Project Evaluation in Emerging Market: Exxon Mobil, Oil Case

Project Evaluation in Emerging Market: Exxon Mobil, Oil Case

Introduction

JetBlue Airways as a low-cost airline built in 2000 suffered problems of high operation expenses due to the jet fuel costs have substantially increased since 2005. To lessen this, JetBlue was using derivatives contracts on WTI oil as the basis for its fuel cross-hedge. However, in 2011, dislocations in the oil market led to a Brent-WTI premium wherein jet fuel started to move with Brent instead of WTI. Faced with hedging losses, several US airlines has changed their hedging strategies, moving away from WTI. But some analysts worried that the Brent-WTI premium might be a temporary phenomenon. For JetBlue, it should decide whether continue using WTI as its 2012 fuel hedge basis or switch to other oil products like Brent or heating oil. The decision would base on JetBlue’s fuel hedging program, statistical analysis and the comparison of ‘crack spread’.

Analysis

• JetBlue’s fuel hedging strategy and its impacts

JetBlue has employed a hedging book combined derivatives contracts including crude call options, crude 3-way collars, heat collars and jet fuel swaps (referring to Exhibit 9) and not hedging to minimize the a risk from price volatility. Firstly, crude oil call options as the largest part of JetBlue’s hedging position can be treated as insurance to protect the jet fuel price increasing. As shown in Exhibit 5, crude oil and refined petroleum price experienced a decreasing in 2011. This decline may be influenced by the glut on Cushing WTI market. An assumption can be reasonable that this situation of oversupply may remain in the coming years, so the price of WTI has a higher possibility to keep decreasing in 2012 with little fluctuation. As the result, JetBlue might suffer a great loss if the price of jet fuel decline dramatically. Secondly, by crude and heating oil collar are aimed to lock the fuel price in a specified range of prices by giving up potential savings from price decline while hedging against further increases. Thirdly, JetBlue imported USGC jet fuel swaps that allow it to fix the relatively low fuel price. In fact, the spot price of USGC jet fuel had fallen to lower than the fixed one would suffer a loss on this hedge.

However, by using these hedge instruments force the company to face several risks such as market risk caused by the price fluctuation on jet fuel. On the other hand, as exchange-traded derivatives are not available in the United States for jet fuel, so airlines must use futures contracts on commodities that are highly correlated with jet fuel, such as crude and heating oil.: (1)

From Exhibit 4, JetBlue showed Price prediction

As shown in Exhibit 4, crude oil and refined petroleum price begin to increase in 2009 and reach the top in half of 2010, then keep decreasing to the end of 2011. This decline may be influenced by the glut on WTI market. According to previous speculation, this situation of oversupply may remain in the coming years, so the price on jet fuel has a higher possibility to keep decreasing in 2012 with little fluctuation.  

1. Structure of hedging

As the basis of JetBlue’s hedges, a call option should be purchased to hedge the risk from jet fuel price rising. However, as jet fuel price tends to decrease, the portion of call option should be smaller than before. However, collars on crude oil, heating oil and jet fuel should be built for diversification to reduce basis risk, price risk (market risk) as well as the risk from high cost on derivatives. Lastly, a swap contract is necessary to lock the jet fuel price to hedge the negative effect caused by price fluctuation.

• The hedge effectiveness judged by the correlation analysis (between the jet fuel price and Crude oil (WTI and Brent), heating oil as well).
• The basis risk measured by crack spread

between the fuel, crude oil and heating oil.As we need to make a decision that would Jetblue continue using WTI for its hedges, or it switch to other selected basis for hedge. The following analysis would base on three considerations: (1) the fuel hedging program and fuel management approach, (2) statistical analysis supporting a correlated relationship between the underlying commodity in the derivative financial instrument and the risk being hedged (i.e. aircraft fuel) on a historical basis and (3) cash flow designation for each hedging transaction executed, to be developed concurrently with the hedging transaction. This documentation requires we estimate forward aircraft fuel prices since there is no reliable forward market for aircraft fuel. These prices are developed through the observation of similar commodity futures prices, such as crude oil and/or heating oil, and adjusted based on variations to those like commodities. Historically, our hedges have settled within 24 months; therefore, the deferred gains and losses have been recognized into earnings over a relatively short period of time.

• Fuel hedging program and fuel management approach

• Threaten: Increase in aircraft fuel costs

The demand for petroleum and related products has historically been cyclical and sensitive to the availability and prices of oil and related feedstock. Historically, international prices of crude oil and refined products have fluctuated widely due to many factors that are beyond the control of companies like JetBlue. Fuel prices and availability are subject to wide price fluctuations based on geopolitical issues and supply and demand, which can neither be controlled nor accurately predicted. According to IATA (International Air Transport Association), in 2011, price of jet fuel rose by about 39% over the year, giving the average price of jet fuel in 2010 as $91.4 per barrel and the price in 2011 as $127.5. IATA estimates that the jet fuel prices would increase to $127.7 in 2012. This would add $1 billion to the industry fuel bill.

In FY2011, fuel costs represented nearly 40% of JetBlue’s total operating costs. Significant changes in fuel prices can therefore have a considerable effect on the company's result. The increase in global and regional oil prices exposes the company to extreme fluctuations in earnings, which is likely to have an adverse consequence on its growth initiatives. Thus, any increase in aircraft fuel costs could negatively impact the company’s operations which in turn pressurize its margins and profitability.