This case explores the fuel hedging strategy of Cathay Pacific Airways Ltd. (Cathay, HKEx: 293).
Cathay’s operating policy was to reduce exposure to fuel price risk by hedging a percentage of its expected fuel consumption. Cathay used fuel derivatives that were economically equivalent to forward contracts to achieve its desired hedging position. Because of the unexpected reductions in airflight capacity due to the COVID-19 pandemic, Cathay’s projected fuel consumption far exceeded its actual consumption. Fuel hedging losses skyrocketed.
Comparing 2020 to 2019, the total fuel cost decreased by HKD18.4bn or 61.8%. Despite the drop in gross fuel costs (i.e., actual costs on fuel consumption) by HKD21.3bn or 71.9%, the fuel hedging losses increased by an astonishing HKD2.9bn or 28.9 times. According to management, this increase in hedging losses was the result of the steep decline in both fuel usage and fuel prices. In 2019, fuel hedging losses were only –2.9% of the operating profit, whereas in 2020, fuel hedging losses contributed to 16.6% of Cathay’s operating losses.
In this case, students will grapple with questions about the accounting treatment and financial analysis surrounding hedging transactions. Students will be asked about the major types of hedges and their accounting treatments. Further, students will be asked about the factors affecting the effectiveness of a hedging transaction and, hence, how this effectiveness can impact the accounting treatment.
On completion of the case, students will be able to:
1. Understand the major types of financial risks
2. Understand the major types of hedges in hedge accounting
3. Adopt the appropriate accounting treatment for cash flow hedges in hedging the financial risks
4. Assess the financial implications and effectiveness of a hedging relationship