The government is often forced to bail out financially strapped State entities and/or quasi-government owned companies. Sometimes it works, most times it doesn’t. Then, there’s the point that little is done to fix the factors causing all the mess namely, mismanagement, underfunding, corruption, political interference, moral hazard (read implied government guarantees), to name but a few.
Most of these are fixable (if the will is there), others require careful execution. A good example is the problem of “defective hedges.” This is seen in the cases involving Kenya Airways and East African Portland Cement specifically. While the solution was rightly ordered, missteps around timing and structure produced undesired outcomes. As a result, the government has had to foot the bill. Now, the story behind Portland Cement’s failed currency swap is well told, KQ’s, not so much. I will try.
Before we jump in, here’s some context. At some point, KQ’s hedging strategy shifted from using crude oil futures to crude oil options most likely because of low cost associated with the latter. Specifically, the airline chose a strategy known as a "costless collar" which involves buying Brent crude oil call options and selling Brent crude oil put options.
And this is how it was preferred; KQ will ensure that the premiums received from the sold put options are enough to offset the premiums spent buying the call options, hence the name “costless collar options”. So, assuming KQ believes oil prices will rise in Q3 2024 and elects to hedge against September Brent prices from trading above US $85/BBL, they would buy US $85 September Brent crude oil call options for a premium of say US $1/BBL.
To offset the cost of the US $1 premium associated with the $85 call option, it would also sell US $50 September Brent crude oil put options for a premium of US $1/BBL Now, let’s look at two possible scenarios.
The Up scenario: Average settlement price for the prompt Brent crude oil futures, during the month of September rises to US $100/BBL. In this case, the price KQ spends for its September crude oil consumption will be approximately US $100/BBL. However, because it was hedged with the US $85 call option, it would receive a hedging gain of US $15/BBL. As such, the net price it receives for its September consumption will be US $85/BBL.
The Down scenario: Average settlement price for the prompt Brent crude oil futures, during the month of September drops to US $35/BBL. In this case, the price KQ spends for its September crude oil consumption will be approximately US $35/BBL. However, because it sold the US $35 put options, KQ would have a hedging loss of US $15 on the call options. As such, the net price KQ receives for its September consumption will be $50/BBL.
This is what I believe happened; the down scenario actualised in 2014-15. After peaking at US $108/BBL in June, 2014, oil prices plunged to US$44/BBL by January 2015, a drop of 60 percent in a little over seven months. But because of the zero cost collar option, KQ was buying “expensive” oil while the competition was buying it cheap.
Unfortunately, the hedging loss was in the billions - remember KQ would hedge up to 60 percent of its fuel requirement. In summary, while the structure cost less, it exposed the airline immensely when prices went the other way in a relatively short period.
Mwanyasi is MD, Canaan Capital
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