Yesterday I wrote about Cathay Pacific’s 2016 reported annual loss. The Hong Kong-based airline blamed weak demand for its premium cabin product and fierce competition from Mainland China as the reason. Although I mentioned that Cathay lost money hedging fuel, one reader took me to task for not focusing on that. So today I will.
Reader Mak wrote (bolding mine)–
I think you’ve got this story exactly backwards thanks to poor press reports about CX earnings, and it is a source of continuing fascination to me that reporters in the financial press don’t know how to read an earnings report. Cathay’s loss has little to do with competition — that is the spin that Cathay’s management is trying to sugarcoat this with. In fact, CX had another huge operational profit this year.
Cathay’s earnings results includes a loss of HK$8.46bn on “hedging” the price of jet fuel — that is, wrong bets that the price of jet fuel would rise. Add this self-inflicted wound back into the report, and you can see that CX’s airline is quite a profitable enterprise, and continues to be so despite competition, etc. The even more shocking thing is that this is the second year in a row that CX has had a loss of this order of magnitude (over US$1 Billion!!) in a row.
You seem to think that CX management would prefer if the loss were caused by operations instead of hedging, but you also have this precisely backwards. Of course, CX management would love to blame competition, and things out of its control for the loss, instead of the reality that management is actually directly responsible for the very foolish choices behind this massive loss.
The real story is that management has been running a commodities hedge fund, instead of running an airline, and have lost vast amounts of their shareholders money in doing so. The scandal is even more acute given that CX shareholders own a minority interest in the airlines, and that management has little or no accountability to them.
You should correct the story so as not to promulgate CX management propaganda, as the rest of the media seem to be doing for them.
Is the Fuel Hedging Really the Primary Culprit?
I want to see raw numbers, but the 2016 annual report has not yet been released. We only have this press release from Cathay, which notes but downplays the fuel hedging program.
The interim 2016 report does state–
Lower fuel prices were partially offset by fuel hedging losses.
The Financial Times reports–
Cathay lost HK$8.46bn on fuel hedges in 2016, roughly on par with the HK$8.47bn hedging loss in 2015, as it continued to pay the price for a decision taken in 2015 to protect itself against what it then feared would be high oil prices.
The airline expects to benefit from lower fuel prices this year but is still forecasting a hedging loss for 2017.
So, the answer is YES. Blame the fuel hedging program. Without that, Cathay Pacific would have reported a healthy profit.
What is Worse?
But what is worse — loss due to fuel hedging or loss to do fierce competition?
Mak asserted, “Of course, CX management would love to blame competition, and things out of its control for the loss, instead of the reality that management is actually directly responsible for the very foolish choices behind this massive loss.”
I still take a different view.
The lack of profits are not due to Cathay’s uncompetitive route network or its service or its seats. Nor is it because of the Mainland carriers squeezing it to the point of unprofitably. No, the problem is just one bad decision on fuel. In 2015, Cathay Pacific executives thought fuel would go up in price — I did too. I’m not a fuel expert (Kyle from Travel Codex is welcome to chime in), but I never thought fuel prices would stay so low for so long.
So they locked in a price that turned out to be too high. That is a strategic blunder. A big blunder that should not be missed. But had it paid off, we would all be hailing them now as geniuses. They missed it. Fine. Hopefully they have learned and will guess correctly next time. The good news is the “fundamentals are sound”. Cathay is still running a lean operation with a great product that is otherwise profitable.
CONCLUSION
Let’s be clear — fuel hedges are the primary culprit for Cathay Pacific’s 2016 annual loss. At the same time, I still view management’s blunder on fuel to be less of a concern that asserting that no one wishes to connect in Hong Kong anymore.
Weird pic you’ve chosen to represent to blog,
Check the conclusion, I think you wrote surcharges instead of hedging.
Thanks.
You’re only looking at one side of the equation. We’d need to look at the net impact after considering a gain in the underlying asset, in this case a gain because of lower fuel prices (which is why the hedges resulted in a loss in the first place).
From the 2015 annual report – “…Total fuel costs for Cathay Pacific and Dragonair (before the effect of fuel hedging) decreased by HK$14,561 million (or 37.8%) compared to 2014, despite increases in capacity. A 40.3% decrease in average prices was partially offset by a 4.3% increase in consumption. Fuel is still the Group’s most significant cost, accounting for 34.0% of our total operating costs in 2015 (compared to 39.2% in 2014). Fuel hedging losses reduced the benefit of lower fuel costs. After taking hedging losses into account, fuel costs decreased by HK$7,331 million (or 18.2%) compared to 2014.”
So for FY 2015 fuel costs, including the hedge losses, went down. I suspect that we will see something similar in the 2016 results based on what fuel has done. I don’t think we can blame a bad year solely on hedging when fuel still saved them money.
I don’t think Mark fundamentally understands what hedging is. I think Cathay did the prudent thing by hedging as any airline would. If they had not hedged, then by definition they would be gambling (i.e. running a commodity HF) on the price of fuel instead of concentrating on running an airline operationally. Had they not hedged and fuel prices were back to 2014 levels, they would have lost billions.
AA is printing billions by turning off hedging completely. Hedging sounds like insurance but is more like a very expensive form of gambling when done incorrectly.
I have been a loyal Cathay customer for over a decade. Everything being equal, I would take CX every single time.
Been flying to Europe quite often and taking service, experience and specially price into account, CX doesn’t stand a chance against the middle east carriers.
CX is a nice product to fly but not 50% more expensive nice. I think they need to bite the bullet and price their product accordingly or permanently risk losing market share.
Matt and all, I’m gratified I spurred a discussion on this. As a disgruntled CX shareholder whose shares have not appreciated a penny in 25 years, I’m glad that this is about the only website in the world (including Bloomberg, Reuters, CNBC, and other financial news outlets which simply parrot the Company’s own self-serving analysis of their earnings. Something to be proud of.
I’ll continue to disagree about the spin which CX management has spun this loss with. In my experience, poor managers love to blame competition, the weather, government policies, changing customer preferences, etc., rather than blaming themselves. CX management has taken a position here not merely to hedge their fuel costs, but has made a massive gamble with their shareholders money that the price of fuel would stay high for years in the future. These people were hired as airline managers, and not as commodity fund traders, and their huge bets are an absolute scandal in my opinion.
Somebody above said that management would be gambling by not hedging fuel, but that is reverse logic that can be said about any decision not to gamble — “you are just gambling that you won’t win!” CX management did not merely “hedge” their fuel price, but took a massive long term position in this commodity. It caused a $1 Billion loss in 2015, again in 2016, and they predict that if prices won’t rise CX will suffer another $1B loss on its “hedge” in 2017 — making it virtually impossible for the airline to turn a profit regardless of its operations. There have been a few similar cases of fund managers taking similar outsize positions which tanked their firms prospects, and those things were rightly called scandals. Here you have a non-financial firm, without such expertise, whom have now done the same thing. The press should be asking why they purchased these complex commodity products which they seem not to have understood, which took on financial risk for the airline that was not disclosed, and who convinced them to take these positions (and made a big commission on them).
Again, total fuel costs decreased by ~$1.87 billion even after you subtract out the hedge losses. If we’re dependent on the airline’s fuel costs decreasing by $1.87 billion AND not having any hedge losses in order to turn a profit then I’m pretty sure we’re missing something. Hedge losses when the price of fuel decreases are almost a certainty and not unexpected. The whole point of a hedging program is that you give back some of your gains when things go your way (i.e. pay for hedge losses when you save on fuel costs) so that you can be compensated when things don’t go your way (higher fuel prices offset by hedge gains). Not surprisingly, people only yell when they see hedge losses and will completely ignore that line item when it is a gain.
You appear to have no idea what hedging fuel costs is about. It’s not gambling, it’s about managing future costs. If you do not hedge, you are completely at the mercy of the fuel markets. High, low – you have no idea and thus no control, no ability to plan. If fuel prices go down, you win. If they go up, you lose. The point of hedging is to find some “middle ground” and stake it out. Clearly, this is what they did, and overall fuel costs went down as several other sensible posters have pointed out, thus making their strategy really quite sensible. Not hedging would have been gambling, and as noted, Cathay is an airline, not a gambling firm, and thus gambling on future fuel prices would have been highly irresponsible. Managing their biggest cost input – that’s just prudent.
I think they have also loss a lot of clients due to their changes of Marco Polo Club. I am based in China, and my colleagues used to take CX before the change of MPC, sine HK isn’t too far away, and they provide good services. However, the change of FFP has “disencouraged” people transfer through HK, due to the short distance between HK an China. Most of us were CX Diamonds, but under the current plan, we would only earn CX Gold. There are no reasons that we would be taking CX unless we’re going to HK. My friend also mentioned that there were MUCH LESS silver and golds in the airport. I am not surprised that CX would lose money given how the managements “run an airline”. Its not simply about financial, they only cut cost, but eventually cut their revenue.
Totally agree Travis . I like many colleagues were avid CX loyalists ,in fact for over 20 years ,providing consistent front end cabin dollars to the airline but since the denegration of the Marco Polo club we have all transferred our business elsewhere . Loyalty should be reciprocated and once again management have made a miscalculation which has badly backfired just like the fuel hedging . It is blatantly obvious they are avoiding any form of responsibility for these poor decisions. Change the Marco Polo club to become competitive again and we will all return to the airline we once loved!
As a CX Diamond, who will probably lose that status next year, I couldn’t agree more. I will (and have already) been looking for alternatives when that happens. Right now I put all my travel through Cathay. Once i lose Diamond, I will be looking for the cheapest business class flights (which is never Cathay!) to get the service I want at a price point I can afford, rather than relying on my Diamond upgrades and other benefits. This one was a pure own goal.
You want to see raw numbers showing that the fuel hedging IS the reason for the loss? Look no further than page 20 of this release to the Hong Kong stock exchange:
http://www.hkexnews.hk/listedco/listconews/sehk/2017/0315/LTN20170315142.pdf
I don’t think that you understand how accounting works — most people don’t. The loss is a result of the lowering of the fuel costs, and that is actually a bad thing on the Earnings Statement. Accounting Standards require that the value of the hedging contracts be “marked to market,” that is that the difference between the strike price and the market price today must be listed as a loss on the financial statement. The lower CX’s “fuel cost” the higher the delta in the mark to market, and the larger CX’s loss. The size of the mark to market write off, versus the size of the actual fuel costs, demonstrate just how reckless this bet was. Of course, its not simple or obvious, as most people don’t have MBAs or Accounting degrees, and that’s why CX has been able to finesse the press spin so easily. If CX were a US company, there would likely be a class action lawsuit over the failure to disclose this risk, or for taking it on in the first place, but in Hong Kong there is no such thing, and shareholders are just left holding the proverbial bag.
My comment above was direct at Rob, by the way.
One thing to perhaps wonder, somewhat….
As has been said, most people don’t have MBAs or accounting degrees, and yes, there are differences between mark-to-market losses on a balance sheet and direct, cash-paid out losses from a bank account.
However, one question does come to mind… every such “bet” (ie, hedging contract) has some one on the other side, right? Someone who took the risk in the form of the opposite bet. Usually banks, investment funds, other kinds of professional financiers….
In the case of Cathay, whose parent company is Swire, I can’t help wondering who exactly is on the other side. If it were, in some way, an entity which is also either directly or indirectly related to Swire, (say, for example, a finance house in which Swire holds a significant stake), would this qualify as a form of money-laundering?
@CuriousJoe That is a very interesting question, but — putting to one side that Swire is not in any business like that — they would have little corporate incentive to take money from one pocket to put in the other. We also know that because of Cathay’s loss, Swire had to cut its own dividend, so the loss isn’t found offset somewhere on Swire’s P&L. Byt you are right that somebody had the other side of this trade, and made a profit, and some firm also made a commission selling them the hedges. There have been many scandals in Europe and the US about financial services firms selling gullible clients unsuitable trades, that the financial services firm is on the other side of. I would hope that CX is investigating how and why this happened to see if there are such responsible parties, but they seem happy to sweep this under the proverbial rug.
@Mak, you seem to know a lot of about finance and accounting and yet you thought it was a good idea to invest in an airline and not only that but to do so for 25 years? You’re write, the mark to market write-offs show how high they were hedging, but to not hedge such a volatile commodity, that would be truly reckless. Because to run an airline knowing that your biggest cost is subject to change on a whim is akin to gambling away your shareholder’s money. I forget what they hedged at, but let’s say you hedge 30% of your fuel at $90 and you still make a loss. The real underlying reason behind the loss is because you were unable to earn revenues in an environment where 30% of your fuel was being bought at $90. Only a few years ago, fuel was way above that price. That means in that year, given the current economic climate and competitive landscape, CX would have made a huge loss even if they had hedged at a very low price. You hedge so that you have clarity in terms of what your break even point will be and then you set your revenue budget at a healthy margin above that so that overall you’re getting a healthy ROCE. Imaging a world where CX weren’t holding hedging contracts but were paying 70% of fuel at 40ish dollars and 30% at 90….that’s what they have right now. And you make a loss. If you know going in that you are operating with those costs and you can’t turn a profit, then you have an acute revenue problem. That’s not to say they shouldn’t cut cost and operate more efficiently because they should (across airlines, CX has some of the highest non-fuel related costs), but the revenue side is the most worrying…for an airline that doesn’t have government backing like the ME carriers or the benefit of going into Chapter 11 like all the major US carriers, CX needs to operate prudently and contrary to what most people think, hedging is the right way to go. Perhaps they could have taken shorter contracts (probably at a higher cost again), but the simple fact is they need to hedge and probably more aggressively than other carriers given their precarious position…
Conclusion: I connect in Hong Kong as from Melbourne to Paris, the flights are all at night … Flat J Class beds … HKG is safe and Cathay;s service is V good.
Cathay Pacific is pretty full for most of their CX and KA flights for both B and Y classes. This makes more revenue from ticketing difficulty.
Cons for this company:
1. Fuel hedge, everyone knows of this.
2. Delay penalty arises from waiting of transit passengers from Mainland China.
3. Pretty well no fuel efficient new aircraft. Average life of CX aircraft is 17.5 years. Fuel was cheaper then. CX has nil A380, 787, and only a few A350.
Options for return to profit:
1. Downsize company by terminating the leases of oldest air crafts.
2. Change ticketing prices for flights initiating from PRC. Beijing -SYD return B class is at about RMB19,000, Shanghai-SYD return B-class is about RMB17,000. But HKG-SYD return B-class is over HK$32,000.
Easiest option:
Swire Pacific sells its remaining shares of Cathay to Air China
“If hedging is not the norm in a certain industry, it may not make sense for one particular company to choose to be different from all others. Competitive pressures from within the industry may be such that the prices of the goods and services produced by the industry fluctuate to reflect raw material costs, interest rates, exchange rates, and so on. A company that does not hedge can expect its profit margin to be roughly constant. However, a company that does hedge can expect its profit margin to fluctuate!”