By staff reporters Zhang Yuzhe and Eva Wu

(Caijing.com.cn) An investigation into the big three state-owned airlines' fuel hedging activities is still ongoing despite fair value gains that have allowed them to show paper profits, a source from the State-owned Assets Supervision and Administration Commission told Caijing on Friday.

Air China Ltd (SSE: 601111, HKEX: 0753), China Eastern Airlines (SSE. 600115, HKEX.0670, NYSE.CEA) and China Southern Airlines (SSE:600029, HKEX.1055, NYSE.ZNH) all posted fair value gains on their fuel derivative contracts in their most recent financial reports covering the third quarter.

However, the focus of the investigation by SASAC is on compliance by the state-owned enterprises, rather than whether their positions are profitable, the source, who declined to be identified, said.

"If they fail to comply with the rules, even if they make huge hedging profits, it will still be a problem," the source said.

An investment banker who declined to be identified told Caijing that several international investment banks have settled disputes with state-owned enterprises over their derivatives contracts as these SOEs' positions are now in the money, eliminating the need for additional deposits.

The hedging contracts of the three airlines will expire in 2011. When asked if Air China would need SASAC's approval to extend the contracts, a source from the airline told Caijing: "It's a commercial activity."

"SASAC won't take part in or intervene in the operations of enterprises. The transactions between enterprises and investment banks are the enterprises' own business," the SASAC source added.

A Caijing report in late August found that six SOEs, under instructions from SASAC, sent legal notice to international banks of their intent to cancel overseas derivatives contracts. SASAC then issued an online statement on Sept. 7 saying it supported the companies' efforts to protect their interests via negotiations and legal measures. SASAC did not identify the six companies and their banks.

Some SOEs suffered huge losses on overseas hedging contracts last year. The decline in crude prices saw the value of airlines' fuel derivatives contracts shrink substantially. This prompted a government investigation into their hedging activities in February 2009.

However, with crude prices rebounding this year, the fair value of airlines' derivatives holdings has risen.

In the first half, China Eastern booked an unrealized profit of 2.79 billion yuan related to changes in the fair value of fuel derivatives. Air China posted a 1.45 billion yuan profit for the same period.

1 yuan = 14 U.S. cents

Full article in Chinese: http://www.caijing.com.cn/2009-11-06/110305827.html