending. Unfortunately, just as with the case of revolutions, volatility spikes are usually more profitable for those who possess solid capabilities, information, and resources. For example, in the commodities market, falling prices are usually accompanied by a futures market in “contango” (steep forward curve) that offers arbitrageurs the opportunity to buy the physical commodity, store it, and secure a high selling price in the future. However, weak players might not have the access to funds and storage facilities to execute this. Even worse, they might struggle to meet margin requirements on their existing hedges or derivatives. Short of funds, many fuel hedgers are obliged to early-terminate their hedging trades at unfavorable exit levels. This book dedicates an entire chapter to discussing unwanted risks associated with fuel hedging to help hedgers learn how to assess risks, negotiate ISDA and CSA, and formulate solid strategies to harness volatility.

       R. Arous

      You explained earlier how macroeconomic and geopolitical factors affect oil prices. Can't fuel hedgers focus on these macro factors in order to anticipate and navigate volatility?

       S.M. Dafir

      That is not enough. The macroscopic and the microscopic are intertwined. The more we learn about the macro picture, the better we understand the microscopic details and vice versa. Take for example the pricing models of derivatives; they are based on our understanding of the dynamics of price movement, which includes mean reversion, regime changes, correlations, and other assumptions borrowed from our knowledge at the macroeconomic level. At the same time, knowledge of derivatives' valuation, risk management, and collateralization helps us understand the market reaction to price movement, triggers of liquidity drainage and credit crunches, and the impact of derivatives replications on the price determination process.

      During the five years preceding the peak of the credit crisis and the collapse of Lehman Brothers,