Huge fuel hedging gains helped Air China post the biggest first-half profit since it went public five years ago. Nevertheless, China's national flag carrier anticipated a bumpy ride ahead for its domestic flights, rocked by cut-throat competition at home.

Air China booked 2.9 billion yuan ($424.5 million) in net profit for the six-month period ended June, 155.3% higher than 1.1 billion yuan ($161.0 million) that the airline gained in the first half of last year, marking the highest half-year springtime earnings over the past 5 years since its debut on Hong Kong Stock Exchange in December 2004.

The record profit mostly came from the substantial extraordinary gain from fuel hedging. Volatile fuel prices shot up in the second quarter of this year and thus greatly increased the fair value of Air China's fuel hedging contracts. The Beijing-based air carrier realized a fair value gain from hedging contracts of 1.5 billion yuan ($219.6 million) as of the end of June, reversing from a loss of 7.2 billion yuan ($1.1 billion) at the end of last year.

That reduced Air China's operating cost by 22%, enabling the company to turn around to positive operating profit of 2.8 billion yuan ($409.8 million), compared with an operating loss of 83.7 million yuan ($12.3 million) last year.

Yet the threat of swine flu hit tourism around the globe. Challenged by the larger-than-expected-slide in international traffic in the first half of the year, Air China carried out an emergency plan to rapidly reallocate its capacity to the domestic market by cutting flights to Europe, the U.S. and Korea, where thousands of swine flu cases were confirmed.

During the first half, Air China carried a total of 19.5 million passengers, 10.9% more than 17.60 million customers in the comparative period last year. Passenger revenue, however, was down 7.1% to 19.2 billion yuan ($2.8 billion). Cargo revenue also fell 46.2%, to about 2 billion yuan ($292.7 million). As a result, total revenue of Air China in the first half was down 9.6% to 23.1 billion yuan ($3.4 billion).

Air China anticipated the impact of the global financial crisis would continue to be felt on the international air passenger and cargo business in the second half of this year. "Despite the increase in demand in the domestic air passenger market, the overly rapid increase in traffic capacity by the domestic airlines and the intensified price competition will affect the ability of the company to improve its yield. Meanwhile, the fluctuation of the exchange rate as well as the rising of fuel price will further increase the difficulty of the Company's operation," said Kong Dong, Chairman of Air China.

The severe competition among domestic carriers, plus its failure in the battle of acquiring Shanghai Airlines from China Eastern Airlines, made Air China realize that the aviation market at home is dominated by companies from Shanghai. So Air China looked for overseas expansion. It announced last week it would pay 6.3 billion Hong Kong dollars ($812 million) to lift its stake to nearly 30% in Cathay Pacific Airway。 a Hong Kong-based international airline, enhancing its chances to evolve into a world-class carrier.

Ally Ma, an analyst with Citi in Hong Kong estimated fuel costs would be the biggest hurdle for Air China in the next six months. "Soaring oil prices and the absence of domestic fuel surcharges may hinder earnings. The second half fuel hedging gains/losses are largely up to the year-end oil price, while rebate of government levies will not persist," Ma said in a research note.