A scheme designed to protect one of China’s largest airlines from volatile fuel prices wound up showering the company in red ink.
Wen Xiu and Li Qing 18 March 2009
China Eastern Airlines Co. Ltd. is stuck in a financial quagmire after adopting an uncommon hedging strategy that some say smells like speculation.
The company, one of China’s big three airlines, reported a massive amount of red ink for 2008 based on falling passenger demand brought on by the global economic downturn, as well as huge fair value losses tied to fuel derivatives hedging.
Soon the airline is expected to be stamped “ST” for “special treatment” -- a warning label slapped on public companies in China that carry substantial financial risk. It’s already qualified for a bailout from the Chinese government, which injected 7 billion yuan in February.
China Eastern announced its significant loss for 2008 in mid-January. Dragging down the annual report were 6.2 billion yuan in fair value losses tied to fuel hedging contracts. The report said the downturn began in the third quarter, when the airline posted a loss of 2.3 billion yuan, after a moderately successful first half.
China Eastern’s hedging began in 2003, according to company documents. But any losses were relatively limited before 2008. Things got out of hand when oil prices fell drastically in the second half of 2008, plunging to the current level of US$40 from about US$150.
China Eastern hoped hedging would fix its jet fuel costs at advantageous levels. The idea took root in 2007, when the company got permission from its board of directors to hedge 35.9 percent of its projected fuel needs for 2008.
But there was a problem. Based on China Eastern’s announcement and fuel-related derivative contracts, it appears the contracts failed to adequately lock out risks from rising oil prices. At the same time, the contracts greatly increased potential risks from falling prices, putting China Eastern in more danger than industry peers that also practice fuel hedging.
As a result, questions have been raised about the entire hedging scheme. Some wonder whether the company went too far with a strategy that turned price hedging into risky speculation.
“This sort of ‘hiding’ strategy looks suspiciously like speculation,” said a trader of a state-owned enterprise who prefers to remain anonymous.
A China Eastern contract for derivatives obtained by Caijing from a well-known international investment bank offers some clues. The contract included a call option for hedging, but covered the cost of the call option by selling two puts.
Huang Ming, an economics professor at Cornell University’s Cheung Kong Graduate School of Business, analyzed the contract text for Caijing without being given specific information about the transaction.
The gist of the contract was that when the price of oil exceeded US$ 118 per barrel, an investment bank would pay China Eastern the difference between the higher amount and US$ 118, but no more than US$ 20 per barrel. Thus, China Eastern had no protection if the price rose above US$ 138. The contract also said that if the price of oil fell below US$ 82.75 – with no bottom limit -- China Eastern would pay twice the difference.
As a result, the airline’s costs “increased geometrically as the price of oil fell” below the US$82.75 floor, Huang explained.
The contract also included an extremely rare clause that acted as a buffer. It said, the bank would add money to a reserve fund proportional to the amount over a US$110 floor but, in a given contract period, no more than US$10 per barrel.
Huang gave this example: Assume the average price of oil in a given month is US$115 and the airline buys just one barrel. Since it’s less than the US$118 ceiling stipulated in the contract, the bank does not compensate the airline. But the price is five dollars over the US$110 buffer line, so the bank puts five dollars into the reserve fund.
But for each dollar the price of oil falls below the US$82.75 limit, the airline must pay the bank two dollars. So if price of oil falls to US$81.75 -- a dollar below the limit – in the next month, the airline would pay the bank two dollars from the reserve fund, leaving three dollars in the fund. If the price falls to US$ 79.75 in the next month, the airline owes the bank six dollars. The reserve covers half that amount, but the airline pays the rest.
Huang guessed that, without the buffer clause, the contract’s bottom trigger price would likely have been much lower than US$82.75. Conversely, the buffer clause probably helped the bank persuade China Eastern to raise the upper limit to US$118.
These contract terms are unconventional, Huang said. “On the surface, it looks like a good thing for the company,” he said. “But in reality, it is simply one of the bank’s bargaining chips.”
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How Hedging Cost China Eastern Billions
A scheme designed to protect one of China’s largest airlines from volatile fuel prices wound up showering the company in red ink.
Wen Xiu and Li Qing
18 March 2009
China Eastern Airlines Co. Ltd. is stuck in a financial quagmire after adopting an uncommon hedging strategy that some say smells like speculation.
The company, one of China’s big three airlines, reported a massive amount of red ink for 2008 based on falling passenger demand brought on by the global economic downturn, as well as huge fair value losses tied to fuel derivatives hedging.
Soon the airline is expected to be stamped “ST” for “special treatment” -- a warning label slapped on public companies in China that carry substantial financial risk. It’s already qualified for a bailout from the Chinese government, which injected 7 billion yuan in February.
China Eastern announced its significant loss for 2008 in mid-January. Dragging down the annual report were 6.2 billion yuan in fair value losses tied to fuel hedging contracts. The report said the downturn began in the third quarter, when the airline posted a loss of 2.3 billion yuan, after a moderately successful first half.
China Eastern’s hedging began in 2003, according to company documents. But any losses were relatively limited before 2008. Things got out of hand when oil prices fell drastically in the second half of 2008, plunging to the current level of US$40 from about US$150.
China Eastern hoped hedging would fix its jet fuel costs at advantageous levels. The idea took root in 2007, when the company got permission from its board of directors to hedge 35.9 percent of its projected fuel needs for 2008.
But there was a problem. Based on China Eastern’s announcement and fuel-related derivative contracts, it appears the contracts failed to adequately lock out risks from rising oil prices. At the same time, the contracts greatly increased potential risks from falling prices, putting China Eastern in more danger than industry peers that also practice fuel hedging.
As a result, questions have been raised about the entire hedging scheme. Some wonder whether the company went too far with a strategy that turned price hedging into risky speculation.
“This sort of ‘hiding’ strategy looks suspiciously like speculation,” said a trader of a state-owned enterprise who prefers to remain anonymous.
A China Eastern contract for derivatives obtained by Caijing from a well-known international investment bank offers some clues. The contract included a call option for hedging, but covered the cost of the call option by selling two puts.
Huang Ming, an economics professor at Cornell University’s Cheung Kong Graduate School of Business, analyzed the contract text for Caijing without being given specific information about the transaction.
The gist of the contract was that when the price of oil exceeded US$ 118 per barrel, an investment bank would pay China Eastern the difference between the higher amount and US$ 118, but no more than US$ 20 per barrel. Thus, China Eastern had no protection if the price rose above US$ 138. The contract also said that if the price of oil fell below US$ 82.75 – with no bottom limit -- China Eastern would pay twice the difference.
As a result, the airline’s costs “increased geometrically as the price of oil fell” below the US$82.75 floor, Huang explained.
The contract also included an extremely rare clause that acted as a buffer. It said, the bank would add money to a reserve fund proportional to the amount over a US$110 floor but, in a given contract period, no more than US$10 per barrel.
Huang gave this example: Assume the average price of oil in a given month is US$115 and the airline buys just one barrel. Since it’s less than the US$118 ceiling stipulated in the contract, the bank does not compensate the airline. But the price is five dollars over the US$110 buffer line, so the bank puts five dollars into the reserve fund.
But for each dollar the price of oil falls below the US$82.75 limit, the airline must pay the bank two dollars. So if price of oil falls to US$81.75 -- a dollar below the limit – in the next month, the airline would pay the bank two dollars from the reserve fund, leaving three dollars in the fund. If the price falls to US$ 79.75 in the next month, the airline owes the bank six dollars. The reserve covers half that amount, but the airline pays the rest.
Huang guessed that, without the buffer clause, the contract’s bottom trigger price would likely have been much lower than US$82.75. Conversely, the buffer clause probably helped the bank persuade China Eastern to raise the upper limit to US$118.
These contract terms are unconventional, Huang said. “On the surface, it looks like a good thing for the company,” he said. “But in reality, it is simply one of the bank’s bargaining chips.”
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