The airline takes out a hedge on fuel prices - usually on a year by year basis and the hedge is made up of two basic components: the actual price of the fuel and the amount of fuel to be edged. (it's really three components because time is a component but we've already referenced that)
In this instance the plain english explanation is:
- We didn't use anywhere near the amount of fuel we anticipated and hedged for
- So that means the hedge contract 'wasted' a chunk of money we already paid out to buy that contract
- And accounting rules require that we uhm account for it.. in our accounts..
Not an actual $550-600m loss - but the 'ineffectiveness' of the amount - which might be say $50m on that amount.
The reason it's not in plain English is that (and I only learned this formally last month) that there is actually multiple separate englishes which can have their own syntax and even vocabulary. Aviation English is an easier example to explain - it has a set of rules that you wouldn't use in normal english.
Accounting English is an example of a systemic English that uses a lot of the same words..
I do not have a Masters in Linguistics but given the breadth of forum knowledge I am sure someone with more knowledge than me will jump in
Good explanation but not correct.
This is an actual loss, impacts P&L. Q will have to pay out that amount, perhaps delayed so the 30 June 2020 balance sheet does not have the equity component reduced - depends what the external auditors have to say about it. So $550m to $600m of Q's rapidly depleting cash & credit lines has just been wiped. They may attempt some smoke & mirrors by paying a fee to some counterparty (that assumes Q could NEVER go under) to allow them to roll this loss forward to the 2020/21 financial year - it would be a substantial fee of course - but that's in the future reckoning.
In an earlier posts (April/May) on other threads I mention Q's external auditors would want to do a very close examination of what Q has the A380s valued on the balance sheet as at 30 June 2019 & what they're proposing to have them at for 30 June 2020 given a second hand A380 is now valued at zero. Just ask Malaysian Airlines how expensive it is to park almost brand new A380s for a long term, let alone 8+yrs old ones. Rumoured offers to Emirates at a fraction of cost (with pre-purchased/contracted parts thown in) got a polite 'no thanks'.
In Q's previous Annual Reports they took some fuel hedge losses (even at those levels). Q has been quite 'strong' in trying to squeeze the most based on their view aka speculating. They also wrote back their losses on their investment in a listed Travel Agent.
In an earnings release call a little while back Q detailed how it goes about 'hedging' which came out sounding like speculating.
A perfect hedging is where you offset gains on one side with losses on the other. In reality most hedges are slightly imperfect but may cover you to within 1-3% of a perfect hedge outcome.
Speculating is where a company takes a hard view on exactly what the outcome will be +/1 a few %.
I've only ever come across one company that was honest in describing their approach (taking a punt).
True input or cost hedging for something like avgas happens either when you are happy to lock in a certain (known) price that will guarantee you make the required return OR you're fearful that the price may rocket & are willing to lock in a higher price than desired to get rid of that possible outcome.
Q on the other hand 'backs its judgement'. Owners/investors may call this gambling, others speculating & company executives may call it 'hedging'. It also helps generate bonuses when they get it right.
An example - One of the RBA backed & regulated official money market dealers (OMMD) back in the late 1980s did something similar & sold me as a fund manager very cheap long dated put options. As luck would have it I did some research when at Uni into financial modelling's failings. The OMMD also happened to be the poster child in the options market within Australia & paid their staff accordingly. Unfortunately this time they were wrong, did not fully understand their 'proprietary option pricing system' and their view on the future was way out. The amount they lost when I exercised the put options (asked for my insurance payout) wiped out their total retained earnings and all but under $1m of their capital. They returned their license to the RBA 3 weeks later and shut down. The Australian options market has never regained the liquidity it had in the mid to late 1980s sadly. Then some large institutions saw an opportunity and one was unable to meet its margin call (to us) in October 1987....
I am not saying this is what's happened with Q (not going to go out of business due to the hedging loss) but it is a case of when hedging may not be what it seems....
Q reportedly confidentally forecast rising avgas prices, forecast their expected avgas usage and then (normally) 'hedge' 80% or so of that figure. Sometimes less & sometimes more depending on their level of confidence in their price forecasts.
As Q believes it is a very good operator it (according to filings & earnings calls) it looks to maximise its profits (or minimise the cost) on 'hedging' so it sets a bet that its forecasts are correct and implements the least cost way of locking in that outcome. This works until it doesn't. Q seemingly DOES NOT allow for the fact it may be wrong. This has cost it significantly once or twice before, and may even have been written off when it grounded its planes last time....
The cheapest way (close too zero cost) is to buy future contracts (individual contracts with a supplier, sometimes called Forward Rate Contracts) that set out volumes to be delivered across a range of dates at set prices. Q does not seem to hedge this way.
The next (most risk-averse non speculating) method is through buying an insurance product by paying a premium. In the financial markets this is known as buying a call option with the fuel at a certain price when you expect the price to rise. If the fuel price is lower then you buy it at the lower price and let the call options expire worthless. That way, if a situation happens where oil prices fall not rise, you lose your premium but get to buy the avgas at the much lower prices - so if the price had dropped 15% (say, not the current 45% in Q's case) then after the cost of buying the option is included you may get a net fuel price 11% below where the price was when you bought the options (the 4% difference = call option costs).
This way you are covered for both being wrong about the direction of prices +/or over-estimating the volume of avgas you will need.
Q doesn't like doing this....
In Q's case they like to go for sophisticated financial engineering to make it nearly no (apparent) cost to set-up. After all they know with absolute certainty what the future avgas prices will be...
Financial engineering is often not fully understood by the investment bankers that sell it, let alone understand the implicit assumptions used in the financial pricing models (drawing on the rate of thermo dynamic decay equation to solve it...). However, unique solutions for a customer = great fees for the investment bank BUT a big bitter pill for the customer if things do not turn out as predicted in a big way.
Does make you wonder whether the Q Board have sufficient understanding - after all fuel is either the number 1 or number 2 cost for an airline so you would hope the Board had delved into this quite deeply.
Q's earnings per share (adjusted for all their share buybacks) have been falling over the last approx 5-6 years at the same time as they've been selling off or cashing in on assets they owned. Nearly all cash raised from underlying earnings & asset sales has then been used to buy-back shares - so this has the effect of leveraging their earnings per share. If you divide the eps by the proportion of shares bought back you can see what amount of the eps is due to this accounting trick and what has come from actual increased profits.
They certainly have a lot of intangibles in their valuation which you cannot use to borrow money, and it appears possibly no planes left to use as security to raise more credit.
According to one of the top 3 Aviation valuation firms (sometimes used by Q in recent years) - second hand aircraft values for 'in demand' models (B737-800, B787s, newer B777s, recent A330s, A350s etc) had fallen from Dec 31 2019 values by between 16% to 27% by late April.
Hard times for all airlines, and no lessor wants to pull the pin.
