What are the arguments for and against an airline company hedging its fuel risk?Morrell and Swan (2006) define hedging as “locking in the cost of future fuel purchases”, as protection against increasing fuel prices, without gaining from decreasing ones (investment needed). Hedging could add value by• (Froot et al. (1994), Myers and Majluf (1984), Sefton (2017)):o reducing capital raising costs (firms’ preferred pecking order: internal funding, then debt, then equity), ensuring cash flow synchronization (not just cyclical) with NPV-enhancing investment opportunities during recessions;• (Carter et al., 2006):o protecting capital expenditures through higher liquidity during market downturns to enable positive NPV projects (undervalued asset acquisitions, advertising, R);o lowering the restructuring costs (debt claims, suppliers, customers, employees) of financially distressed firms;• (Berk and DeMarzo (2017), Graham and Smith (1999))o increasing the airlines’ debt capacity through lower cash flow volatility (to repay debt) and therefore, their value through tax reductions (Modigliani & Miller’s Theorem);• (Morrell and Swan, 2006): o being financially and strategically sustainable without indefinitely increasing operational efficiency or transferring cost increases to customers; o stabilizing profits when oil supply shrinkages caused by political perturbations (war, terrorism) negatively impact business confidence and economic growth;o reducing the total expense of bankruptcy-facing airlines, where feasible, by liquidating profitable hedges;Hedging is unlikely to add value where• (Froot et al., 1994):o during strong economic growth, and consequently scarce investment opportunities, firms do not require excess capital;• (Morrell and Swan, 2006):o oil price increases are based on economic growth fuelled demand, thus, increasing volatility, because just as hedging profits rise with operating profits in an expanding economy, the converse is also true;o airlines hedge to speculate and achieve sustained profits, rather than stabilize them, hedging being a zero NPV investment with balanced buyer and seller bets, highly active and liquid markets, and airline fuel purchases rarely impacting fuel prices;• (Carter et al., 2006):o investment resources or strategic hedging foresight are lacking (smaller airlines) unlike in larger airlines with higher Tobin’s Q ratios and credit ratings (with the highest potential gains from hedging and losses from high leverage);• (Nytimes.com, 2013):o exotic derivatives are used, possibly endangering the firms’ cash flows;ConclusionHedging is essentially a zero-cost assurance to stockholders of the managements’ alertness and dedication to making the best decisions on their behalf. Efficient executions add value to companies (Southwest Airlines in 2005 (Carter et al., 2006)), whereas inefficient ones reduce the same (Southwest Airlines in Q4, 2008-09 (Rivers, 2012)).?Based on this, would you advise Ryanair to continue on hedging its fuel price risk?Ryanair is a cost leading airline (Kumar, 2016) “carrying 131m p.a. on more than 1,800 daily flights from 86 bases, connecting over 200 destinations” (Corporate.ryanair.com, 2017). To retain leadership, it actively manages risk to contain fuel price, interest rate and exchange rate fluctuations, while maximising shareholder value (Sefton, 2017b; Sefton, 2017c). A SWOT analysis could help contextualize whether Ryanair should continue their current fuel price hedging policy or optimize it:Strengths- Diversified hedging: “Ryanair had hedged approximately 90% of its forecasted fuel-related dollar purchases against the Euro at… approximately $1.12 per euro… (till) March 31, 2018 and approximately 74% of (the same at) approximately $1.13 per euro (till) March 31, 2019” (Ryanair, 2017).- Long view on the dollar: As jet fuel and crude oil prices are quoted in USD, Neil Sorahan, Ryanair’s CFO, confirms that Ryanair has locked in both at “around 137… against the Eurodollar (2017-18), 133 (2018-19) (and) 123 (2019-20).” (Sefton, 2017b).- Value creation: Ryanair’s current fuel hedging policy has contributed to maximizing stockholder value more than its competitors (below, (Investor.ryanair.com, 2017b)). Weaknesses- Fuel cost impact: Fuel, which is Ryanair’s biggest cost (43%), is highly volatile (below, (Iata.org, 2017)). Ryanair tightly controls all other costs (aircraft acquisitions, airports, staffing costs) (Sefton, 2017b). While hedging provides some predictability, it does not protect Ryanair from drastic price drops (Rivers, 2012). Opportunities- Competitive advantage: From a Porter’s Five Forces viewpoint (Porter, 2008), even market cost leaders have strong buyers faithful only to prices. Successful long-term fuel price hedging could allow Ryanair to reduce buyer power through strategic products (such as 12-month advance bookings (Sefton, 2017b)).- Shareholder value maximization: Ryanair has a “very conservative” hedging strategy (upto 90% of fuel costs) (Sefton, 2017). Given their considerable market advantage (below, (Ryanair, 2017b)), it could consider taking on additional risk to maximize shareholder value (Mullins Jr., 1982). – Credit rating: Ryanair has a high and stable credit rating (right, (Investor.ryanair.com, 2017)). It could consider acquiring more debt to reduce its tax burden (Carter et al., 2006; Sefton, 2017).Threats- Rapid expansion: “…to almost 430 aircraft by March 2018… (and) traffic to over 130m customers.” (Ryanair, 2017). Without a successful hedging strategy this growth could be jeopardized.ConclusionBased on the aforementioned evidence, Ryanair is advised to continue pursuing their hedging strategy, while also maximizing shareholder value and reducing the corporate tax burden through calculated risks and optimal debt.