China Eastern and Air China's 2008 fuel-hedge collars

Two carriers, one fuel bill

China Eastern Airlines and Air China, two of China's largest state-owned carriers, both burn large volumes of jet fuel to keep their fleets flying, so a rise in oil prices raises their costs directly and immediately. Both had used fuel-hedging instruments through the 2000s to manage that exposure, and by the middle of 2008 both were running hedge books built mainly from a collar: a bought call option that pays off if oil keeps rising, financed by writing a put option struck below the market. Because the premium received from the sold put roughly matched the premium paid for the bought call, the structure was marketed and booked as "zero cost", with no cash changing hands at the start.

The peak, and the reversal

On 11 July 2008, WTI crude oil traded to an intraday record of about US$147.27 a barrel, then fell fast. Air China's interim results for the nine months to 30 September 2008 already showed a fair-value hedging loss of about RMB 3.1 billion, since oil had begun sliding from its July peak, and the fall only accelerated as the global financial crisis took hold. By December 2008, WTI was trading in the US$30s to low US$40s, a decline of more than 70% from July's high.

The ratio turns against the airlines

Several of the airlines' collars were ratioed, with more puts sold than calls bought, so the written-put side of the book was larger than the bought-call side. As oil kept falling, the bought calls expired worthless, while the sold puts moved deep in the money and had to be marked to a strike far above the collapsed market price. In January 2009, China Eastern issued a profit warning ahead of its full-year results. When the 2008 annual reports were filed, the scale became clear: China Eastern reported an unrealised fair-value hedging loss of RMB 6,256 million, about RMB 6.3 billion, or around US$906 million, part of a full-year net loss of about RMB 15.3 billion. Air China reported a fuel-hedging fair-value loss of about RMB 7.5 billion for the same year.

Paper losses, real consequences

These were fair-value, mark-to-market losses on contracts that were still open, not cash the airlines had actually paid out at the time they were reported. China Eastern went on to receive state capital injections from SASAC, the State-owned Assets Supervision and Administration Commission, including a round of about RMB 7 billion, to shore up its balance sheet after the combined operating and hedging losses. The regulator did not stop there: in 2009, SASAC issued a circular tightening its supervision of derivatives use at central state-owned enterprises, a direct response to this and other SOE derivatives losses that year.

Both airlines were natural hedgers: they buy fuel to operate, so rising oil prices are their risk, not falling ones. A collar combines a long call, which protects against oil rising above a strike, with a short put, written to fund the call's premium. The put is the price of that protection. If oil falls below the put's strike, the airline must settle at that strike, an obligation that has nothing to do with the airline's actual fuel purchases; cheaper fuel is good news for its operations, not a risk it ever needed covering.

The ratio is where the real damage comes from. A ratioed collar, where more puts are sold than calls bought, makes the "zero cost" framing look even better on paper, since the extra premium lets the call strike sit closer to the market. It also means the downside notional on the written puts is larger than the upside protection the airline actually needed. The position stops being a one-for-one hedge and becomes partly a hedge, partly a short-option bet that oil will not fall much. When oil did fall sharply, the mismatch between what the airlines needed (protection against rising costs) and what they had actually sold (a large exposure to falling prices) showed up as a multi-billion-yuan fair-value loss on both hedge books, even as their real fuel bills were falling at the same time.