Air Canada is Canada's largest domestic and international airline, providing scheduled and charter air transportation for passengers and cargo. The airline industry has suffered many difficulties and financial setbacks in the past decade. The high costs associated with operating an airline have claimed many "victims," including Canadian Airlines, which was purchased by Air Canada in 2000 in a highly publicized takeover battle. One of the largest cost components on Air Canada's income statement is aircraft fuel.
Since aircraft fuel is a commodity good, its price is subject to significant fluctuations. The cost of a barrel of aircraft fuel is determined by supply and demand relationships and other global economic conditions that affect production. As a result, Air Canada, like all other airlines, faces a high amount of uncertainty about the cost that it will be required to pay for aircraft fuel. In order to reduce the uncertainty and attempt to limit exposure, Air Canada uses a fuel hedging strategy to manage the risk. The notes to the company's financial statements describe the airline's strategy for its fuel hedging and provide additional disclosure as follows:
Fuel Price Risk
In order to manage its exposure to jet fuel prices and to help mitigate volatility in operating cash flows, the Corporation enters into derivative contracts with financial intermediaries. The Corporation uses derivative contracts on jet fuel and other crude oil-based commodities, heating oil and crude oil. Heating oil and crude oil commodities are used due to the relative limited liquidity of jet fuel derivative instruments on a medium to long-term horizon since jet fuel is not traded on an organized futures exchange. The Corporation's policy permits hedging of up to 75% of the projected jet fuel purchases for the next 12 months, 50% for the next 13 to 24 months and 25% for the next 25 to 36 months. These are maximum (but not mandated) limits. There is no minimum monthly hedging requirement. There are regular reviews to adjust the strategy in light of market conditions. The Corporation does not purchase or hold any derivative financial instrument for speculative purposes.
During 2009, the Corporation purchased crude-oil call options. The premium related to these contracts was $6.
As of December 31, 2009, approximately 18% of the Corporation's anticipated purchases of jet fuel for 2010 are hedged at an average West Texas Intermediate ("WTI") capped price of USD$95 per barrel and approximately 10% is subject to an average floor price of USD$96 per barrel. The Corporation's contracts to hedge anticipated jet fuel purchases over the 2010 period are comprised of crude-oil based contracts.
Instructions
Discuss the various accounting issues that arise as a result of Air Canada’s aircraft fuel hedging strategy. Specifically, discuss whether or not it makes sense for the company to use hedge accounting (which is optional) and from an accounting perspective, what type of hedge this is.